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|Federal Income Tax Spring 2003|
Federal Tax (A) Outline
Fundamentals of Federal Income Taxation
Chapter 2 – Identification of Income:
Page 41 -- Income tax is imposed annually – Taxable income is “gross income” less certain authorized deductions
§61 Defines gross income as – all income from whatever source derive.
§61 lists 15 potential sources of income, but is not limited to these sources.
Gross income can potentially be referred to as “gross take” because the definition is so broad.
The term income in the Code and incomes in the 16th amendment may vary in meaning accorded.
Example – treasure trove may not be income to an economist because not recurring, but maybe for tax purposes.
Cesarini v. US – page 42 –
Cesarini purchased a piano in ’57. In ’64 they found $4,300 in cash in the piano, which they included as ordinary income on their ’64 tax return, in ’65 they filed for a refund claiming the money was not ordinary income under §61, and that if the income was ordinary income under §61 it should have been filed in ’57 and therefore the claim by the US is barred by the 3 year statute of limitations, and that if a tax were to be assessed then it should be a capital gains tax. IRS denied the refund, and Cesarini appealed to district court.
Issue: is the found money includable as ordinary income?
Holding: Yes, §61 states, all income shall be included unless specifically excepted, no exceptions are listed for found money. No, statute of limitations bar because the money was not reduced to undisputed possession until ’64 – further found money does not qualify as a gift or capital gains treatment, found money treated as ordinary income within the year it was reduced to undisputed possession.
Concise rule: Found money is treated as ordinary income in the year in which the taxpayer attains uncontested possession of it.
Old Colony Trust Co. v. Commissioner – page 47 –
Company resolved to pay the income taxes of certain officers, including president Wood’s taxes. Wood’s taxes for 1918 and 1919 totaled a little more than $1,000,000. The Commissioner argued that the payment amounted to additional income, and was also taxable as ordinary income.
Issue – Does the payment by an employer of the income taxes assessed against an employee constitute additional taxable income?
Holding: Yes, the payment is considered inconsideration of services rendered, the form of payment is irrelevant. The payment is not considered a gift, even though the payment was entirely voluntary it is nevertheless compensation.
Concise rule – The payment by a employer of income taxes assessed against his employee’s constitutes additional taxable income to the employee.
Commissioner v. Glenshaw Glass Co. (1955) – page 51 –
Two cases representing identical issues were consolidated for review. Glenshaw sued a supplier for fraud and antitrust violations seeking compensatory damages and exemplary damages for the fraud and treble damages for the antitrust violations. A settlement was reached and Glenshaw received $800,000 of which $325,000 represented punitive damages. Goldman theaters sued corporation for antitrust violations and was awarded $375,000 representing treble damages of sustained loss of $125,000, $250,000 was punitive. Neither company reported the punitive damages they won. The IRS assessed tax deficiencies against both.
Issue: Does the general definition gross income include all amount recovered as the result of a lawsuit that represents an increase in wealth to recipient rather than compensation for non-contractual losses?
Holding – Yes, the general definitions of gross income concludes by including as gross income, gains and profits and income derived from any source whatsoever, this broad language has consistently been given broad application.
Concise rule – The general definition of gross income includes all amounts recovered as the result of a lawsuit that represents an increase in wealth to recipient and not merely compensation for non-contractual damages.
Charley v. Commissioner (1996) – page 54 –
Note on Page 56 –
Glenshaw attempts to define gross income, when it refers to undeniable accessions in wealth, clearly realized, and over which the taxpayers have complete dominion. This obviously does not include loans, loans are based on concurrently acknowledged obligation to repay which, offsetting the receipt, negate an accession of wealth. A security deposit maybe likened to a loan, in Commissioner v. Indianapolis Power and Light, the Supreme court concluded that a contractual arrangement between customers and the power company cast a deposit as a loan to the company, but if the company has no intention to give this back, “repay the loan” it becomes an illegal appropriation of the would-be creditor and is considered income under §61.
The Court in James v. US – deciding that illegal gain is income despite a legal obligation to make restitution. The court said that both lawful and unlawful are comprehended in the terms of gross income, extortion, kidnapping bribes, graft, black market gains, most all illegal gains are taxable since the revision of the code specifically excluded the word lawful from the gross income definition where previous versions included the word “lawful gains.”
In more recent cases, the Commissioner has been successful at attempts at taxing illegal gains from narcotics sales.
Page 59 – Income without Receipt of Cash or Property –
Regulations sections 1.61-2(a)(1), - 2(d)(i)
Helvering v. Independent Lifer Insurance Co. – Page 60 –
Independent owned an office building. Independent occupied a portion of the building for its own use. The IRS alleged that fair market value of the rental space should be included as income by independent. Independent brought suit alleging that article 1, §9, Cl. 4 of the Constitution mandated against such construction of the tax law, since it merely saved money by occupying a portion of its own building an no income was ever realized.
Issue: May the IRS tax the owner and occupier of a building for its fair rental value?
Holding – No, Article 9, §1 Cl.4 of the Constitution requires the apportionment of direct taxes. The tax assessment herein is on property, not income. The insurance company did not receive an income, it merely used already taxed funds to save money on its own building. The 16th amendment required direct taxes to be apportioned between the states. Taxing of space occupied by the owner of the building is a direct unapportioned tax, which is unconstitutional. Judgment for Independent.
Concise rule – The rental value of buildings used by their owners is not taxable income.
Page 60 – Revenue Ruling 70-24:
Situation 1 – a painter and lawyer barter for the exchange of services.
Situation 2 – Landlord takes a painting in exchange for six months rent.
Law: Applicable sections are §61(a) and 1.61-2 relating to compensation of services
Sections 1.61-2(d)(1) – provide that if services are paid for in means other than money, the fair market value of services at time must be included as income. If services were rendered at a stipulated price, such price will be presumed to be the fair market value of the compensation received in the absence of evidence to the contrary.
Situation 1 – the fair market value of exchanged services is to be included as income under §61.
Situation 2 – The fair market value of both the painting and six months rent for both parties are includable as income under §61.
Dean v. Commissioner (1951) – page 61 –
Dean and his wife were the sole shareholders of the Nemours Corporation. They occupied a residence which was owned by Mrs. Dean prior to their marriage. The residence was transferred to Nemours to secure a bank loan for the corporation. The Dean continued to live in the house but paid no rent to Nemours. The commissioner sought to include the fair market rental value of the house and the tax court agreed. Dean Appealed.
Issue: Does fair rental value of premises occupied by a taxpayer without payment of rent constitute income, which must be included in such taxpayer’s gross income?
Holding: Yes, Taxpayer provided a family home, the property was held by the corporation, and the fair rental value therefore became income to him. The fair rental of a premises occupied by a taxpayer without payment of rent constitutes income which must be included in such taxpayer’s gross income. Affirmed.
Concise rule – The fair rental value of premises occupied by taxpayer without payment of rent constitutes income, which must be included in such taxpayer’s gross income.
Chapter 3 –
The Exclusions of Gifts and Inheritances – Page 63
Applicable Code § 102(a) and (b) first sentence
Regulations: 1.102-1(a) and (b)
Congress has been unwilling to rely on unexplained gross income, two series sections set out certain specific items that are either includable or partially includable as gross income: §71 – 90 and §101 – 137 but these sections are not exhaustive
General definitions of gross income §61 – list 15 items still not a exhaustive list
Important note – When an explicit statutory rule applicable it takes precedence over the general definition. Example, interest is an illustration of an item of gross income specified in §61(a)(4), but there are explicit statutory exclusions for this, §103(a) gross income does not include interest on some state or local bonds.
There is no single definition of gross income that will answer all the questions that may arise; but there is a kind of checklist that may help:
Gross income includes receipts of any financial benefit, which is –
A simple long-standing exclusionary rule is found in §102 – the exclusion from income tax for inheritance – this can be read literally.
Securities received that produce dividends must be treated as income - §102(b)(1)
Page 64 - Irwin v. Gavit, the Supreme Court held that language such as it now appears in §102(a), excluding from gross income property by bequest, did not exclude a gift of the income from property – this is codified in §102(b)(2).
Page 64 –
B. The Income Tax Meaning of Gift – §102(a)
Commissioner v. Duberstein -
Duberstein (P) through his company had conducted business dealings with Berman, the president of another corporation, P gave Berman many good business leads and Berman decided he wanted to reward P with a Cadillac as a gift. P initially refused the gift but finally gave in. Berman’s company later deducted the car off their corporate taxes as a business expense. Second consolidated case, Stanton, Comptroller of church resigned, the board of the church decided to give him a $20,000 departing bonus in appreciation of services rendered.
Issue: Were the car received by Duberstein and the money received by Stanton given with a detached and disinterested generosity and thus gifts under §102.
Holding – No, the car received was taxable income- but the court reversed the decision in Stanton because the factual findings did not show the legal standards. In reaching its decision the court first rejected the government’s definition of a gift (all transfers of property made for personal and not business reasons) on the grounds that such a definition was too concise and not suitable for all factual situations that may arise. As such, a gift is not shown by the mere absence of legal or moral duty to make a payment, or from lack of economic incentive; where payments are made for compensation. As a general rule a gift will be found where “it proceeds from a detached and disinterested generosity, out of affection, respect, admiration, charity, or like impulses, and it is the donor’s intention which is controlling as to those factors.
Concise rule: In order to be a gift under §102, amounts received must have been given with a detached and disinterested generosity.
Page 75 –
C. Employee Gifts - § 102(c), 274(b). See §74(c); 132(e) and 274(j)
Regulations § 1.102 –1 (f)
§102(c)(1) is fairly straight forward – An employee “shall not exclude from gross income any amount transferred by or for an employer to, or for the benefit of an employee – the 1986 reform act makes no specific exception, except in passing as follows:
Except to the extent that new section 74(c) exclusion or section 132(e) applies, the fair market value of an employee award (whether or not satisfying the definition of an employee achievement award) is includable in the employee’s gross income under §61, and is not excludable under §74 or §102 (gifts).
Legislative history is lacking, but the statute seems to indicate a broad congressional intent to deny “gift” classification to all transfers by employers to employees.
The regulations recognized to tax all transfer would be unfair so its carves out certain exceptions, “extraordinary transfers to the natural objects of an employer’s bounty *** if the employee can show the transfer was not made in recognition of an employee’s employment.
To additional exceptions - §102(c) inclusion rule. Under §132(e) certain traditional retirement gifts are treated as de minimis fringe benefits; second under §74(c) certain employee achievement awards are freed from tax, these are both examples of specific statutory rules of exclusions to gross income.
§274(b)(1) generally limits the deductible amount of business gifts to $25 per donee per year. As employee “gifts” now are includable in gross income under §102(c), they are not subject to §274(b)(1) ceiling. That ceiling is applicable only to non-employee business gifts.
Page 77 –
D. The Income Tax Meaning of inheritance –
§102(a), (b) and the first sentence of (c)
Regulations §1.102-1(a), (b)
Lyeth v. Hoey
Lyeth’s grandmother left the bulk of her estate to a chuch, the heirs contested this further saying she was under undue influence, a compromise was finally reached whereby by the heirs and the church each got half. The IRS charged a tax where it claimed the money was received by contract and not inheritance.
Issue: Are funds received through the compromise of rights under a will contest income under the tax laws?
Holding: No, Lyeth was one of the heirs, an heir has a right to take under a will or contest it, the money received was for the release of his rights as an heir. Congress did not intend for state law to mandate a different result between states. We hold for tax purposes state law on the nature of a taking is not controlling, where an heir compromises his claim, funds received are not income, they are excluded under §102 as received through inheritance.
Concise rule: Money received from the compromise of a will contest is received through inheritance and is exempt from income tax.
Wolder v Commissioner – page 82:
Wolder (D), an attorney, contracted with a client, Mrs. Boyce, to provide her with free legal services for the rest of her life in exchange for her to leave him her securities. Wolder received about $16,000 from convertible preferred shares. Wolder argued that the bequest was specifically excluded from gross income under §102(a), which provides that gross income does not include the value of property acquired by gift, bequest, devise or inheritance, Wolder appealed an adverse judgment.
Issue: Where a bequest is made to satisfy an obligation under a contract, is it receipt income taxable under §61.
Holding: Yes, where the bequest is made to satisfy an obligation, its receipt is income taxable under §61 and not excludable under §102, Wolder was contracted for services, while limited in nature the services were rendered.
Concise rule – Where a bequest is made by contract to satisfy and obligation, its receipt is income, taxable under §61, and not excludable under §102.
Chapter 4 ---
Limitations in Employment Relationships
A. Fringe Benefits
§132 omit (j)(2) and (5). See §61(a)(1); 79; 83; 112; 120; 125
Regulations - §1.61-1(a), -21(a)(1) and (2), (b)(1) and (2). Also see 1.132-1 through 8.
Section 61(a)(1) specifically includes in gross income “compensation for services”, such compensation may take the form of property paid as well as cash, and it can be directly paid as well as indirectly. The Supreme Court has stated that §61(a)(1) is broad enough to include in taxable income any economic or financial benefit conferred on the employee as compensation.
This section now under takes the concept of fringe benefits, for example coffee provided at work, technically each cup is income, these items are impossible to account for and are considered de minimis anyway. The issue is when the fringe benefits become more substantial, such as travel passes or store discounts.
The 1984 Congress passed a series of enactments that allow for certain fringe benefit exclusion; for example, a retail store that sells clothes will offer discounts to employees to buy and wear their clothes when selling them, this serves as a type of advertising for the stores products, things such as this the committee believes, that employers may provide a broad group of employees, either free or at a discount, the products and services which the employer sells or provides to the public do not serve merely to replace cash compensation.
But this area is still very unsettled, employee in similar situations may have very different outcomes, there is still much unsettled in this area.
An important point is that under this bill most fringe benefits, which may be made available tax-free to officers, owners, or highly compensated employees only if the fringe benefits are also provided on substantially, equal terms to other employees.
The tax law on fringe benefits still completely statutory now, though still subject to judicial and administrative interpretation, if an employee benefit is not specifically excluded from gross income, then it must be included within the meaning of section 61.
Most of the exclusionary rules of the 1984 appear within §132.
§132 excludes fringe benefits for employees and the definition for employees is expanded to include not only persons currently employed but also retired and disabled ex-employees and surviving spouses of employees or retired or disabled ex-employees as well as spouses and dependant children of employees.
§132 excludes the first two classifications of fringes and employee-eating facilities provided to highly compensated employees only if those fringe benefits are offered to all employees on a non-discriminatory basis.
§132(a)(1) – No additional cost services – The first type of fringe benefit excluded from an employee’s gross income under §132 is services provided to an employee by an employer.
Their value escapes gross income if the services are offered for sale to customers in the same line of business as that in which the employee is performing services, the employer incurs no additional substantial charge in providing the service to the employee, and to highly compensated employees as long as it is provided on a non-discriminatory basis.
Examples of no additional cost services include – airline, railroad, or subway seats and hotel rooms furnished to employees, if they are working in their respective business and they do not displace non-employee customers – the exclusion is allowed whether the services are provided at no charge or at a partial charge or rebate program.
Services must be provided in the same line of business as that in which the employee is employed. For example, an employee is an steward for an airline owned by a company that also owns a cruise ship, free standby flights are excludable for employee, spouse and his dependants are excludable but the cruise is not. This is to preclude an unfair advantage for employees of conglomerates.
But is one company has a reciprocal agreement to provide no additional cost services to each other’s employees then they can be excludable.
Page 92 --
Section 132(a)(2): Qualified Employee Discounts – employees may exclude from gross income courtesy discounts within limits.
The code imposes a ceiling on the amount of the exclusions; in the case of services the exclusion may not exceed 20% of the price at which the employer offers the services to the customers. The maximum discount for property is essentially the employer’s gross profit percentage on the goods in the employer’s line of business --
Aggregate sales price reduced by cost / aggregate sales price
Example – Employee works for a home appliance store and her employer has total sales for the entire year of $800,000 and paid $600,000 for the goods sold, the gross profit percentage is 25%:
800,000 – 600,00 / 800,000 = 200,000 / 800,000 = 25%
If the employer allows an employee to buy an item that generally sell for $1000 for $750, the full discount is excludable, anything beyond the discount ($250 in this case) must be reported as income.
132(a)(3): Working Condition Fringe –
Congress allows exclusion for any property or services provided to an employee the cost of which, had the employee paid for it, would have been deductible by the employee as a business expense or by way of depreciation deductions. --- §162 business expenses, §167 depreciation deductions.
Examples of this – use of a company car, or airplane for business purposes, an employers subscription to a periodical for an employee, bodyguard provided, and on-the-job training.
Under §132(j)(3) – a full time auto salesperson can exclude the use value of an employer provided demonstration car if the car is used primarily to facilitate the salesperson’s performance of services for the employer and there are substantial restrictions on the personal use of the car by the salesperson.
§132(a)(4): De Minimis Fringes –
Any property or service whose value is so small as to make accounting for it unreasonable or administratively impracticable is excluded as a fringe benefit, in determining whether an item is within the de minimis concept, the frequency with which similar fringes are provided by an employer to employees must be taken into account.
Examples of above that are excludable – typing of personal letters by a company secretary, occasional personal use of company copying machine, occasional cocktail parties or picnics for employees, occasional sporting of theater tickets, low value holiday gifts—and finally an exception added in the 1986 reform, “traditional” retirement gifts after a long period of service.
§132(a)(5): Qualified Transportation Fringe –
An excludable transportation fringe was added by the 1992 Energy Bill. A qualified transportation provided to an employee by an employer may include:
Transportation in a “commuter highway vehicle” between an employee’s residence and work, a transit pass, token, fare card, voucher, or similar item for mass transit facilities or for a commercial transportation service; and qualified parking provided on or near the business premises or on or near the location form which the employee is picked up by a commuter vehicle; except in cases of qualified parking, the transportation benefit must be provided in addition to and not in lieu of any compensation otherwise payable to the employee. The exclusion applies to cash reimbursements for qualifying items. The exclusion is limited to $60/month for all benefits in the form of commuter highway vehicle transportation and transits passes etc., and $155/month for qualified parking, any amounts paid for qualified transportation which, exceed the limits provided may not be excluded by any other subsection of §132.
§132(a)(6): Qualified Moving Expense Reimbursement –
see also §132(g)
§132(j)(4): Athletic Facilities:
Employee may exclude the use of any on-premises athletic facility, the exclusion applies to: gym, pool, golf course, tennis courts or other athletic facility, located on the premises operated by the employer, if substantially all the facility’s use is by employees, their spouses and their dependant children.
The Statutory Exclusions of Other Fringe Benefits:
An important point - §132 indicates that if another code section provides an exclusion of a benefit, §132 is generally inapplicable to that type.
Other sections that exclude benefits from gross income:
§79 – excludes group term life insurance premiums up to a maximum of $50,000 of coverage from an employee’s gross income, §120 which excludes the value of group legal services, §129 excludes amounts paid by an employer for “dependant care assistance” up to a maximum of $5,000/year. §137 excludes qualified adoption expenses, §112 compensation for military personal, §134 additional military benefits, §125 establishment of cafeteria plans.
Page 97 -
B. Exclusions for Meals and Lodging -
§107, 119(a) and see 119(d)
Herbert G. Hatt (1972) – page 98 –
Hatt married the president and majority stockholder of Johann, a funeral home and embalming business, by antenuptial agreement, Hatt became president, general manager and majority stockholder of Johann. He moved into an apartment located in the building used by Johann for its funeral home business, the building also housed and ambulance crew which picked up the bodies. The telephone which rang in the office also rang in the apartment and Hatt used the place to meet with clients after hours and he also supervised the ambulance crew. Hatt sought to deduct the apartment off of Johann corporate expenses or alternatively deduct it from his own personal expenses. Commissioner denied this because he was not required to live their as part of his employment; it also taxed Hatt on the fair market value of the apartment as a constructive dividend, Hatt contested this.
Issue: Is the value of lodging furnished to an employee excluded from gross income if the lodging is on the business premises of the employer, the employee is required to accept such lodging as a condition of his employment, and the lodging is furnished for convenienc of the employer?
Holding: Yes, IRC §119 grants an exclusion from gross income the value of lodging furnished to an employee if three conditions are met: (1) the lodging is on the business premises of the employer (2) the employee is required to accept such lodging as a condition of his employment (3) the lodging is furnished for the convenience of the employer. Acceptance of lodging is considered a “condition of employment” if the employee must use the lodging in order to enable him to properly perform the duties of his employment, whether the lodging is furnished for the convenience of the employer is subject to the same test. Hatt being president determined himself what was for the convenience of the employer, he required himself to be available around the clock, plus the on-call nature of his work, Hatt Qualified for the exclusion.
Concise rule: The value of lodging furnished to an employee maybe excluded from gross income if the lodging is on the business premises of the employer, the employee is required to accept such lodging as a condition of his employment, and the lodging is furnished for the convenience of the employer.
Note page 100 –
Commissioner v. Anderson – a motel manager was always on-call at a residence owned by the motel owner two blocks away from the motel. The court concluded that ownership was not the test but that the employee performs a significant portion of his business. §119 was held inapplicable because the “on-call” status did not constitute a significant portion of the taxpayer employee’s duties. In Linderman held that a residence adjacent to the motel (across the street) was not geographically separated from the motel and was therefore “on the business premises.”
§119(d) allows an employee of an educational institution to exclude from gross income the value of lodging, not otherwise excluded under §119(a), if lodging is located on or in proximity of the campus of the educational institution. Lodging maybe used as a residence by the employee’s spouse and dependant’s, there is a ceiling amount.
Housing benefits provided to a “minister of a gospel” are excluded from the minister’s gross income by §107, but these have to be furnished to him as compensation, this not only applies to fair rental value of a home actually provided for the minister’s use, similar to §119, but also to a rental allowance.
Chapter 5 – Page 102:
§74, see 102(c); 132(a)(4), (e); 274(j)
Regulations: 1.74-1. Proposed Regulations: Section 1.74-1.
Two major congressional goals in enacting the 1986 revenue-neutral tax legislation – first to broaden the tax base (increase the amount of taxable income subject to the income tax) a second, to lower the income tax rates.
Two principal ways to broaden the tax base: one is to increase the items included in gross income, and the other is to decrease items allowed as deductions
§74 income tax rules on prizes and awards relates to things such as: winning a company’s sales or other contest, Nobel Peace Prize, Pulitzer
§117 – Scholarships and fellowships
§74 now excludes prizes and awards from gross income only in two limited circumstances: first, under the current §74(b) prizes and awards that satisfy the requirements of old §74 (b) are excluded from gross income only if the taxpayer winner designates a governmental unit or §170(c)(1) or (2) charity to receive the award and if the award is transferred directly to the designee without use or enjoyment of it by the taxpayer. – Page 103
Second, §74(c) creates an exclusion for employee achievement awards. This exclusion needs to be considered in conjunction with several other code sections, §102(c) does not include gifts from an employer to an employee within the §102(a) gift exclusion rule. However a gift from an employer to an employee such as a retirement gift after a long period of service may escape gross income inclusion by qualifying as a §132(a)(4) de minimis fringe benefit. §74(c) adds an exclusion or partial exclusion from gross income for the value of certain employee achievement awards ---- An award may qualify if it relates to length of service or to safety, it must be in the form tangible personal property, be awarded as part of a meaningful ceremony, and not be mere disguised compensation. A length of service award does not qualify unless the employee has been in the employer’s service for five years or more and has not received a length of service award for the current or any of the prior four years.
A safety achievement award qualifies only if made to other than a manager, administrator, clerical or other professional employee, and only if 10% or less of the employers employees receive the same award during the same year, it cannot be part of the general pay scale, the amount of the employee exclusion is geared to the extent to which the employer qualifies for a deduction for the awards under §274(j).
Allen J. McDonell (1976) – Page 104:
McDonell was an assistant sales manager for DECO, a bulk milk cooler sales company, at the time McDonell’s wife was interviewed and expected to go on DECO social trips with him. In 1959 a sales contest was held, there were 11 winners that year that got free trips to Hawaii for them and their wives, DECO also decided to randomly select 4 sales managers and send them with the employees, McDonell was selected with his wife and was told to consider the trip an assignment, and not a vacation. If manager were not with the employees the company was afraid the trip would turn into a big gripe session. McDonell did not report the approximately $1122 on this ’59 return, but did report $600 as additional income attributable to his wife’s presence on the trip. The commissioner petitioned the court for deficiency.
Issue: Does all expenses paid business trip constitute taxable “disguised remuneration” when the recipient is required to go as an essential part of his employment and is expected to devote substantially all of his time on the trip to performance of duties on behalf of the employer?
Holding: No, An all-expenses paid trip does not constitute a taxable award under IRC §74 or additional compensation under §61 when the recipient is required to go as an essential part of his employment and is expected to devote substantially all of his time on the trip to performance of duties on behalf of the employer. Although the presence of an employer business purpose does not necessarily preclude a finding of compensation, but maybe taken it into account, this is not conclusive. The McDonell’s were required to take this trip, being selected at random does not make the trip taxable, the random selection was to obviate any discrimination, thus the McDonell’s are entitled to a $600 refund.
Concise rule: An all-expenses paid business trip does not constitute taxable “disguised remuneration” when the recipient is required to go as an essential part of his employment and is expected to devote substantially all of his time on the trip to performance of duties on behalf of the employer.
New developments – since 1986, currently under §74(b) prizes or awards given to recognize achievements in religious, charitable, scientific, educational, artistic, literally, or civic fields are excluded from gross income only if the winner designates a government unit or eligible charity for receipt and if the winner enjoys absolutely no use of the award. §74(c) length of service awards.
B. Scholarships and Fellowships – Page 108:
§117; 127(a) and (b)(1)
Proposed regulations: 1.117-6(b)-(d)
§117(a) excludes from gross income amounts received as a “qualified scholarship” by a degree candidate at an educational organization, the principal requirements here are found in the definition of a qualified scholarship, which is a grant that in accordance with the grant is used for “qualified tuition and related expenses.” Those expenses encompasses tuition and enrollment fees at the educational organization as well as fee, there is no exclusion for amounts which cover personal living expenses, such as meals and lodging, or for travel and research.
Under 117(c) a portion of an otherwise excluded scholarship or fellowship is required to be included in gross income to the extent that the portion represents a payment for teaching, research or other services by the student required as a condition for receiving the otherwise excludable amount.
Educational grants made by an employer, current or former, are generally taxable because they are considered compensation for past, present or future services. This result has been upheld even in cases in which the employee has not contractual obligation to render future services.
Exclusion is allowed for a university athletic scholarship if the university expects but does not require the student to participate in a particular sport, requires no particular activity in lieu of participation, and cannot terminate the scholarship if the student cannot participate. So to qualify for the exclusion there must be a gratuitous or non-contractual flavor to the grant, similar to the gift concept as ultimately developed out of the Duberstein Opinion.
Page 110 ---Two additional related exclusions of educational benefits: first, §117(d) allows a qualified tuition reduction below the graduate level or graduate level if the graduate student is engaged in teaching or research activities. The reduction is made available to the employees of the educational organization, employees is defined in §132(h).
The section invokes the §132 concept of nondiscrimination, §117(d) is applicable to highly compensated employees.
§127 permits an employee to exclude up to $5250 from gross income for amounts paid by the employer for educational assistance. Educational assistance under §127 includes, tuition, books, supplies and employer provided educational course, but does not include assistance for courses involving sports, hobbies, or graduate level courses, such as law, business, medicine, or other advanced academic or professional degree.
Gain form Dealings in Property
A. Factors in the Determination of Gain – page 112
§1001(a), (b) first sentence, (c); 1011(a); 1012
If T lends money to B there is no gain from mere repayment of the principal, repayment constitutes a mere return of capital, no element of gain in this transaction.
§1001(a), which identifies gain on the disposition of property as the excess of “amount realized” over the adjusted basis.”
§1001(b) defines amount realized, as the amount of money received and the fair market value of property (other than money) received on disposition
So if T sells his $10,000 property for $15,000 his unadjusted basis is 10,000 and his gain is 5,000, §1001(c) requires gain to be recognized unless otherwise provided by another code section.
B. Determination of Basis
1. Cost as Basis
§109; 1012; 1016(a)(1); 1019
Regulations: §1.61-2(d)(2)(i); 1.1011-1; 1.1012-1(a)
Philadelphia Park Amusement Co. v. US (1954) – page 113:
Philadelphia obtained a 50-year franchise to operate a railroad service to its park. A bridge was constructed for over $300,000 to operate the railroad. When the franchise was about to expire Philadelphia offered to transfer the bridge to the city in exchange for a ten-year franchise extension. No gain or loss was reported from the transaction. Philadelphia later abandoned the railroad in favor of a bus system. It the attempted to take a loss deduction from its income based on the abandonment of the franchise. The IRS denied the deduction on the grounds the transaction had no value, there had been no taxable exchange so no loss could be maintained. Philadelphia maintained that the value of the franchise was equal to the value of the bridge and it was entitled to take the undepreciated basis as a loss.
Issue: Is the basis of property established as of the date of a taxable transfer?
Holding: Yes, a transfer of assets, except where exempted by statute, is a taxable event. The taxpayer’s basis in the new property is fair market value as of the date of the transfer plus any taxable gain to him associated with the transaction. Where the transfer is at arms length and the new asset cannot be valued, it is deemed to be equal to the value of the asset given up by the taxpayer. While the franchise extentsion cannot be valued the court felt the bridge had some value. The amount should be deemed the basis of the Amusement franchise. The undepreciated value of the franchise as of the date of abandonment was a proper deduction. The failure of the Co. to properly record the transaction originally does not prevent it from later establishing valuations for the purpose of deducting the loss.
Concise rule: Where a taxable exchange of property occurs, gain or loss should be recognized in establishing the basis for the property on the date of the transfer.
Additional notes – If the property is exchanged for other than cash the adjusted basis is the value of the property received, plus any gain which is taxed to the taxpayer as a result of the transaction. If a loss was taken, the adjusted basis is the value of the property received.
Property Acquired by Gift
§1015(a). See §1015(d)(1)(A), (4) and (6)
Regulations: §1.1001-1(e); 1.1015-1(a), -4
Taft v. Bowers (1929) – Page 117:
Taft (P) received appreciated stock from her father as a gift. P later sold the stock for a profit. P paid taxes on the profit from the time she held the stock, no taxes were paid on the time when her father held the stock and it appreciated. The IRS assessed a deficiency on the grounds that the donee takes the donor’s basis, P argued her basis was fair market value at the date of transfer.
Issue: Is the donee’s basis in a gift the same as the donor’s?
Holding: Yes, the donor is exempt from tax if he makes a gift of the property. §202 was a proper vehicle for deferring this tax until the property was ultimately disposed of by the donee by giving him the donor’s basis rather than the value of the asset at the date of transfer.
Farid-Es-Sultaneh v. Commissioner (1947) – Page 119:
Farid (P) was given shares of stock to protect her if her fiancé died before marriage. The stock plus additional shares were given to her in exchange for her promise to marry and the release of marital rights. An antenuptial agreement to this effect was signed. P later married her fiancé and later sold her stock. The commissioner determined the stock had been a gift and that the donor’s basis in the stock should be used to compute the basis and gain.
Issue: Is property transferred pursuant to a release of marital rights and a promise to marry under an antenuptial agreement a gift?
Holding: No, Congress determined that such a transaction required the imposition of a gift tax on such transactions is not dispositive of the issue for income tax purposes. Where, as here, the transfer was not motivated by primarily donative intent and very real property rights were released, there was a bargained for arm’s-length transaction. No gift may be presumed. The construction placed on the transaction for gift tax purposes has no bearing with respect to the basis accorded the transferred property for income tax purposes. Since the court found that the transfer was not a gift, the basis of the property to P was its fair market value on the date of transfer.
Concise Rule: No gift occurs for the purpose of computing the donee’s basis in property received in exchange for a promise to marry and the release of marital rights.
Additional notes: Arm’s length transfers of any valuable inchoate right dispel a gift presumption. If a family member transfers to another family member in exchange for an assignment of heirship rights, if any, bargained for consideration exists unless the value of the transferred property so exceeds the value of the right given up that a donative intent can be inferred, the intent of the donor in such cases is normally controlling.
3. Property Acquired Between Spouses or Incident to Divorce – page 124
Regulations: 1.1041-1T(a) and (d)
Except for the purposes of determining loss on the sale of the property, the basis of property in the hands of a donee is the same basis the property had in the hands of the donor, §1015
§1041 accords almost complete tax neutrality to transfers of property between spouses and between former spouses and between former spouses if, in the latter instance, the transfer is incident to divorce. No gain or loss is recognized, this rule applies whether the transfer of property is for cash or other property, for the relinquiment of marital rights or for any other consideration or for the assumption of liabilities in excess of basis (unless the transfer is to a trust).
When is a sale-purchase not a sale-purchase? When §1041 applies.
Page 125- In the case of any transfer of property between spouses or former spouses, the transferee is treated as if the property were acquired by gift, and the basis of the property in the hand of the transferee is the same as the basis of the property in the hands of the transferor. Unlike the gift basis rule, the §1041 transferee spouse or former spouse always takes a transferred basis, even for computing loss.
Page 126 – Property Acquired from a Decedent:
§1014(a), (b)(1) and 6 (e)
Regulations §1.1014-1(a) – 3(a)
Under §1014(a) property acquired from a decedent generally receives a basis equal to its fair market value on the date on which it was valued for federal estate tax purposes.
The effect of this rule is that it gives the item a “stepped up” basis with no income tax cost to anyone, and of course a stepped down basis occurs without deductible loss if the property declined in value during the decedent’s ownership
§1014 applies not only to property held by the decedent at death, but also to some property that a decedent transferred during life if the value of the property is nevertheless required to be included in decedent’s gross estate for federal estate tax purposes
If appreciated property is acquired by a decedent within the one year period ending on decedent’s death, and if the property passes from the decedent back to the donor or the donor’s spouse the adjusted basis of the property is the same as in the hands of the decedent immediately prior to her death. Example, if a some buys a piece of property for $20,000 worth $100,000, transfers to mom, then upon death mom transfers back the basis is the $100,000; see §1014(e).
C. The Amount Realized:
Regulations: 1.1001-1(a) – 2(b)
International Freighting Corporation v. Commissioner (1943) – Page 128
Dupont owned all the shares of IFC (P) from 1933-1935 and two-thirds of the shares in 1936. During those years, IFC informally adopted Dupont’s bonus plan for its employees. Class B bonuses were awarded to employees who contributed the most to IFC’s success in a general way. The bonuses were funded by profits set aside by IFC. There was no requirement that the entire bonus fund be used, and the program could be discontinued at any time. In 1936, IFC paid to the class B award winners certificates representing 150 shares of Dupont stock, consisting of $16,153.36, and having a market value of $24,858.75. Each recipient paid income tax on the market value of the stock received. IFC took a deduction of $24,858. In a notice of deficiency, the Commissioner reduced the deduction of 16,153, and recalculated IFC’s tax finding a deficiency of $2,156. IFC petitioned the Tax court for a redetermination of deficiency. The Tax court upheld the deduction of $24,858 but also held that IFC realized a taxable profit of $8,705, the difference between the market value and the cost of stock. The deficiency resulting from the decision was the same, $2,156, the decision was appealed.
Issue: Does an employer who pays bonuses in stock realize a taxable gain if the market value of the stock at the time the bonus is paid is greater than the cost of the stock to the employer?
Holding: Yes, an employer who pays bonuses in stock realizes a taxable gain if the market value of the stock at the time the bonus was given is greater than the cost of the stock to the employer. The Tax Court was correct in allowing the deduction for the full market value of the shares as the payment depleted IFC’s assets in an amount equal to that market value. The delivery of shares was not a gift, but compensation for services rendered. The basis of the shares is their cost, and the gain realized is the excess of the amount realized from the disposition over the basis.
Concise rule: An employer who pays bonuses in stock realizes a taxable gain if the market value of the stock at the time the bonus is paid is greater than the cost of the stock to the employer.
Additional note: gain must also be realized under §1002
Crane v. Commissioner (1947) – Page 131:
Crane (P) inherited an apartment building. The building has a mortgage on it which when combined with unpaid interest exactly equaled the estate tax appraisers valuation of the building and property. P did not assume the mortgage, she agreed to remit the net rental proceeds after taxes to the mortgagor, some six years later faced with foreclosure P sold the property and received $2,500 net in cash for it. P included $1250 in her income for the year on the theory that the property was a capital asset; her original basis was zero; and therefore, one-half the profits had to be included as income from the sale of a capital asset. The commissioner levied a deficiency tax, claiming that basis is fair market value at the time of acquisition less allowable depreciation. Therefore, P realized a gain of $2,500 in cash plus six years of depreciation deductions totaling $23,767. P argued that only her equity in the property could be considered as her basis, since it was zero to begin with, no depreciation was allowed, since she only realized $2,500 in cash, this was all that could be taxed.
Issue: Is basis based on the fair market value at date of acquisition rather than equity?
Holding: Yes, §113(a)(5) states that the basis for property received by inheritance is the fair market value of the property on the date of acquisition. Value is nowhere defined or treated synonymous with equity, therefore petitioner’s basis was $262,045 i.e. the fair market value at date of acquisition. The building is subject to wear and tear; see §113(b)(1)(B) requires that proper adjustments to basis shall be made in such cases. Adjusted basis is defined under §113(b)(1)(B) as the basis less allowance for depreciation of he asset whether or not actual deductions were taken. The difference between the selling price and P’s adjusted basis is $23,767; P actually took most of the deductions allowed her by law. P used these deductions to reduce her income; P cannot be allowed to benefit from such a deduction with no corresponding gain as of the date of sale. P actually realized $2,500 in cash plus all her allowable deductions over six years.
Concise rule: In computing basis, it is the fair market value of the property rather than the purchaser’s equity, which determines the basis.
Commissioner v. Tufts (1983) – Page 140:
Tufts (P) and others entered into a partnership with Pelt, a builder who previously entered into an agreement with Farm and Home Savings to transfer a note and deed of trust to the bank in return for a loan to construct an apartment complex in the amount of $1,851,500. The loan was made on a non-recourse basis in that neither the partnership nor the partners assumed personal responsibility for repayment. A year after construction was completed, the partnership could not make the mortgage payments, and each partner sold his interest in Bayles. The fair market value of the property at the time did not exceed $1.4 million. As consideration, Bayles paid each partner’s sales expenses and assumed the mortgage. The IRS assessed a deficiency against each partner, contending the assumption of the mortgage constituted the creation of taxable gain to each of them, which they failed to report. P and the others sued for a redetermination, contending that no gain was realized because the mortgage exceeded the fair market value of the property. The Tax Court upheld the deficiencies and the court of appeals reversed, Cert was granted
Issue: Does the assumption of a non-recourse mortgage constitute a taxable gain to the mortgagor even if the mortgage exceeds the fair market value of the property?
Holding: Yes, The assumption of a non-recourse mortgage constitutes a taxable gain to the mortgagor even if the mortgage exceeds the fair market value of the property. When a mortgage executed the amount is included, tax free, in the mortgagor’s basis of the property. The amount is tax free because of the mortgagor’s obligation to repay. Unless the outstanding amount of an assumed mortgage is calculated in the seller’s amount realized, the money originally received in the mortgage transaction will forever escape taxation. When the obligation to repay is canceled the mortgagor is relived of his responsibility repay the amount he originally received. Therefore he realizes value to the extent of he relief from the debt. When the obligation is assumed it is as if the mortgagor was paid the amount in cash and then paid the mortgage off. As such it is clearly income and taxable. Reversed
Concise rule: The assumption of a non-recourse mortgage constitutes a taxable gain to the mortgagor even if the mortgage exceeds the fair market value of the property.
Additional notes: This case illustrates cost basis of property under §1012 is the cost of the property includeing any amount paid with borrowed funds.
Diedrich v. Commissioner (1982) – Page 147:
Both Mrs. Grant (P) and the Diedrichs (P) had made certain gifts conditioned upon the donee of each gift paying the resulting gift taxes. The cases were consolidated before the Supreme Court to resolve a conflict among the circuits as to whether the commissioner (D) was correct in his position that a donor who makes a gift of property on condition that the donee pay the resulting gift tax received taxable income to the extent that the gift tax paid by the donee exceeds the donor’s adjusted basis in the property transferred.
Issue: Does the donor realize taxable income to the extent that the gift taxes paid by the donee as a condition of the gift exceed the donor’s adjusted basis in property transferred?
Holding: Yes, to the extent the gift taxes paid by a donee as a condition of the gift exceed the donor’s adjusted basis in the property transferred, the donor realizes taxable income. It has been recognized that income may be realized by a variety of indirect means. In Old Colony, payment of an employee’s income taxes by an employer was held to constitute income. In Crane, relief from the obligation of a non-recourse mortgage (in that case the value of the property exceeded the value of the mortgage) was held to constitute income to the taxpayer. The principles of these cases control and dictate that when, as in the cases at bar, the donor realizes an immediate economic benefit by the donee’s assumption of the donor’s legal obligation to pay the gift tax, it can be considered as income.
Concise rule: A donor who makes a gift of property on condition that the donee pay the resulting gift taxes realizes taxable income to the extent that the gift taxes paid by the donee exceed the donor’s adjusted basis in the property transferred.
Additional notes: In essence, the Commissioner treats such conditional gifts as part gift and part sale, it is viewed as sold the property to the donee for the amount of gift taxes paid by the donee (which is generally less than fair market value, the balance of the property is seen as a gift.
#18 - DAMAGES
Code: Sections: 104(a)(2),(3), Reg: Sections: 1.104-1(c), (d)
Amounts received as damages or reimbursements, for damages are governed in part by statute. Code Sections 104-106 contain most of the tax rules on compensation for injuries and sickness.
Raytheon Production Corporation v. Commissioner
Facts: Taxpayer settled a lawsuit under the Federal Anti-Trust Laws against R.C.A.
Issue: Was the settlement required to be included in gross income?
Reasoning: Damages in an antitrust action are not necessarily nontaxable as a return of capital. Recoveries which represent a reimbursement for lost profits are income. (Since profits would be taxable income, the proceeds of litigation which are their substitute, are taxable in like manner.) The question is "In lieu of what were the damages awarded?" Compensation for the loss of Raytheon's good will in excess of its cost is gross income.
Problems (p. 185)
1(c). P's suit was based on a breach of a business contract and P recovered $8,000 for lost profits and also recovered $16,000 of punitive damages.
$8,000 taxable (Raytheon)
$16,000 taxable (Glenshaw)
1(d). P's suit was based on a claim of injury to the goodwill of P's business arising from a breach of a business contract. P had a $4,000 basis for the goodwill. The goodwill was worth $10,000 at the time of the breach on contract.
(1).What result to P if the suit is settled for $10,000 in a situation where the goodwill was totally destroyed?
$6,000 gain (Raytheon - compensation in excess of its cost is gross income)
(2). What result if P recovers $4,000 because the goodwill was partially destroyed and was worth $6,000 after the breach of contract?
No Tax (Basis=$4,000, Damage=$4,000)
(3). What result if P recovers only $2,000 because the goodwill was worth $8,000 after the breach of contract?
No tax, $2,000 reduced basis.
IRC: Sections 104(a); 105(a)-(c) and (e); 106(a)
Reg: 1.104-1(a), (c), (d); 1-105-1(a),-2, -3; 1.106-1.
The premise of §104 and §106 is the taxpayer has suffered enough already.
a. If an employer directly or indirectly reimburses an employee for expenses of medical care for the employee or the employee's spouse or dependents, the amount received is excluded for gross income.
Revenue Ruling 79-313
Taxpayer sustained severe and permanent personal injuries as the result of being struck by an automobile. Taxpayer brought action against X, who had insurance through M. Suit settled with 50 annual payments, each annual payment to be increase by 5% over that amount of the preceding payment.
Are payments excludable for gross income?
Yes. Under §104(a)(2), all payments received by the taxpayer, pursuant to the settlement agreement, are excludable for gross income.
Problems (P. 192)
#19 - MARRIAGE, DIVORCE AND SEPARATION
A. Classification of Taxpayers and Rates
I.R.C.: Sections 1; 2; 68; 151(d)(3) and (4); 6013(a) and (d).
Note: For many years all individuals were taxed under a single set of tax rates. In 1930, the Supreme Court held that in community property state earnings and other income of either spouse were taxable 1/2 to each spouse.
Note: Use of the joint return by married persons is elective and is allowed only if the requirements of §6013 are satisfied. A consequence of doing so is joint and several liability, not only for tax reported, but also for deficiencies and interest and possibly civil penalties.
Note: "Sham Transactions" a term given by the Service to married couples who travel to a winter vacation resort at the end of the year, to obtain a divorce and desirable single tax status by New Year's Eve, and return home to remarry after the New Year. In the 1st judicial confrontation, the court concluded that as both parties were domiciled in their home state its courts would not recognize their divorces, because the foreign courts lack subject matter jurisdiction.
Note: §6012 is the requirement to file a return. Most, but no all, are required to file.
Problems (P. 956)
SEPARATION AND DIVORCE
A. Alimony And Separate Maintenance Payments
I.R.C.: Sections 71 (omit ©(2) and (3)); 215(a) and (b); 7701(a)(17).
A payment that is made in cash (or check or money order) qualifies as alimony or as separate maintenance, if five requirements are met:
Problems (p. 202)
I.R.C.: Section 71(b)(1)(A)
Note: If payments are made merely to maintain property owned by the payor spouse that is simply used by the payee spouse, they do not qualify as indirect alimony payments. These include premium payments on life insurance or mortgage payments on real property where the underlying property is owned by the payor spouse. However, if payments are made in satisfaction of a legal obligation exclusively that of the payee spouse and are applicable with respect to property in which the payor spouse has no legal interest, such indirect payments qualify as deductible alimony.
Advice is requested whether premiums paid by a husband on (1) a life insurance policy assigned to his former wife and with respect to which she is the irrevocable beneficiary, and (2) a life insurance policy not assigned to the wife and with respect to which she is only the contingent beneficiary are includible in the gross income of the wife under §71(a) and deductible under §215.
In the instant case, the husband and his former wife entered into a property settlement agreement which provides, in addition to monthly support, husband pay premiums on two life insurance policies covering the husband's life. The 1st is assigned absolutely to the wife, as the irrevocable beneficiary. This policy's premiums are includible in gross income, and are deductible by the husband. The 2nd policy is assigned to the children. This policy's premiums are not includible in gross income nor are deductible by the husband
What types of indirect payments qualify as alimony? The answer turns on, "what is the nature of the payments?" Payments made merely to maintain property owned by the payor spouse that is simply being used by the payee spouse, do not qualify as indirect alimony payments. Examples: life insurance, mortgage payments on real property where either is owned by the payor spouse. If the payment are in satisfaction of a legal obligation exclusively that of the payee spouse and are applicable with respect to property in which the payor has no legal interest, then such payments qualify as indirect alimony payments.
I.R.C.: Section 71(b)(1)(D); (c)
Commissioner V. Lester
Reversed in 1984 by §71(c)(2)
Required the parties in the divorce agreement to "specifically state the amounts or parts thereof allocable to the support of children." The court added that the amounts must be specifically designated, and not left to determination by inference or conjecture. In Lester, because the amount for child support was not fixed, the entire payment was alimony. The Lester rule had the distinct advantage of providing an easy means to shift income tax liability to the recipient
"The object here in part is to pull together some peripheral problems that arise in connection with payments, including indirect payments and property transfers, occasioned by separation and divorce."
a. Annuity Payments - What are the consequences of a lump sum transfer by a payor spouse that does not go directly to payee spouse but which generates periodic income received by payee? The income generated by the investment is taxable to the payee in accordance with the taxing rules applicable to the nature of the property that generates the receipts. Such income is not included in the payor's gross income, since payor does not own the property that produces it. The allocation provisions of §71 and §215 are not needed. In the case of an annuity policy, the payee s taxed with respect to each annual receipt under the annuity rules of §72.
a. Borax and Wondsel cases. Similar to casebook hypo. Ex-h and Ex-w were married in State S. They separated. No separation agreement was signed, nor was decree of support entered. Later, Ex-h obtained an ex parte Mexican divorce. The divorce decree provided for alimony payment to Ex-w. Ex-w obtained an ex-parte decree in State X declaring the Mexican divorce invalid. Ex-h took §215 deductions for alimony paid. Ex-w never treated payments as GI. Commissioner filed deficiencies against Ex-h on the ground §215 deductions for alimony payments were improper because the divorce was a nullity. Tax Court has consistently held that state law govern marital status and has denied the validity of an ex parte divorce decree for tax purposes where that decree is subsequently invalidated by a court of competent jurisdiction.
#20 - KIDDIE TAX
I.R.C.: Sections 1(a) through (e), (h); 6013(a).
Generally, an item of income is taxed to the person who earned it or who owns the producing property. However, the progressive tax rates encourage attempts to divide income among family members or other entities, and in so doing reduce the earner's total tax liability.
(anticipatory contracts, holding: income)
Facts: By contract, made in 1901, Earl and his wife agreed that any income either of them earned would owned by them as joint tenants. Earl claims he can only be taxed on 1/2 of his income as a result of this contract.
Issue: Does a contract allow an earner of income to prevent his salary from vesting for tax purposes?
Reasoning: "That seems to us the import of the statute before us and we think that no distinction can be taken according to the motives leading to the arrangement by which the fruits are attributed to a different tree from that on which they grew."
§61(a) taxes the net income of ever individual "derived from salaries, wages, or compensation for personal services. One cannot, by agreement, attribute fruits to a different tree from that on which they grew.
(Anticipatory assignments, holding: no income)
Facts: D was president of a bank. From 1919 to 1925 he received no income. In June 1927 the board of directors approved a plan whereby D would receive 5% of profits each year. For the first 1/2 of the year he received $445,704.20. He refused any further compensation and suggested the board do something worthwhile with the money. The donated the among which would have been D's salary for the last 1/2 of the year, $1.5 million, to U.C. The actual compensation was 1,357,607.40. D made up the difference, 142,392.60. He did not report the 1.3 million as income.
Issue: does a taxpayer’s unqualified refusal to take the compensation for his services avoid the consequences of taxable income?
Reasoning: The taxpayer refused to accept any further compensation for his services. All he did was suggest the money be used for some worthwhile purpose. So far as the taxpayer was concerned, the corporation could have kept the money. "In this circumstance we cannot say as a matter of law that the money was beneficially received by the taxpayer and therefore subject to the income tax provision of the statute.
Facts: Taxpayer served as executor of estate. He and his adult sone were each given 1/2 of estate. Taxpayer decided to make no charge for serving in such capacity. He filed with the intention to waived the same. No other action was taken that was inconsistent with this.
Question: Are amounts which ten taxpayer-executor could have received as feeds or commissions are includible in his gross income for Federal income tax purposes and whether his waiver of the right to receive these amount results in a gift for Federal gift tax purposes?
Holding: No. Amounts which the taxpayer would have otherwise become entitled to receive as fees or commissions are not includible in his gross income for Federal income tax purposes,, and are not gifts for Federal gift tax purposes.
Facts: Urban law clinic. Each faculty member has agreed, as a condition of participation in the program, that since the time spent in supervising work of students on these cases and in the representation of the client is part of the faculty member's teaching duties for which the faculty member is compensated by a total annual salary, all amount received under the Criminal Justice Act will be endorsed over to the law school.
Question: Can amounts received for services performed by a faculty member be excluded from gross income?
Holding: Yes. The U.S. Supreme court has stated that the dominant purpose of the revenue laws is the taxation of income to those who earn or otherwise create the right to receive it and enjoy the benefit of it when paid. (Horst, Lucas v. Earl) However, the IRS has recognized that amounts that would otherwise be deemed income are not in certain unique factual situations. (Rev. Rul. 65-282, legal aid attorneys exempt from gross income received pursuant to employment contracts.)(Rev. Rul. 58-220, Checks made to physician, signed over to hospital are exempt)(Rev. Rul. 58-515, an undercover police officer takes a position of employment for his case, and remits salary to the pension fund. Exempt.)
"Fruit tree", owner of tree pick fruit and gives to someone else who converts to cash. The fruit, for tax purposes, belong to the owner.
Facts: The owner of negotiable bonds, detached interest coupons and delivered them as a gift to his son who in the same year collected them at maturity.
Issue: Is the gift of interest coupons, detached from bonds, realization of income taxable to the donor?
Reasoning: Income is realized by the assignor when he diverts the payment that he could have received to the donee. This satisfies a want of the donor who, in a real sense, enjoys compensation from such fulfillment.
Income taxable to assignee
Facts: P was to receive income from a trust created by his father. P assigned some of the income to his children.
Issue: Is P liable for tax on income he had assigned to his children?
Reasoning: If the interest is assignable without reservation, the assignee becomes the beneficiary, and thus liable for the tax.
Note: Horst is distinguishable from Blair. To what extent did the donor in each case retain the corpse, or the source of the income?
Facts: In 1964 P paid $754,816 in interest for past tax deficiencies. In 1965 his income was not large enough to take full advantage of the large interest deduction. P arranged to accelerate his future income, by assigning his son $122,820 from an anticipated future stock dividends. The commissioner said the assignment was in a reality a loan masquerading as a sale.
Issue: Is the assignment valid?
Reasoning: The transaction was economically realistic, with substance, and should be recognized. A taxpayer is not prohibited from arranging his financial affairs to minimize his taxes. Here, the purchase price was adequate and there were no claims that the transaction was a sham. P's son paid fair consideration to receive future income. The presence of tax avoidance motive will not nullify an otherwise bona fide transaction.
Facts: P's husband ran a gas station. When he died, he left the station to her, and some of her children ran it. Susie received $100 per week, and the remainder was divided among the children who ran the station. In 1963 Texaco offered to purchase the station for $295,000. The family accepted. The money would pay an $8,000 lein, $50,000 mortgage to Texaco, Susie $100,000 (enough to generate $100/week for life), and the balance divided among the children. In July the agreement was signed. In August, Susie conveyed 1/2 interest in the property to her five children by warranty deed recorded September 6, 1963. The sale was completed. Susie filed a gift tax return, reported $115,063 capital gain, and an ordinary gain of $665 as her share of the gain from the sale. The children all reported their proportionate shares. The commissioner determined the entire sale/gain belonged to Susie.
Issue: Is a taxpayer liable for the entire gain realized on a sale when she has used other parties an instrumentalities through which to pass title?
Reasoning: A sale by one person cannot be transformed, for tax purposes, into a sale by another. The conveyance to the children when viewed as a part of the whole transaction, was only an intermediate step in the transfer of legal title to Texaco.
Problems (P. 281)
#21 - INCOME PRODUCING ENTITIES
Three principal types of income producing entities: partnerships, corporations and trusts.
We did not spend any time on this in class. We are responsible for understanding that a partnership or sole proprietorship is not a corporation, and for being familiar with the basic concepts of how corporation, partnership, estates and trusts are taxed. If you learn nothing else, learn that corporations are taxed separately on their own income, but partnership income is passed through to the partners for tax purposes.
#23 - INTRODUCTION TO DEDUCTIONS FOR BUSINESS EXPENSES
IRC: Sections 1; 63
IRC: section 162(a)
Reg: Section 1.162-1(a)
(Payments not deductible. Instead they are capital expenditures, outlay for development of reputation and goodwill)
Facts: P was secretary of the E.L. Welch Company, a Minnesota corp., engaged in the grain business. The corp. went bankrupt. In order to reestablish his relations with customers whom he had known when acting for the Welch Co. and to solidify his credit and standing, he decided to pay the debts of the Welch business so far as he was able.
Issue: Are payments, by a taxpayer who is in business as a commission agent, allowable business deductions if made to the creditors of a bankrupt corp. in an endeavor to strengthen his own standing and credit?
Reasoning: These payments were not deductible from income as ordinary and necessary expenses, but were rather in the nature of capital expenditures, an outlay for the development of reputation and good will. "We may assume that the payments to creditors of the Welch Co. were necessary for the development of the petitioner's business, at least in the sense that they were appropriate and helpful. He certainly thought they were, and we should be slow to override his judgment."
IRC: Sections 162(a); 198(a), (b)(1), (c)(1)(A)(ii), (c)(2)(A); 263(a).
Reg: Sections 1.162-4; 1.263(a)-2
Facts: INDOPCO arranged a holding company to allow for transfer of stock without gain to the shareholders. Frank and Anna Greenwall were the largest shareholders, 14.5% (approx. $170 million)
Issue: Are certain professional expenses incurred by a target corp. in the course of a friendly takeover deductible as "ordinary and necessary" business expenses under §162(a)"
Reasoning: The expenses that National Starch incurred in Unilever's friendly takeover do not qualify for deduction as "ordinary and necessary" business expenses under §162(a).
(Asbestos removal is capital expenditure)
"Deductions are exceptions to the norm of capitalization" INDOPCO
§162 - Business expenditure
§263 - Capital expenditure
Facts: P remodeled its building. In the process, it also removed asbestos materials.
Issue: Are petitioner's costs of removing asbestos-containing materials deductible (§162) or are they rehabilitation (§263)?
Holding: The expenses are a capital expenditure.
Reasoning: the costs of removing the materials must be capitalized because they were part of a general plan or rehabilitation and renovation that improved the Douglas Street building.
IRC: Sections 162(a); 195; 262
Reg: Section 1.162-6
(Business travel expenses NOT deductible when looking for a business or entering business)
Facts: P and his wife spent ~ one year traveling around the country in an attempt to locate a newspaper or radio station to buy and operate. They deducted their travel and other related expenses.
Issue: Under §162(a), may travel expenses in searching for a business to purchase and operate be deducted as an ordinary and necessary business expense?
Reasoning: Deductible expenses may be incurred only in connection with the operation of an existing business. The Franks were not engaged in a business when the expenses were incurred; the trips were preparatory to entering into a business.
Note: §195 allows taxpayers to amortize "start-up" costs over five years. Start-up costs are defines as investigation, creation, or acquisition of an active trade or business. However, such costs are limited to those that would otherwise be deductible if the taxpayer was already engaged in such trade or business.
Note: This case references Hundley. Semi-pro father helps sons. 1/2 contract. O.K. Hundley could extend to any situation in which payment for employment-seeking services is contingent upon employment and does not become due until employment is secured.
IRC: Section 162(a)(1)
Reg: Section 1.162-7,-8,-9.
(Compensation must be reasonable to be deductible under §162(a)(1))
Facts: Smith had been engaged in several gaming operations prior to 1935. In 1935, his 25 year old son, Harold, opened a club in Nevada. The following year Harold's brother was made a partner. Smith managed the club. In 1941 his compensation was a salary of $10,000 plus 20% of the profits. From 1952 to 2956 his compensation ranged from 350,201 to 557,560. P deducted these salaries as a business expense. The Tax Court found the portion above 15% of the profits was unreasonable, and thus not deductible for tax purposes as an ordinary business expense.
Issue: Was Smith's salary reasonable and therefore a valid business expense for tax purposes?
Reasoning: Contingent compensation is ordinarily allowed as a deduction even though it may be greater than the amount ordinarily paid, if paid pursuant to a "free bargain" between the employer and the individual. The Tax Court concluded that there the agreement was not the result of a free bargain, due to Smith's position and dominance as the father of the owners of the club (ie. Harold and Raymond acquiesced in virtually all of Smith's decisions.)
Ch. 16 - Deduction Not Limited To Business or Profit Seeking Activities
§262 - Generally precludes deduction for personal, living or family expenses.
#22 - BUSINESS, TRAVEL & ENTERTAINMENT
IRC: Sections 162(a)(2), 162(a) last sentence; 274(n)(1)
Reg: Sections 1.162-2; 1.262-1(b)(5)
Facts: Robert Rosenspan, a jewelry salesman who worked on a commission basis, paying his own traveling expenses without reimbursement. He did not maintain a home. §162 allows for deductions for meals and lodging "while away from home". D disallowed the deduction, as Rosenspan did not have a home to be away from.
Issue: Does §162 allow for deductions while away from home, if one does not maintain a permanent home?
Reasoning: Three conditions must be satisfied to receive the deduction:
(This three prong test was established in C.I.R. v. Flowers)
While P defined home as business headquarters, courts have rejected this position. The original intent of this provision was to allow as a deduction the excess over "home" food and lodging expenses caused by business travel. Because of the extreme difficulty in determining the amount of the excess, Congress said all of the expense away from home is deductible.
(A taxpayer can have only one home)
Facts: P operated a swimming pool construction company in New England. P also owned two horse farms in Florida. P spent summers in New England, and winters in Florida. P spent so much time in Florida, he bought a condo, and then replaced that with a single family home. In 1984, P deducted housing and meal costs as travel expenses incurred away from home.
Issue: May a taxpayer claim as a deduction his duplicative living expenses cause by having tow businesses that require him to spend a substantial amount of time in each of two different places?
Reasoning: A taxpayer's home, for purposes of §162, is the area or vicinity of the principal place of business. In this case the Tax Court incorrectly held P had two homes. Where business necessity requires that a taxpayer maintain two homes, the duplicate expenses are a cost of producing income and should ordinarily be deductible.
Note: If a taxpayer is engaged in business at two or more separate location, the "tax home" for purposes of this deduction is located at the principal place of business during the taxable year.
Note: A taxpayer "away from home" on business may deduct the cost of his meals only if the trip requires him to stop of "sleep or rest".
Problems (P. 369)
IRC: Sections 162(a); 274(a), (d), (e), (k), (l), (n)
Reg: Sections 1.162-20(a)(2), 1.274-2(a), (c), (d)
§162(a) states all ordinary and necessary business expenses are deductible including those specifically listed. The following are examples.
Prior to 1962, the Cohan rule was often applied to allow some deduction in the absence of proof. Congress enacted §274, which narrows the scope of §162 with respect to expenses for business meals, entertainment, gifts, employee awards, and travel by imposing some limitations and requiring substantiation. §274(d) requires the taxpayer keep adequate records.
§274 imposes two general limitations on the deductibility of business means and entertainment;
Deductions for uniforms are allowed if:
Generally advertising expenses of a business are deductible in the year in which they are incurred or paid even though the benefits may extend over several years.
In general, dues paid to organizations directly related to one's business are deductible under §162.
Problems (P. 399)
#25 - §212 "NONBUSINESS EXPENSES"
IRC: Section 212; 274(h)(7)
Reg: Sections 1.212-1(g), (k), (l), (m); 1.262-1(b)(7).
(no longer the law. §212 written in response)
Facts: P had extensive investments in real estate, stock and bonds, etc. He spent a large portion of him time managing them and hired several people for that purpose. He deducted their salaries for 30 years. In 1932 and 1933 the D denied the deductions. The board held that P's investment activities with stocks and bonds did not constitute a business, but rather were personal investments.
Issue: Do personal investment activities of a taxpayer constitute carrying on a business for purposes of deducting expenses related thereto?
Reasoning: Whether management of personal investment constitutes "carrying on a business" depends on the facts of each case. Here, P and his staff merely kept records and collected dividends and interest from P's securities. No matter how continuous or extensive the work, these facts are not sufficient to reverse as a matter of law, the determination of the Board.
Note: The Higgins decision prompted Congress to enact §212. Types of expenses involved in this case are now deductible.
Facts: P was the beneficiary of a life interest in a testamentary trust that owned 1/2 the stock in a corporation. She purchased the other 1/2 from the trustees of an orphanage. During 1936 and 1937 the incurred substantial legal costs in defending her title against an attack by the AG of South Carolina. She deducted these legal fees under §212 as ordinary and necessary expenses incurred for the conservation of property held for the production of income.
Issue: May legal expenses incurred in defending title to property be deducted as "ordinary and necessary expenses" under §212?
Reasoning: Except for the requirement of being incurred in connection with a trade or business, §212 deductions are subject to the same condition as any other business deduction. It is well established that legal fees incurred in defending legal title to property are not "ordinary and necessary" expenses. Legal expenses incurred in defending or protecting title to property should be capitalized and taken into account in computing the capital gain or loss on a subsequent sale.
Facts: P purchased 4,000 shares of Montgomery Ward stock, on advice of Wolfson who owned a larger block. He was convinced a change in management was needed. P contributed $17,000 to the committee and deducted it as a non-business expense. The committee's objectives were realized in part. P sold his stock for a substantial capital gain in addition to the substantial dividends already received. D disallowed the $17,000 deduction on the ground that there was no proximate relationship between the contribution and the production of income and that it was speculative whether the contribution would result in greater income.
Issue: Must a proximate relationship be shown between a deductible non-business expense and the production of income or management of income-producing property?
Reasoning: Congress intended to allow a deduction for expenses genuinely incurred in the exercise of reasonable business judgment in an effort to produce income. Here, the payments, even if speculative, were made with the anticipation that increased profit would result. Since the expenses were incurred in the exercise of reasonable business judgment, the deduction should be allowed.
This decision held that proxy fight expenditures are deductible by a stockholder under §212, if such expenditures are proximately related to either the production or collection of income or to the management, conservation or maintenance of property held for the production of income. (Surasky v. U.S. is cited).
Facts: Fleischman got married in 1955. Before his marriage, he and his wife entered into a prenuptial agreement whereby she, in the event of divorce, relinquish all claims to his property in exchange for $5,000. In 1961 the wife sued for divorce and in a separate action sued to have the prenuptial agreement set aside. The 2nd suit was dismissed with prejudice. On his 1962 return, Fleischman did not deduct the costs of the divorce suit, but he did deduct $3,000 for legal expenses of defending the other suit. The Commissioner disallowed the deduction and assessed a deficiency. Fleischman argues that these expenses were caused by a separate suit to rescind a contract, bot by the divorce proceeding, and that they were incurred to preserve and protect real property inherited from his mother.
Issue: Are legal expenses incurred in a suit to set aside an antenuptial agreement deductible?
Reasoning: (1) Legal expenses incurred in a suit to set aside an antenuptial agreement are no deductible because they flow from the marriage relationship and not from a profit-seeking relationship. The expenses incurred were personal in nature, specifically nondeductible under §262. (2) The "origin of the claim" test is used because it is most consistent with the meaning of §23(a)(2). Under this test, expenses to preserve and protect income-producing property in a divorce proceeding are not deductible because they are a personal expense arising out of the marital relationship. (3) Legal expenses incurred by a wife in securing alimony are, however, deductible because alimony is taxable income and the law provides that legal expenses incurred to produce taxable income are deductible.
IRC:Sections 121(a), (d)(6); 165(a), (b), (c)(2); 167(a)(2); 168(a); 212
Reg: Sections 1.165-9(b); 1.167(g)-1; 1.212-1(h)
Facts: Horrmann inherited his mother's house. Within the year he redecorated it and moved in. He sold his former residence. Two years later, he abandoned the house, complaining it was too expensive and too large. Conversion to apartments was impractical. He made several attempts to sell or rent to property. He sold it for net proceeds of $20,800. The house had been worth $60,000 when acquired, and $45,000 when sold. Horrmann contends that he is entitled to depreciation deductions for 1943, 1944, and 1945. He claims to be entitled to a deduction for maintenance expense for that period; and also entitled to a deduction for a long-term capital loss from the sale.
Issue: One a building once used as a primary residence, but later offered for rent or sale: (1). Can depreciation deductions be taken? (2). May a taxpayer deduct expenses incurred for maintenance and conservation of the property? (3). May a taxpayer deduct a long-term capital loss arising from the sale of such property?
Holding: (1) Yes (2) Yes (3) No
Reasoning: (1). "Property held for the production of income," and the owners use of the property along with his future intended us are generally controlling. When efforts are made to rent the property, it is being held for production of income and the depreciation deductions are allowed. (2). Same controlling issue as (1), and hence deductions for maintenance and conservation of the property should be allowed. (3). "in any transaction entered into for profit". When property has been used as a personal residence, in order to convert the transaction into one entered into for profit, the owner must do more than just abandon the property and lit it for sale or rent. If he actually rents, the (irrevocable) conversion takes place for the term of the lease. If he only instructs his agent to sell or lease, the change of character remains subject to his will, since he can revoke the agency at any time. Thus, it would strain the language to the regulation to say that such property was "appropriated to" or "used for" income producing purposes. Previous cases which have held that actual rental was not necessary involved different facts, where the owners had inherited the property and never intended to occupy it as a personal residence.
Facts: P owns property on Martha's Vineyard. He ahs used the property as a summer home for many years. P bought a house in NH, and decided he no longer needed the Vineyard house. The house was worth $50,000, but P believed the house would be worth $150,000 after the real estate boon. He did not use the property after that, except to open the property in the summer and close it in the fall. P did not attempt to rent the house because he felt it would be easier to sell an empty clean house, and because he did not want the expense of furnishing household items. P's daughter wanted to use the property, and he told her no, because the property was a business proposition. P sold the house for $150,000, showing $100,536.50 NLTCG on his tax return. P deducted maintenance expenses for 5 years, and D challenged those deductions for 1970 only.
Issue: Is residential property converted into income producing property if it is abandoned an offered for sale, but not rent with a reasonable expectation of profit?
Reasoning: The old rule: property must be offered for rent to claim maintenance deduction. But in Frank A. Newcombe, the court found the "intention of the taxpayer in light of all the facts and circumstances" to be the key question. In determining whether the taxpayer intended to obtain a profit, the following are important considerations: (1). The length of time taxpayer occupied the former residence prior to abandonment, (2).availability of the house for taxpayer's personal use while it was unoccupied, (3).the recreational character of the house, (4).attempts to rent the property, and (5).whether the offer to sell was an attempt to realize post conversion appreciation. P had extensive experience in the real estate market. He reasonable believed that he would be able to realize the asking price on the real estate within a few years, and during the interim he carefully treated the property as a "business proposition." Thus, in light of all the circumstances, it is clear that P intended to convert his property in income-producing property and benefit from post-abandonment appreciation.
Questions (P. 473)
B. Property Settlements – Page 207:
§ 1041; see sections 1015(e)
Under the current statutes – payments that fail to meet any of the objective statutory requirements for alimony or separate maintenance do not qualify for the tax allocation afforded by §71(a) and 215(a), therefore depending on the facts, they are either for child support or are in the nature of a property settlement and in either instance they have neutral tax consequences.
United States v. Davis (1962) – Page 207:
Davis (P) separated from his wife. He transferred 1,000 shares of stock to her as full settlement of all her rights in his property. Under Delaware law she had no active interest in the ownership, management, or control of Davis’ property. Her only rights were inchoate including dower and intestate succession. The Commissioner assessed a tax on the transfer. Davis appealed to the court of claims on the basis that this was really a division of property between co-owners and if this was found not the case, it would result in a totally different tax treatment between taxpayers in community and non-community property states. The court of claims reversed the Commissioner on the basis that the settlement might be a taxable event, but gain realized thereby could not be determined since the wife’s marital rights cannot be valuated. Because of the split in circuits, Cert was granted.
Issue: Is the transfer of property pursuant to a marital settlement agreement a taxable event?
Holding: Yes, there is no question that §61(a) is intended to tax the economic gain on the stock. The question is whether it should be taxed to Davis now or taxed when his wife disposes of it. §1001 and 1002 state that gain from dealings in property are to be taxed upon the sale or other disposition. The taxpayer’s argument that the transaction is akin to a non-taxable division of property between co-owners cannot be sustained. Davis’ wife under current Delaware law has no right to ownership, management or control of his property. She must survive Davis for her rights to ripen under Delaware law. Having determined this was a taxable event we must decide on the measure of the taxable gain realized. Taxable gain is equal to the value of the property received minus the adjusted basis in property given up. Davis received a release of all his wife’s claims to his property, when parties bargain at arms length; it is presumed that the properties exchanged are of equal value. Therefore, Davis received property equal to the value of the stock less the original purchase price, decision of Commissioner affirmed.
Concise rule: The transfer of property pursuant to a marital settlement agreement is a taxable event. Taxes are computed based on the fair market value of the property at the time of transfer.
Additional notes: Revenue ruling 67-221, 1967-2 C.B.63 sate the wife takes the fair market value of the property at the time of transfer as her basis. No gain or loss is taxed to the wife. A division of community property is non-taxable event, but if one party take substantially all of the community property and gives the spouse a cash settlement, the transaction will be considered a sale of the spouse’s one-half interest.
Page 215 - §1041 actually reaches beyond the Davis facts, providing clear non-recognition rules for gains and losses with respect to any transfer of property between married persons and also between formerly married persons, further the transferee spouse or former spouse takes the property with a transferred basis.
Reasons for this:
The committee in general believes it is inappropriate to tax transfers between spouses, the policy is already reflected in the Code rule that exempts marital gifts from the gift tax, and reflects the fact that husband and wife are a single economic unit.
Furthermore, in divorce cases, the government often gets whipsawed, transferor will not report any gain on the transfer, while the recipient spouse, when he/she sells, is entitled under the Davis rule to compute his/her gain or loss by reference to a basis equal to the fair market value at the time received.
Committee believes that to correct these problems and make the tax law as unintrusive as possible with respect to relations between spouses.
Explanation of Provision – page 216:
Bill provides that the transfer of property to a spouse incident to divorce will be treated, for income tax purposes, in the same manner as a gift. Gain (including recapture income) or loss will be recognized to the transferor, and the transferee will receive property at the transferor’s basis.
A transfer of property is treated as related to the cessation of the marriage if the transfer is pursuant to a divorce or separation instrument, as defined in §71(b)(2) and the transfer occurs not more than 6 years after the date, which the marriage ceases.
The Characterization of Income Deductions – Page 676
Capital Gains and Losses
Whether a gain or loss is subject to treatment as capital as opposed to ordinary is usually dependant upon (1) whether it arises in a transaction involving a capital asset (2) whether the capital asset has been subject of a “sale or exchange and (3) how long the taxpayer has held the asset. Also be alert to statutory provisions that may artificially accord capital gain or loss treatment to some transactions, which do not actually involve the sale or exchange or a capital asset.
Under the modern federal income tax the proposition that capital gains should not be taxed was never accepted. In Merchants Loan and Trust v. Smietanka the Supreme Court held that capital gains were income within the meaning of the 16th amendment.
§435 – taxation of installment sales
§1231 – gain on the disposition of property used in a trade or business
§ 1031 - for the non-recognition of gain on certain exchanges
§1033 – involuntary conversions
The 1986 Tax reform act put a ceiling on the on capital gains tax rate to 28%.
The 1993 act put the ceiling for ordinary income at 39.6% but capital gains rate maintained its ceiling at 28%.
In 1997 – legislation reduced the top rate for many capital assets from 28% to 20% and to 18% for some gains recognized after the millennium.
Reasons for lowering the capital gains rate, Page 681:
Tax policy needs to be conducive to economic growth, economic growth cannot occur without saving, investment, and the willingness of individuals to take risks, the greater the savings pool the greater the monies available for business investment. Through such investment output and production is increased, increased productivity means greater wages, greater saving is necessary for all Americans to benefit through a higher standard of living.
Committee believes reducing the capital gains rate households will respond by increasing savings. Will also increase the efficiency of capital markets, because taxation of capital gains upon realization encourages investors to keep their monies locked in even if better investments present themselves.
B. The Mechanics of Capital Gains – Page 683
§1(c) and (h) – omit (h)(3), (5)(B), 6(B), (10), (11), (12), (13)(B) and (C);1222. See sections 1(a)-(e); §1201(a); 1202(a)-(e); 1221
Read §1(h) along the lines of §1222, 1222 provides a special netting provision
§1222(1) through 1222(4) define short term capital gain, short term capital loss, long-term capital gain, and long term capital loss.
§1222(5) through 1222(8) then in essence provide for the netting of short-term losses against short-term gains and long-term losses against long-term gains in the following manner: see page 684.
In the final netting process under §1222 net gains can arise in three situations: (1) a net short-term gain in excess of a net long-term loss (2) a net long term gain in excess of a net short term loss (the excess net long term gain in this situation is classified by section 1222(11) as net capital gain); and (3) a combination of a net short-term gain and a net long-term gain (with the net long-term gain again classified as net capital gain).
If the taxpayer falls into one of the three types of final net gain situations above, only the amount of the net gain is included in gross income.
Example of above Pages 684-685 ---
T, single, long term capital gain (§1222(3)) $30,000 and long term capital loss of (§1222(4)) of $10,000 and short term capital loss of (§1222(2)) of $5,000, and other income of $50,000, technically T’s gross income is $80,000 (salary of 50,000 + 30,000 long term gain).
But T will net capital gains and loses on Schedule D and will have a gross income of $65,000.
Long term Capital gain $30,000
Long term Capital loss -10,000
Net long term Capital gain $20,000
Short term Capital gain 0
Short term Capital Loss 5,000
Net Short Term Capital loss $5,000
Net Capital Gain $15,000
Gross income (after capital loss) $65,000
A one-year ling is drawn between short term and long-term gains and losses, a long term requiring more than a one-year holding period.
If, however, there is a net long-term capital gain (either in excess of a net short-term capital loss or in conjunction with a net short-term capital gain) some preferential treatment is provided to “net capital gain” which is defined by §1222(11) to constitute the excess of net long term capital gain over net short term capital loss.
If in a year a non-corporate taxpayer has a “net capital gain” §1(h) comes into play.
When §1(h) applies, net capital gains are treated as though they were the last taxable income received (i.e. the top incremented amounts of taxable income). §1(h) accords preferential treatment to net capital gains and that preference can take a variety of forms. §1(h) begins by extracting a portion of a non-corporate taxpayer’s taxable income and taxing it at ordinary income tax rates under §1(a)-(e), generally, but not always, this reduction will be an amount equal to the taxpayer’s taxable income less net capital gain, leaving only net capital gain to be taxed at a variety of rates under the remainder of §1(h).
The 28% rate is imposed on many types of capital gains, it is imposed on; gain from the sales or exchange of a long-term capital asset that was sold prior to May 1997, or was held long-term (more than one year) but not more then 18 months, sometimes this applies to thing that have been held longer than 18 months such as collectibles, art work, antiques, gems, coins, stamps, alcoholic beverages. §1202
The 25% rate – imposed upon §1250-unrecaptured gain, to the extent is makes up net capital gain, generally on depreciable real property.
The 20% rate – imposed on gain on most capital assets (other than collectibles, unrecaptured §1250, and §1202) if assets are held for more than 18 months, the gain on stocks bonds, and investment land, and other types of capital assets which are statutorily called “adjusted net capital”.
The 18% rate – imposed on all assets whose gain would normally be taxed at 20% if the asset is acquired after December 31, 2000 and is held for more than 5 years – see page 687 for the explanation of the special election that may be made.
The 15% rate – under §1(h)(1)(A) – to the extent net capital gain would be taxed either at 28 or 25 percent gain and the taxpayer has inadequate ordinary income (including net short-term capital gain) to fill up the amount of taxable income taxed at 15%. Example – Single taxpayer normally taxed under §1(c) has $25,000 taxable income composed of 10,000 of ordinary income and 15,000 from gain of sale of stock held for 16 months, resulting in 15,000 net capital gain. The taxpayer’s ordinary income and $12,100 of net capital gain are taxed at 15% and only $2900 (15000 – 12100) of that gain is taxed at 28%, read carefully §1(h) to see when the 15% rate applies. More examples page 687.
The 10% rate – to the extent that adjusted net capital gains held for more than 18 months would otherwise fall into the 15% bracket such gains are taxed at 10%. For example, if the stock in the previous example had been held for more than 18 months, the first 12,100 of such gain would be taxed at 10% and the remaining 2,900 of gain would be taxed at 20%
The 8% rate – an 8% rate is imposed on gains that would otherwise be taxed at a 10% rate if the asset involved is held for more than 5 years and is sold after December 31, 2000.
Examples page 689.
§1202 has an incentive to encourage non-corporate taxpayers to invest in start-up companies, the provision allows a non-corporate taxpayer an exclusion of 50% of the gain on “qualified small business stock” held for more than 5 years – qualified stock in general is domestic C corporation stock issued through an underwriter to the taxpayer after August 10, 1993 in exchange for money, not stock, or as compensation, see page 691.
Page 692 – Corporations – 1986 code reduced maximum tax rate on corporations from 46% to 34%, §1(h) provides the method of taxing capital gains of an individuals and other non-corporate taxpayers, it is not applicable to corporations; see §1201(a) for corporations – in 1993 congress raised maximum rate on corporate ordinary income to 35%, and also raised the §1201(a) alternative rate on net capital gains to 35%.
C. The Mechanics of Capital Losses – page 693
§ 1211(b); 1212(b)(1), (2)(A)(i); 1222(10), 165(c) and (f); 1211(a); 1221; 1222
The primary code section that determines whether a loss is deductible is §165(c)
Capital losses are generally deductible only from or against capital gains. Capital losses, whether long-term or short-term, offset capital gains, long-term and short-term, dollar for dollar. In the case of non-corporate taxpayer, capital losses in excess of capital gains can be deducted from ordinary income, but only to a limited extent. Any capital loss balance is carried forward to succeeding taxable years, retaining its original character, long or short-term capital loss. This carry over loss is applied against capital gains, and to limited extent ordinary income until fully used up - §1211(b), 1212(b), 1222(10).
The mechanics of 1222 require first to “net out” long term and short-term transactions, and then “net out” net longs against net shorts – the netting process results in three possible net loss situations. First, may be a net short-term loss that reduces or eliminates dollar for dollar, the amount of long-term gain. Next, there may be a net long-term loss, which reduces or eliminates, dollar for dollar, any net short-term gain. Third, is net losses in both short term and long term categories. The double netting process now utilized in any year to the extent that there are capital gains for the year.
§1211(b) limitation – starting point for capital losses. It provides that capital losses are deductible only to the extent of capital gains plus, if such losses exceed such gains, and amount of ordinary income not to exceed the lower of $3,000 (1,500 in the case of married filing separately) or the excess of such losses over such gains.
Illustration of §1211(b) – T, single, has salary income of 12,000 and the following capital gains and losses over the same year:
Long-term gain $400 Short-term gain $400
Long-term loss $1200 Short-term loss $1000
Net long-term loss ($800) Net short-term loss ($600)
Total of T’s net long term loss and net short term loss is $1400, well within the 1211(b) limitation, and T can deduct the 1,400 from ordinary income under §1211(b)(2), T’s adjusted gross income is:
Less §1211(b) deduction (see §62(a)(3)) ($1,400)
Adjusted gross income $10,600
What is T exceed the 3,000 limitation:
Long-term gain $400 Short-term gain $400
Long-term loss $2400 Short-term loss $2000
Net long-term loss ($2000) Net short-term loss ($1,600)
§1211(b)(1) limited to 3,000, the lower dollar ceiling or the excess of capital losses over capital gains ($3,600). Of the total excess capital losses of 3600 under 1211(b) the taxpayer can only 3,000. So what happens to the other 600, see §1212(b) carryover.
§1212(b) provides capital losses not used in a particular year are carried over into subsequent taxable years and treated as long or short-term dependant upon their original character. The “if” clause in at the beginning of §1212(b)(1) makes the carryover provisions dependent upon the taxpayer having a “net capital loss” which is defined in §1222(10) as the “excess of the losses from the sales or exchanges of capital assets over the sum allowed under §1211.” These carryover are used until gone or the taxpayer dies, the carryover die with the taxpayer and cannot be passed on.
§1212(b) – Note, when working with the statute, one must complete the §1212(b)(2) computations first, before computing carryover losses under §1212(b)(1).
Explanation of statute at work:
Long-term gain $400 Short-term gain $400
Long-term loss $2400 Short-term loss $2000
Net long-term loss ($2000) Net short-term loss ($1,600)
T was allowed only to deduct on 3,000 from ordinary income under §1211(b). As a result, T has a net capital loss, §1212(b) applies, and first applying §1212(b)(2) T is deemed to have a constructive $3,000 short-term gain under §1212(b)(2)(A)(i) with that result that T's capital gain and loss picture (for purposes of §1212(b) only) is as follows:
Long-term gain $400 Short-term gain $3400
Long-term loss $2400 Short-term loss $2000
Net long-term loss ($2000) Net short-term loss ($1,400)
Now see 1212(b)(1)(A), there is no net short term capital loss excess because there is no net short term capital loss and none of the $2,000 short term capital loss is carried over. Turning to §1212(b)(1)(B) there is a $600 excess of the $2,000 net long-term capital loss over the $1,400 net short-term capital gain and the $600 excess is treated as long-term capital loss in succeeding years. §1212(b) answers a couple of questions, the $600 excess is carried over and it is carried over as a long-term capital loss.
Page 697 – Corporations – The major difference in the treatment of capital losses between corporations and individuals is that §1211(b), authorizing non-corporate taxpayers a limited deduction of excess of capital losses form ordinary income, is neither applicable nor duplicated for corporations. In the case of corporations, §1211(a) provides that losses form sales or exchanges of capital assets shall be allowed only to the extent of gains from such sales or exchanges - another difference 1212(a) treats excess capital losses in given year as short-term capital loss carry back (regardless of its origin) to each of three taxable years preceding the loss year and to the extent not so used, as a short term capital loss carry over (regardless or origin) to each of the five years succeeding the loss year.
D. The Meaning of “Capital Asset” – Page 698
1. The Statutory Definition
§1221, see sections 1234; 1236; 1237
Mauldin v. Commissioner (1952) – page 698:
In 1921 Mauldin (P) received title to 160 acres of land ½ mile from the city of Clovis, New Mexico. While P bought the property to begin a cattle business by the time title was taken a decline in the business and the climate resulting from drought, crop failures, and bank failures made the plan untenable. P built a home on the land, divided it into small tracts and blocks and tried to sell the land at a loss, no land was sold until the city limits began to encompass it in 1931. The growth resulting a paving project for which the city assessed P $25,000 in 1939. Unable to pay this P had to engage in a sales campaign in 1939 and ’40 to pay off paving liens acquired by the city. From ’40 – ’49 nothing more was done to promote sales, P having decided to hold his land for investment and devote full time to a lumber business organized in 1939. While he had no real estate office or license, no price fixed lots, no ad campaign and even refused to sell certain lots sometimes, P sold lots in varying numbers form ’41 to ’48, the location of war facilities nearby having placed the lots in great demand. Throughout these years P showed income form real estate, along with income from the lumber business. In ’44 $3000 was from real estate and $12,000 from lumber, although P did not designate the nature of his business. ’44 and ’45 showed the lots as long-term capital assets and computed tax accordingly. Commissioner assessed additional tax after determining profit was ordinary income – Tax court affirmed, P appealed.
Issue: When sales are continuous and frequent, is that sufficient to show the character of an asset has changed?
Holding: Yes, the primary purpose or use of an asset, which determines its nature, can change during its life. A number of factors including the purpose for which it was acquired and the continuity and frequency of sales, as opposed to isolated transactions, help determine if such a change has occurred. There is no fixed formula to determine is land was held for sale to customers in the ordinary course of trade or business, each case must rest on its facts. In this instance lots were for sale at all times, the volume sold depended mainly on prevailing economic conditions, and substantial part of P’s income was derived from these sales. P sold more lots in ’45 than he did in ’40 during a buyers market. Under such circumstances we cannot say tax court conclusions are without merit, decision affirmed.
Concise rule: Where the primary use of purpose of an asset has changed, the primary purpose at the time of sale determines the nature of the asset for tax purposes.
Malat v. Riddell (1966) – Page 702:
Malat (P) and others purchased property in a joint venture. They intended to develop and operate an apartment project on the land. If this could not be done, they would sell parcels. P and the others encountered difficulties in obtain financing and therefore sold portions of the parcel. When it appeared that commercial financing for the apartment project could not be obtained, P sold his interest and reported the proceeds as capital gains. Commissioner determined that the joint venture had a dual purpose in purchasing the land and had utilized it s non-capital asset, which was held for resale. The district court and court of appeals affirmed on the basis the resale was a “primary” purpose of the original transaction within the meaning of §1221(1).
Issue: Where resale is not the main reason for he purchase of real property, does the asset change character when the taxpayer is later forced to sell the asset?
Holding: No, giving the word “primary” its normal meaning, §1221(1) states that if the principle or main reason for the purchase of the asset was to hold it for resale to customers it would be denied capital gains treatment. Nothing in the statute indicates that a secondary or lesser option would change the character of the asset. Here, the joint ventures were forced to sell portions of the parcel because no financing could be obtained. They continued to try and obtain financing but ran into zoning and other financial difficulties. When P realized they could not accomplish the primary purpose he sold his share. Since the lower courts applied the wrong legal standards as to the meaning of the word primary, remanded for new facts along these lines.
Concise rule: As used in §1221, the word “primary” means of first importance or principally and a secondary, non-capital purpose, will not change the nature of the asset.
Hort v. Commissioner (1941) – Page 702:
Hort was left a building under the terms of his father’s will. One of the tenants, Irving Trust co., wished to terminate the lease prior to its expiration date. They settled the lease by paying P $140,000 in exchanged for being released from it. P did not report the 140,000 as income and claimed a deduction for the difference between the fair rental value of the space for the unexpired term of the lease and the 140,000 received. The commissioner disallowed the deduction and assessed a deficiency tax on the 140,000. P claimed that the 140,000 was a capital gain and even if it was ordinary income, he sustained a loss on the unexpired portion of the lease. The tax and circuit court sustained the commissioner.
Issue: Where a lease is terminated prior to the expiration date and the taxpayer receives cash compensation, must is be reported as ordinary income?
Holding: Yes, P received the money, after negotiations, as a substitute rent. §61(a) would have required P to include prepaid rent or award for breach of contract as income. P received an amount of money in lieu of the rental income he was entitled to under the lease. Since it was a substitute for ordinary income, it must be treated in the same manner. The consideration received by P was not a return of capital. A lease is not considered a capital lease within the context of §61(a). Further, the fact that P received the less than then he would have under the terms of the lease does not entitle him to a deduction. No loss was sustained. He released a legal for a settlement sum, and did so believing the settlement amount to be fair. An injury to P can only be fixed when the extent of the loss can be ascertained, i.e. when the property is re-rented. Until that time no loss is deductible. Commissioner is sustained.
Concise rule: Where the unexpired portion of a lease is settled for cash, the payment received by the taxpayer is merely a substitute for rent and must be reported as ordinary income.
Metropolitan Building Co. v. Commissioner (1960) – Page 710:
On December 3, 1907, Metropolitan (P) acquired a lease executed in 1907 by the U of Washington, owner of 4 downtown Seattle blocks. P gave a sublease to one of the blocks on August 1, 1922. Under the agreement the sublessee was to construct a hotel, pay $25,00 annual rent, and pay its just proportion of an ad valorem personal property taxes assessed against the leasehold. On March 31, 1936, the Olympic Inc., acquired the sublease. Which was due to terminate on October 31, 1954 one day before the mater lease. In ’52 U of W began trying to arrange a long-term arrangement for the lease of the hotel and property after the P lease would expire. Olympic seeking to enter into such an arrangement offer to enter into a new lease for 22 years beginning as soon as it could by P’s release of rights under the master lease. And arrangement was made Olympic paid 137,000 to P to convey, quitclaim, assign, and release to the sate of Washington all of its rights, title, and interest in and to that portion of the leasehold the Olympic hotel was located on. The commissioner contends the 137,000, including monies for ground rent, P just share of the ad valorem personal property tax assessed against the leasehold, and money increased taxes, was ordinary income. Tax court affirmed, P appealed.
Issue: Is the sale of a leasehold interest the sale of a capita asset?
Holding: Yes, unlike the situation where the right to future rent or income under a lease is discharged by a monetary or other settlement, the sale of a leasehold interest is the disposition of income producing property. This latter type of sale, then, results in any gain being considered capital gain. In the instant case, the lease itself had value beyond the fixed amount of rental dues, precisely because its acquisition was of value to Olympic. The commissioner concedes the transaction would have constituted a sale if the University had paid by a third party to whom the lease had been assigned or the consideration. The person of the payor, we feel, does not control the nature of the transaction. Thus, this variance cannot alter the fact that the transaction was not a release of a right to future income under the sublease but a sale of the leasehold in its entirety, making the amount received taxable as capital gain. Tax court reversed.
Concise rule: While a discharge of the rental obligation under a lease by way of compromise and liquidation results in ordinary income, the sole of the leasehold interest itself results in a capital gain.
Note page 713 – 715:
With Hort in mind consider the question of tax consequences of the sale of life or other term interest or of an income interest in a trust. For example, S transfers securities to T, as trustee, the income from the assets to be paid to L for life and then the securities to be distributed to R. A trust of this type is viewed essentially as a conduit and that the income earned by the trust property, which is distributable to L, will be taxed to L. Suppose L sells his interest to P (1) how is gain or loss measured (2) how is gain or loss to be characterized?
Measurement of Gain – Three possibilities – if one purchased a temporary interest, such as L’s life interest, one would have a cost basis for it, the cost would be amortized, written off by way of deductions, over the expected duration of the interest. Upon the sale of the interest, the adjusted basis would be subtracted from the amount received to determine the gain.
If temporary property is received by gift or bequest, it too is accorded a basis determined, as usual, with reference to section 1015, §1014 or §1041. Bequest situation is under §1014 basis for underlying property. In the case of a lifetime gift as L received above, the basis for the income interest is part of the transferred basis of the donor under §1015 or §1041.
§273 and 102(b) are also relevant. The amortization deduction permitted one who purchases a temporary interest is denied to one such as L who acquires a life or other terminable interest by gift, and also one acquiring a temporary interest by bequest or by inheritance. Congress in §102 expresses a policy to exclude from gross income a gift or bequest of property, but not the income therefrom. The entire basis will ultimately be passed on to R, the remainderman. That being the case it would be inappropriate to allow L an amortization deduction using a part of the uniform basis.
Page 715 - Now, let L assert L’s share of the uniform basis when L sells L’s interest to P. Several cases have held that L may. If L’s interest has a relative value that gives L 40% of the uniform basis, which L subtracts in determining L’s gain, it is still true that R will have 100% of the uniform basis when L’s interest which P purchased ends. Thus 140% of the uniform basis which is violative of the policy embodied in §102(b). Yes, but P invested new funds equal to the added basis, but P’s amortization of the cost basis is not foreclosed by section 273 as it for someone like L who acquires the interest by gift.
In 1969 congress passed 1001(e), which requires L to upon the sale of the interest to disregard L’s share of the §1015 (1014 or 1041) uniform basis, a zero basis for L taxes L on all that L receives as gain.
§1001(e)(3) makes an exception to the zero basis rule of §1001(e)(1) if there is a transfer of the entire interest in the property , such as by sale by L and R their interests to P.
Characterization of Gain – life interest in property, not within any exclusionary part of §1221, it is a capital asset, if sold the gain is capital.
Corn Products v. Commissioner (1955) – Page 717:
Corn Products (P) found it very difficult to purchase corn because drought conditions forced the price up toa point where its products would be too expensive to compete with other brands. To protect itself, P began to purchase corn futures. Gains and losses were reported as ordinary income or ordinary losses. After several years, P claimed that it was really a true capitalistic investor and it was investing in capital assets. Therefore, profits and losses should be treated as capital gains and losses. The Commissioner found that this was not a true capital investment but an integral part of P’s business operation. It was designed to hedge against price and to provide a ready-made source of raw materials.
Issue – When a taxpayer’s investment in commodity futures is an integral part of its business, should income and losses be treated as ordinary income?
Holding: Yes, P contends it was an investor, which purchased a capital asset and should qualify for capital treatment. But its officers testified it used the futures to hedge against prices. While commodity futures fit the definition of capital assets contained in §1221, this section should not be interpreted so broadly as to defeat the reason for Congress’ passage of it. It applies to property, which is not the source of normal business income and is used to stimulate the economic community by giving tax breaks to investors. P used these futures is not within the meaning of capital assets as envisioned by Congress. Therefore, the decision to Commissioner is sustained.
Concise rule – Where the purchase of commodity futures is an integral part of taxpayer’s business, it is not true capital investment, and gains or losses produce ordinary income or losses.
Additional notes: In Hollywood Baseball v. Commissioner the player’s contracts of minor league baseball team where found to be within the Corn Products rule. Sine the club was required to sell their player contracts to the major clubs on demand the court found they were really sales items pursuant to contract agreements. These in effect were raw material of stock and trade, considered an integral to the club’s business and was treated as producing ordinary income.
Arkansas Best v. Commissioner (1988):
Arkansas Best (P) was a diversified holding company, in ’68 it bought about 65% of the stock of National Bank of Dallas. Between ’69 and ’74 P pumped additional capital into National Bank and tripled the number of shares it held in the subsidiary, although its overall percentage ownership remained relatively constant. In ’75 P sold most of its stock in National Bank leaving it only a 14.7% share and loss of nearly $10 million on the sale. P deducted this loss as ordinary, a deduction, which was disallowed, and the IRS asserted the loss was capital. P appealed to the tax court, which held that P’s intent in acquiring the stock was relevant to the determination of whether the loss was capital or ordinary in nature. The tax court found that Arkansas had acquired the stock for business purposes, not investment reasons, and held therefore that its loss in ‘75 was ordinary. 8th circuit reversed holding the loss realized was capital because the stock fell within the general definition of capital asset in §1221 and did not fall within the general definition of the specific exclusions to this definition.
Issue: If a taxpayer holds property (whether or not connected with his business) which does not fall within any specific exclusions of §1221, will loss or gain on the sale of property be treated as capital rather than ordinary.
Holding: Yes, §1221 defines capital asset as property held by the taxpayer (whether or not connected with his trade or business) and then excludes five specific classes of property from capital asset status. The five exceptions in the section are not illustrative, they are exclusive. If property held by a taxpayer does not fall within one of these exclusions, it is a capital asset which will give rise to a capital gain or loss upon its sale. Corn Products if often misread, the taxpayer’s motive in purchasing the asset (i.e. for investment as opposed for business purposes) is irrelevant to the classification of an asset as capital or ordinary, such a motive test finds no support in the statute itself. Corn products turned on the inventory exclusion in the section and not on a motive test.
Concise rule: If a taxpayer hold property (whether or not connected with his business) which does not fall within any of the specific exclusions of §1221, loss or gain on the sale of property will be treated as capital, not ordinary.
Kenan v. Commissioner (1940)
A clause in the will of Mrs. Bingham, in which she left Louise Wise (her niece) an annual income and a $5,000,000 lump sum to be paid when she became 40, permitted the trustees to substitute securities of equal value in making certain payments (including that Wise). Mrs. Bingham’s death in 1917 was followed later by the trustees’ decision to pay part of Louise’s allocation in securities (which they selected and valued in keeping with the will); this occurred when Louise reached 40 in 1935. All of the securities, most of which has been owned by the testator and became part of her estate and some of which the trustees had purchased, had appreciated. The Commissioner determined the distribution of same to Louise constituted a sale or exchange of capital assets and resulted in taxable gain. The board overruled the trustees contention that no income of any character was realized and denied a motion by the commissioner to amend his answer to assert al the gain was ordinary income. From this confirmation of the original deficiency determination of $367,687 both sides appealed, the commissioner seeking a deficiency $1,238,841.
Issue: When property is exchanged pro tanto to satisfy a legatee’s general claim, does a sale or exchange of capital assets occur?
Holding: Yes, a satisfaction of a legatee’s general claim against an estate via a pro tanto property exchange is not akin to the donative disposition that occurs via the transfer of specific property bequeathed by will to a legatee. The first is the sale or exchange of a capital asset with the rules concerning capital gains being applicable, while the latter is a donative transfer in which no gain is realized. Unlike a legacy of specific property, the instant legacy did not give title or right to the securities until they were delivered upon exercise of the trustee’s option. Furthermore, Louise was not subject to the same chances that a specific property legatee faces in dealing with the fluctuating vale of the same. The result was the same as if the securities were sold by the trustees and the $5,000,000 cash derived therefrom was used to pay Louise. In either case a taxable gain was realized, thus the board’s decision is affirmed.
Concise rule: While no gain is realized on the transfer by a testamentary, trustee of specific securities or other property bequeathed by will to a legatee, a pro tanto exchange of securities or other property to satisfy the general claim of a legatee is a sale or disposition and can result in such gain.
Galvin Hudson (1954)
Mary Harahan obtained a $75,702 judgment against Howard Cole on November 23, 1929, which Taylor and Hudson (P) purchased from the residuary legatees of her estate on June 30, 1943. In May 1945, Howard Cole paid the equal partners $21,150 as full settlement of the judgment. Taking into account the $11,004 cost of the judgment to the partners, P realized a $5,073 gain; this he treated as a capital gain, reporting 50% of it as such on his ’45 return (such being the proper treatment of capital gains). This was disallowed by the commissioner, who asserted it was ordinary income.
Issue: Is capital gain realized when the assignee or transferee of a prior judgment creditor settles with the judgment debtor?
Holding: No, when there is a settlement between a judgment debtor and the assignee or transferee of the judgment creditor there is no acquisition of property by the debtor. Rather, a debt is paid or a claim extinguished. Thus there can be no sale or exchange of property, be it capital asset or not. So, it makes no difference that a judgment is a capital asset because capital gain only occurs upon such a sale or exchange of a capital asset. That being the case, the gain was ordinary income, as the commissioner decided.
Concise rule: Gain realized from the settlement between a judgment debtor and the assignee or transferee of a prior judgment creditor constitutes ordinary income.
Additional notes: reconcile this with Kenan – look at the Kenan transaction as akin to one where the trustee-obligor paid the obligee-legatee cash which she used to purchase the transferred property. In one sense the trustee-obligor sold or exchanged property while the legatee-obligee, like the assignee of the judgment creditor herein, only received a payment due, using that to make a purchase. Not a great reason but it works
Yarbro v. Commissioner (1984):
Yarbro (P) was a self employed financial and tax consultant. He formed a joint venture for a land purchase paying 10% in cash, with the balance covered by non-recourse loans secured by deeds of trust on the property. The evidence indicated that the property was bought primarily for investment purposes, the only income on the property coming from a livestock-grazing lease, which provided approximately $1000 per year. In 1976 the property taxes on the property were increased approximately 435% and the real-estate activity in the area completely dried up. The joint venture decided to abandon the property and decided not to pay the real estate for 1976 or the annual interest payment of $22,811. P notified the bank of the abandonment and refused to re-convey the property back to the bank. In 1977, the bank foreclosed and none of the joint venture participants received anything from the foreclosure sale. On his 1976 income tax return, P claimed an ordinary loss of $10,376 for abandonment. The commissioner determined that this was not an ordinary loss but a long-term capital loss, taking the position that the abandonment was a sale or exchange. The commissioner also contended that the interest held by P in the joint venture was for investment purposes and not for use in his trade or business. The tax court agreed with commissioner and P appealed.
Issue: Does the abandonment of realy property subject to a non-recourse debt constitute a sale or exchange for purposes of determining whether the loss associated with the abandonment is a capital loss?
Holding: Yes, in analogous situations, the lack of any surplus from a foreclosure sale did not make the foreclosure any less of a sale or exchange. In several cases where the value of the land had fallen below the amount of the non-recourse debt and the owner conveyed the land to the mortgagee by quitclaim, there was a sale or exchange.
Concise rule: The abandonment of real property subject to a non-recourse debt is a sale or exchange for purposes of determining whether a loss associated with such abandonment is a capital loss.
Arrowsmith v. Commissioner (1952):
Arrowsimth (P) and another taxpayer held all the stock in a corporation. The corporation was liquidated over a 4-year period. P reported all gains on the transaction as capital gains. Several years after the liquidation, a judgment was rendered against the corporation, and P as one of the transferees of corporate assets had to pay his share of the judgment under §6901(a)(A). P deducted these payments from his income as ordinary losses. The commissioner integrated all of the transactions and determined that the payments represented capital losses, court of appeals affirmed.
Issue: May related transactions be integrated in order to classify one of them for tax purposes?
Holding: Yes, P correctly states the rule that each year is a separate unit for accounting purposes. However examining related transactions to classify the latest transactions is not an attempt to reopen or readjust earlier tax years.
Concise rule: A series of related transactions, even though occurring in different tax years, may be considered together in determining the proper classification of most recent transactions for tax purposes.
United States v. Skelly Oil Co. (1969):
In 1958, Skelly (P) refunded $505,536 to two customers because a price order by the Oklahoma Corporation commission setting the minimum price on natural gas was vacated. Thus, the repayments were made to settle two of many claims resulting from the overcharging from 1952-57. That amount had been included in P’s computation of gross income, which was figured under a section permitting an initial 27% depletion allowance, making $366,513 the actual amount taxed. When P attempted to deduct the full amount of repayment on its 1958 return the commissioner objected and assessed a deficiency, asserting only $366,513 was allowable as a deduction, that being the actual increase in taxable income attributable to the receipts in question. P brought suit in district court; an unfavorable decision there was followed by a reversal in the court of appeals.
Issue: In allowing for a deduction for previously taxed restored income, should the amount actually included in income in previous years be considered in determining the amount subject to a present deduction.
Holding: Yes, to allow a deduction for later refunded items which does not reflect previous depletion allowances would be akin to permitting a double deduction. The IRC allows a present deduction for an item when it is subsequently shown that ht taxpayer did not have an unrestricted right to the item in the year received. It is apparent that item means the amount actually included in gross income in the year of receipt because any other interpretation wold violate eh concept disfavoring double deductions not explicitly provide for. P allows just such a reference to past tax transaction to determine the nature of the present tax transaction, a deduction to refund only the money that was taxed when received. Thus the assessed deficiencies were proper, and the original district court decision is affirmed.
Concise rule: Although they may have occurred in different tax years, a series of related transactions or tax consequences should be considered in determining the amount and nature of a present deduction based thereon. Thus, a deduction designed to compensate a taxpayer for previously paying tax on income later refunded must be based on the actual amount included in the previous year, and not just on the amount of income itself.
Page 400 – 403
2. Business Losses
If a transaction produces a loss the threshold question becomes, whether the loss may be deductible and this must always be answered on the basis of the rules in §165, codes central switchboard for all losses.
165(a) seems to make all losses deductible, but see 165(c), taxpayer can only deduct only losses identified here, 165(c)(1) permit deduction for loss incurred in trade or business transaction – see also 165(c)(2) or (3) focusing on business losses.
Only realized losses are taken into account, the mere decline in value of property is not a deductible loss, the loss must be evidenced by a closed or completed transaction, such as a sale or fixed identifiable event such as fire.
Examples of deductible losses:
A buys a delivery truck for use in her business, sells it a year later for less than the adjusted basis.
B buys a tractor for use on farm, completely wears out gives it to junk man for no consideration.
D buys a boat for hire at a resort, its not insured, then its destroyed in a storm.
Measurement of the loss deduction depends in part on the adjusted basis of the property. A’s loss will be the difference between the amount realized and adjusted basis.
Example – If D had a $6,000 adjusted basis for his boat, and it had a $10,000 value before the storm and its value after the storm (uncompensated by insurance) is $7,000 D has a $3,000 – to the extent that D’s loss is compensated by insurance D’s deductible loss is reduced.
If §165(c)(1) losses incurred in a business during the year, along with other expenses exceed its income the business will be unprofitable and the owner will have an overall business loss for the year.
If the loss suffered cannot be all claimed in one year in a single year the business will get a carry-back, carry forward benefit.
§280B deal with demolition loss deduction, the improvement of property – the effect of this section is to place unamortized cost of razed buildings and of the expenses of demolition as far as possible away from affording any benefit to the taxpayer as a charge in computing taxable income.
Pages 839 – 850
C. Casualty and theft Losses Allowed
1. Nature of Losses Allowed
Regulations: 1.165-1(e), -7(a)(1), (3), (5), -8(a)(1), (d)
Losses are deductible under 165(a) sub§ (c) imposes some limitations regarding individuals, Losses incurred in taxpayer’s trade or business are deductible under 165(a) and (c)(1) without regard to how they arise.
Deductions claimed in this category may be challenged under §183
Anther possible ground, as stated above, for a taxpayer to claim a loss without regard to how the loss may arise, namely with §165(a) and (c)(2) as one incurred in a transaction entered into for profit, although not a trade or business – but this is also restricted by 165(f), which allows capital losses only to the extent allowed under §1211 and 1212.
A loss may occur outside the taxpayer’s a transaction for profit or business. Generally these are not deductible, §262 forecloses deductions for personal living, or family expenses – a taxpayer does not a get deduction for a loss suffered on sale of property unless it was held for profit and he realizes the loss, such as after a sale. However §165(c)(3) permits a deduction for some losses unconnected with business and not involved in attempt to make a profit – Casualty and theft losses. Causalty and theft business losses should be treated under §165(c)(1) or (c)(2) without regard to 165(c)(3) – those losses are characterized under §1231 - §165(c)(3) losses are characterized under 165(h).
Revenue Ruling 63-232 – Page 840:
Began with a series of case saying that damage done by termites over a 15 year was a deductible casualty expense. Later on based on scientific research decided that this did not happen as with the same suddenness as fire, storm or shipwreck. So ruling ended by saying that damage caused by termites does not constitute an allowable deduction as a casualty loss within the meaning of §165(c)(3) - such damage is a result of gradual deterioration, this ruling over-rules the cases in the beginning.
Pulvers v. Commissioner (1969) – Page 842:
The Pulvers (P) lived near some hills. A landslide damaged several houses in the neighborhood. Fear of future landslides caused a temporary or permenant reduction in the value of the Pulver’s property. The P’s declared a casualty loss on the tax return. The commissioner denied the loss since no physical injury occurred.
Issue: May a casualty loss deduction be claimed absent actual physical damage to the taxpayer’s property?
Holding: No, Congress only intended that casualty loss deduction be granted in cases involving actual and physical damage to the taxpayer’s property. Here the landslide did not damage taxpayer’s property or block a ingress/egress, their property declined in value due to fear of future incidents, a hypothetical fluctuation in value is not a type of loss contemplated by Congress when it granted deductions for casualty loss, these are too uncertain can cannot be adequately determined. Denial by commissioner affirmed.
Concise rule: A casualty loss deduction is only granted when the taxpayer’s property has suffered actual physical damage.
Additional notes: reduction in value of a dwelling because of the fear of some future storm/tornados or other frequent, recurrent natural disasters does not entitle the taxpayer to casualty deduction, Lewis F. Ford, 33 TCM 496 (1974). – but the court did say that if the fear of damage ever became a practical certainty requiring abandonment of the property, a casualty deduction would probably be allowed.
Mary Francis Allen (1951) – Page 843:
Mary Francis Allen (P) visited the Metropolitan Museum of Art in New York. The broach she wore disappeared and was never recovered. There was no direct proof of theft or of the type of clasp used, safety or not, or that she was jostled in the museum. She claimed a casualty loss deduction based on the broach.
Issue: Does a taxpayer have the burden to present evidence either direct or indirect, which lead to reasonable inferences that loss was due to theft?
Holding: Yes, taxpayer has the burden which includes presentation of evidence which reasonably leads one to believe it was stolen, if the inferences leads to theft, plaintiff entitled to prevail, if the inference points the other way, must fail, if the evidence does not point in either direction the plaintiff must also fail since the burden is not met.
Concise rule: The taxpayer has the burden of proof which includes presentation of evidence which reasonably leads to the conclusion that the casualty loss was due to theft.
Additional notes: deduction requires establishment of theft; thief does not have to be caught or identified. Determining the value, done is same manner as casualty loss deduction, the property after the theft being treated as having a value of zero. Theft loss is to be treated as having been sustained in the year in which occurs, if at time of discovery, recovery is reasonable deduction must wait, but a remote possibility will not delay the deduction.
2. Timing Casualty Losses
§165(c)(3), (e), (i), (k)
Regulations: 1.165-1(d)(1) through (3), - 7(a)(1), - 8(a)(2), - 11(a) and (d)
Casualty losses are deductible for the year in which the loss is sustained. This may be the year of the loss or a year when the true extent of the loss is learned. ‘
Under 165(i) – is casualty loss is attributable to a disaster in an area subsequently declared by the president to warrant disaster under the Disaster relief act of ’74, taxpayer may elect to claim a deduction for the year immediately before the year in which the loss occurred.
3. Measuring the Loss – Page 846
§67(b)(3); 123; 165(b), (h)
Regulations: 1.165-7(a)(2), (b)(1) and (3) Example (1), -8(c)
Helvering v. Owens (1939)- Page 846:
Case no. 180 involves an automobile purchased by Donald Owens (P) prior to 1934 for $1825 used for pleasure until June 1934 when it was damaged in a collision. The car was uninsured. Before the accident its fair market value was $225, after the accident its was $190, Owned claimed a deduction of $1635 on his ’34 return. The commissioner reduced that to $35, the difference between cost and fair market value – the board of tax appeals sustained the taxpayer. Case No. 318 involves the destruction of an uninsured boat, boathouse and pier. The property was acquired in 1926 for $5325, used for pleasure, it was destroyed in 1933 with a value prior to destruction of $3905, the commissioner allowed a deduction only for the value at the date of destruction, board of appeals sustained he taxpayer, circuit court reversed.
Issue: should the amount of loss through injury to property not used in trade or business, and therefore not subject to depreciation allowance, be measured by the original cost?
Holding: No, amount of loss through injury of property not used in trade or business and therefore not subject o annual depreciation, may not be measured by it original cost. Loss must be measured by the depreciated value, that is, that loss actually sustained in the taxable year.
Concise rule: The amount of loss through injury to property not used in trade or business and therefore not subject to annual depreciation allowance may not be measured by the original cost but by its depreciated value.
Additional notes: 165(b) requires use of adjusted basis of the property determined by §1101, 1101 requires the cost basis be used – this must be adjusted by §1016 which require a deduction of basis for depreciation allowed or allowable on depreciable property used in gain seeking. The court decided that the value of property before the loss, i.e. the actual loss, would be the correct measure of the loss.
Note Page 848:
Three important differences in a loss sustained in a for profit transaction and a personal loss.
Pages 403 – 420
§167(a), (c); 168(a), (b), (c), (e)(1) and (2), (f)(1) and (5), (g)(1), (2), and (7), (i)(1); 1016(a)(2). See section 62(a)(1) and (4); 168(d); 263(a); 263A.
Regulations: 1.162-4; 1.167(a) – 1(a) and (b), -3, -10; 1.167(b) – O(a), - 1(a), -2(a).
§167 and 168 treat depreciation as if were an operating expense by allowing an annual deduction for exhaustion and wear and tear of property.
Prerequisites for a deduction:
167(a) and 168(a) restrict depreciation deduction to (1) property used in a trade or business (2) property held for the production of income, inventory and property held for sale to customers is outside the scope of this section
Only property that will be consumed or will wear out or will become obsolete or will otherwise become useless to the taxpayer can qualify for a deduction. Unimproved realty is non-depreciable.
It is only property with an identifiable useful life to the taxpayer, which can qualify for the deduction. Depreciation is a cost-spreading device, spreading cost over time, if property is such that is has no useful life that is ascertainable, it is said to be non-depreciable.
Page 405 – quote on useful life from Supreme Court
If for example a shoe stitching machine has a useful life of eight years, and cost $8,000, then its depreciation rate will be 12.5% so the entire cost can be taken over its life, 12.5%*8000 = 1000, 1000*8= 8000.
Accelerated Cost Recovery System (ACRS) – this system provides for shorter useful life. One may write off something that cost nothing to her, if you get a machine by gift, §1015 gives you the basis and you may write off that basis by way of depreciation deductions.
Technically the cost of an asset must be taken into account not only acquisition cost but also the amount that may be recovered on disposition of the asset, referred to as the salvage value. So deductions taken over the useful life should equal only the net cost, i.e., cost less salvage value.
Suppose the shoe-stitching machine was acquired for 1600 and will have a salvage value of 400 at the end of 8 years, so the 12.5% rate would properly be applied to the 1200 net cost of the machine.
Methods of Depreciation –
(1) Straight – line
The cost or other basis, less its estimated salvage value, is deducted in equal annual installments over the period of its estimated useful life, divide the amount to be depreciated by its useful life.
(2) Declining balance method –
Here a uniform rate is applied, the rate is applied constantly to an declining balance. The rate to be used under this paragraph may never exceed twice the rate which would have been used had the deduction computed under straight-line. The salvage value is not deducted from the property under this method, since at the end of the useful life there will be a left over balance and this represents the salvage value.
As deductions are claimed downward basis adjustments effect a shrinkage of the supply and “adjusted” basis reflects the remaining amount that can be claimed as deductions.
Basis adjustments arising out of depreciation are governed by §1016(a)(2)
Deprecation is viewed as a continuing expense each year.
Page 410 –
ACRS is mandatory not elective, though some elections may be made within the system. ACRS applies to tangible depreciable property, intangible property does not qualify for this treatment, and so if ACRS does not apply then §167 is used.
ACRS schedules apply the same whether the property is new or used.
Under ACRS each item of property is assigned to one of several classifications which is generally dependant upon the property’s class life under the ADR (Asset Depreciation Range), which sets various class lives for property which has shorter lives than the previous depreciation rules) system, property is assigned to applicable recovery periods, which becomes the period over which the item is depreciated.
Cars have a 5-year life, most real property is assigned either a 27.5 or 39 year recovery period.
The shoe stitching machine example, under ACRS it has a 7 year life and under ADR is has an 11 year life or recovery period, so if the shoemaker buys it for 1600 and places it in service, he uses the 7 year recovery period, this methods disregards salvage value, the shoemaker is entitled to recover the entire cost over 7 years, even though he hopes to sell it for 400 in 10 years.
Current ACRS provides that the type of depreciation methods available with respet to property also depends upon the classification of property. Property within the 3, 5, 7, and 10 year classes qualify to the 200% declining balance method with a switch to straight – line, and 20 year qualifies for 150% declining balance with a similar switch to straight-line
Under §168(g) – current ACRS provides an alternative depreciation system that is required for some properties.
Current ACRS provide a series of anti-churning rules, Congress did not want taxpayers to merely churn their old investments, ACRS is meant to encourage new investments – so anti-churning rules apply if and only if the current ACRS rules allow the taxpayer a more rapid write-off in the first year the property is placed in service than depreciation allowed for that year by the rules under which the property was being depreciated by related persons.
Example – current year taxpayer acquires property from a related person who owned or used the property and who acquired it after 1980 but before 1987, that taxpayer cannot use the current ACRS but must use old ACRS – page 413
Related persons include – brothers, sisters, ancestors and decedents, and entities such as corporations, partnerships and trusts in which the taxpayer has an interest.
Depletion (minerals) – page 414
The Revenue act of 1913 permitted “cost” depletion. Effect of this provision was very much like the current depreciation deduction allowing a recover of cost or other basis as wasting asset was consumed by its exploitation.
§613(b) presents a list of types of property that are subject to percentage depletion.
Sharp v. United States (1961) – Page 415:
The partnership of Hugh and Bayard Sharp (P) bought a Beech craft airplane for 45,875 on December 17, 1946, and additional $8400 in capital expenditures between 1948 and ’53 brought the total up to 54,300. They took allowed depreciation over the years totaling 13,700. P acquiesced to a depreciation, which reflected the ¼ - ¾ split in business and personal use of the plane. When the plane was sold for 35, 380 in the 13,777 allowed depreciation diminished 1954 the IRS required that the loss or gain be figured by using an adjusted business basis of $520.98; the 14,298 representing ¼ of the cost. The sale price was allocated to reflect the ¼ - ¾ business-pleasure split, making 9321 and 26,058 portions. By subtracting the adjusted basis from the allocated proceeds (9321 – 420) the IRS came to the figure 8800. In their actions to recover alleged income tax overpayments due to this method, P asserted the adjusted basis to figure loss or gain should be computed by subtracting the depreciation allowed from the total cost without any allocation reflecting use (54,273 – 13, 773 = 40,495). This base they contend should be subtracted from the sale rice to arrive a loss of 5,115, they do not seek to deduct this, their claim being only no gain was realized.
Issue: In figuring gain or loss on the sale of property used for both business and pleasure, must the cost basis and sale price be allocated to reflect the percentage of business use (as is the basis on which depreciation is figured)?
Holding: Yes, because it promotes uniformity and is a practice long accepted by the courts, the basis used to figure the loss or gain realized from the sale of property used for income p producing and pleasure purposes, must reflect the portion of business use
2. Special Depreciation Rules on Personal Property
§176(a), (c); (d)(1), (3) and (4)(A) and (C), (e)(1) and (3), (f)(1) and (5), (g)(1), (2), (3)(D) and (7), (i)(1), 179; omit – (d)(4)-(9); 280F(a), (b), (d) and (d)(6)(C) and (D) and (9) and (10). See section 197.
§197 applies the rules for the write off of many types of intangible property
§179 first year bonus and §280F limitations on allowances
Current §168 ACRS applies to most tangible personal property placed in service after December 31, 1986 (remember anti-churning rules), if the applicable recovery period is not in excess of 10 years the system employs a 200% double declining balance method, if greater then 10 years a 150% declining balance method which also disregards salvage value – further, current ACRS requires a switch to straight-line in the first year in which that method results in a greater amount of depreciation than the applicable declining balance method.
Current ACRS uses the half-year convention – the half-year convention treats property as if it were placed in service at he midpoint of the year no matter when it was placed into service, does not matter if placed into service Jan. 1 or Dec. 31. A half-year deduction is necessitated for the year following the end of the normal recovery period. This means, if you have an asset with a normal recovery period of 5 years, the allowance of a half year for year one and a half year for year six and full allowance for each of the other four years results in full depreciation of five years.
See tables of depreciation on page 430
To combat abuse a of this half-year convention a rule is in place, where if more than 40% of the cost of all ACRS personal property acquired during a year is placed into service in the 4th quarter of the year the mid-quarter rule is invoked.
Under current ACRS if personal property is disposed of prior to end of recovery period, the half-year or mid-quarter convention applies in computing depreciation for the year of disposition – meaning you have a 5 year recovery period, you dispose of it on last day of fourth year, in that fourth year you are allowed only ½ of year four.
But if ACRS is inapplicable to taxpayer elects out of §168, then §167 controls.
§179 in order to encourage investment, allows taxpayers to elect to write off a part of the cost of some depreciable personal property as an ordinary deduction in the year in which the property is placed in service, see section of page 432 for limitations. Limits apply not to each piece of property but to all the property qualifying during that period, and the amount is reduced by $1 of each dollar the property placed in service is in excess of $200,000
Not all property qualifies for §179, it is applicable only to property qualifying under ACRS which is §1245 property and which is acquired by “purchase” for use in the active conduct of taxpayers trade or business.
Just as the basis of property must be reduced by §167 of 168 depreciation deductions, the basis must also reflect a §179 deduction, which in essence is a depreciation deduction. The basis of the §179 property must be reduced before the property is depreciated under 168 ACRS, the reduction precludes a double depreciation.
If §179 property is not used predominantly in the taxpayer’s trade or business until the end of the property’s recovery period, recapture of §179 amount is required in the year of conversion.
§280F limitations on Luxury Automobiles –
Current ACRS – 5 year recovery period for cars – But congress decided decrepitating expensive luxury cars over a short period is too much of a good thing. So the maximum under §280F is 12,800 adjusted for inflation after 1988 of cost of recovery over 5 years - to the extent a car is luxurious (costs more than 12,800) a maximum amount of $1,475 can be written off in each year following the first 5 years during which the taxpayer continues to use the car in a depreciable capacity, until the acquisition base is exhausted.
§280F limitations on listed property –
Listed property includes passenger vehicles and other property used for transportation; property of a type generally used for entertainment, recreation, or amusement purposes; computers not exclusively used at a regular business establishment and cellular phones or similar telecommunications equipment.
In general, listed property is not cnonsdiered business use, unless the use if for the convenience of the employer and is required as a condition of employment. Listed property with a business use of 50% or less, can be depreciated using only the alternative depreciation system of §168(g).
Amortization of Goodwill and other Intangibles – Page 435
§197 – recovering the cost of most acquired intangible assets.
And intangible which is acquired in connection with conduct of trade or business – may be amortized over 15 years beginning with the month in which the asset is acquired, §197 is generally not applicable to an asset that is self created by the taxpayer, it must be acquired.
If taxpayer disposes at a loss only a part of the §197 intangible acquired in the transaction, the loss is not recognized and the basis of such assets is allocated to the adjusted basis of the remaining §197 asset acquired in the transaction, selective disposal are not allowed.
§197 intangibles are treated as depreciable property under §167 and as a result their disposition is potentially subject to characterization under §1231, 1239 and 1245 and the anti-churning rules also apply.
Procedure on page 437 –
3. Special Rules on Reality
§168(a), (b)(3)(A), (B) and (4), (c)(1), (d)(2) and (4)(B), (e)(2), (f)(5)(B)(i), (g)(1)(E), (2) and (7) – see sections 42; 46(a)(1); 47(a) and (c)
Prior to 1986 legislation, most new or used real estate qualified for old ACRS treatment, under old ACRS it was assigned a 19 year recovery period and qualified for either 175% declining balance, or straight line method of depreciation
After the 1986 legislation property placed into service after December 31, 1986, it classified real estate as either, residential rental or nonresidential real property. Both types must be depreciated using only straight-line – residential rental property is assigned a 27.5 year life, nonresidential real property is assigned a 39 year life.
Rental property is classified as residential only if 80% or more of the gross rental income from the building is from dwelling units, the code does not allow this to mean hotel units in which more than half are used on a transient basis.
Real property does not use the half year convention, this generally applies to personal property, real property used the mid-month convention, allowing property to begin using the middle of the month the property was put into service.
Page 440 – Congress provides two more rules to encourage two different types of investments – 1st goal is to encourage investment in the rehabilitation of older real estate – certain tax credits are allowed – also subject of §47(c)(1)
2nd set of rules is aimed at low-income housing, rules allow for credits for cost incurred by owners of low-income housing.
Chapter 22 –
Characterization on the Sale of Depreciable Property
B. The §1231 Hotchpot
§1231, see §1(h); 1060; 1211(b); 1221; 1222
The function of 1231 is exclusively characterization
In general, 1231 provides, if during the taxable year the gains on the disposition of certain types of property exceed the losses on the disposition of the same types of property, all gains and losses are treated as long-term capital gains or losses.
Conversely, if the losses on the disposition of these properties equal or exceed the gains, all the gains and losses are treated as ordinary.
There is a temptation to net the gains and losses under 1231(a), such netting is not proper here, the net capital gains and losses will need to be separately classified under 1(h).
1231 applies to any recognized gain or loss from the sale or exchange of depreciable business property held for more than one-year, and real property used in business, which has been held for more than one year.
It also applies to any gain or loss from the compulsory or involuntary conversion of any depreciable business property or real property held for more than one year and of any capital asset held for more than one year, if the asset is held in connection with a trade or business held for profit making activities.
1231 only applicable to property connected with a trade or business or profit-seeking activity.
The combination of transactions is brought together in the §1231 hotchpot are compared with gains and losses, if the gains exceed the losses, then all the gains and losses are treated as long-term capital gains and losses, if the losses exceed the gains all the gains and losses are treated as ordinary gains and losses.
§1231(a)(4)(C) – the Sub-hotchpot:
Two special rules that cut across §1231
First, a sub-hotchpot rule must be applied prior to consideration of main htchpot consequences, §1231(a)(4)(C) providees that, before any gains or losses from involuntary conversions (fire, storm, theft etc) are to be included in the main hotchpot, gains from such conversions must equal or exceed losses from such conversions. So, a taxpayer first compares allowable involuntary casualty gains and losses from trade or business or profit-seeking activity, if gains exceed losses, then all these gains and losses are routed into the main hotchpot, if losses in the sub-hotchpot exceed gains, then 1231 does not apply at all to any of the gains or losses, they all remain ordinary gains and losses, never entering the main hotchpot.
§1231(c), Lookback Recapture Rule – page 766:
Taxpayer can maximize benefit of 1231 by timing all losses to fall in one year and all gains to fall into another year, thereby characterizing all gains as long-term capital and all losses as ordinary
§1231(c) establishes a lookback rule which if applicable overrides the main hotchpot and re-characterizes some or all of a main hotchpot net gains from the current year from long-term capital gain to ordinary income. The rule requires such a re-characterization to the extent that there are unrecaptured §1231 main hotchpot net losses for any of the preceding five years, such losses are the sum of net losses established by the main hotchpot over the prior five years which have not been offset as ordinary. See page 766 for examples.
Stephen Wasnok (1971) – Page 766:
The Spring Grove Loan Co. loaned Mary and Stephen Wasnok (P) a substantial portion of the purchase price of a home they purchased in 1960 in Cincinnati, Ohio, the Sage crest property. This home was subject to a first mortgage to secure the aforementioned note. In 1961, (P) moved to California and unable to sell the Sage crest property rented their home ot various tenants between June 15, 1961 and May 7, 1965. Two separate listing during this period were unsuccessful in producing a sale, so the decision to rent stood, bringing an average of $200/month, until May 1965, at that time P was unable to make the payments so they deeded the property back to Spring Grove to settle 24,000 outstanding debt. From ’61 – ‘64, depreciation totaling 4,700 has been taken on improvements, thereby reducing the basis so that the difference between this adjusted basis and the mortgage balance produced a loss of 3,600. In ’61 the IRS examined P’s return, a cost basis of the land and improvements totaling 32,790 was agreed upon. No returns were filed for ’64 and ’65 because it appeared not tax was due, although there was gross income of 5,600 and 3,180 respectively. Predicated on their ’65 disposition of the sage crest property, Mary and Stephen each claimed on separate ’67 returns, a capital carry-forward loss of $1000 and one of $389 on the joint ’68 return. The commissioner, disallowing the capital loss carryover on the grounds that the loss was an ordinary one deductible in the year sustained 1965, assessed deficiencies, which resulted in this action by P.
Issue: Can non-business property become property used in trade or business when an inability to sell same forces the owners to rent it at a substantial for a fairly continous period during which they claim expenses and depreciation brought about by the rental activity on the tax returns?
Holding: Yes, once acquired the nature of the property may be changed by the subsequent use in what amounts to a trade or business. In this instance, fairly continuous rental at a substantial rate combines with the claims of expenses and deductions on tax returns to establish the use of such property as a rental business.
Concise rule: In sales of exchanges of depreciable property and/or real estate used in trade or business, net gains are treated as capital gains and net losses are treated as ordinary losses.
Additional notes: §1231 assets are quasi-capital nature, the losses on sale of same producing deductible ordinary losses and the gains producing taxable capital gains.
Williams v. McGowan (1945) – Page 771:
Williams and Reynolds (P) formed a partnership, when Reynolds died, Williams purchased Reynolds’s interest from the estate. Williams (P) then sold the assets of the business to a third party. P reported the as ordinary loss on his tax return. Commissioner determined the business was a capital asset, which demanded capital gains treatment.
Issue: Does the sale of a sole proprietorship result in capital gains and losses?
Holding: No, While it has been held that a partner’s interest in a going concern should be treated as a capital asset, when P bought Reynolds share, the business became a sole proprietorship, no suggestion of tax avoidance scheme here, business must be treated as a sole proprietorship, to determine tax treatment see §1221, which requires all assets be treated as capital ones unless they fit within three exceptions; stock and trade, property held primarily for sale to customers, and depreciable business property. P transferred cash receivables, fixtures and inventory. Fixtures are depreciable, inventory is held for re-sale, neither of these is subject to capital treatment, cash transfers cannot result in gains or losses, therefore, only asset which might be deemed capital in nature is the receivables, however they may be subject to depreciation, so the case was remanded for a decision on this point.
Concise rule: The assets of a business must be separately treated to determine if income from their assets is capital or ordinary based on §1221.
Additional notes: Goodwill is considered a capital asset when a business is sold. Rev ruling 57-480; Regs §1.167(a)-3. But accounts receivable acquired on the sale of inventory property will be deemed non-capital assets, §1221(4), since most businesses on accrual basis should already be reported – but may be more significant for cash basis taxpayers.
D. Recapture Under Section 1245 – Page 781:
§64; 1245(a)(1)-(3), (b)(1) and (2), (c), (d). See sections 179(d)(10); 1041(b); 1221; 1231
Regulations: §1.1245-1(a)(1), (b), (c)(1), (d), -2(a)(1) through (3)(i) and (7), -(6)(a)
§1245 as well as §1250 is predominantly a characterization provision converting what is possible capital gain to ordinary income.
Problems here is – In §167 and 168 there are authorized deductions for property used in trade or business, under 1016(a)(2) the price paid for such deductions is a reduction of basis. It is a fair price; deprecation deductions are viewed as a tax recovery of cost.
If depreciable property is sold at a gain, quantitatively the prior depreciation that reduced taxable income is offset at the time of sale by a corresponding increase in the gain on the sale.
But using 1231, with respect to property used in trade or business, if the sale of 1231 gains exceed such losses, the gains get capital gains treatment. Gains held on property for production of income also get capital gain treatment.
The concept of recapture, the Gotcha, is the principal congressional answer to this problem, converting what would normally be 1231 gain or capital gain to 64 ordinary income. The code sections providing for recapture, most important of which are, §1245 and 1250 – these are made applicable not withstanding any other code section, they override other code sections, except where recapture provisions say otherwise directly.
The general rule – Paragraph 1 of §1245(a) – provides the general rule tha if §1245 property is disposed of, the amount by which the lower of “recomputed basis” or the amount realized (or fair market value if no amount is realized) exceeds the adjusted basis of the property is to be treated as gain from the sale or exchange of property which neither capital nor property described in §1231.
Recomputed basis is determined with respect to adjustments to basis for deductions for depreciation (and for amortization) which were either allowed or allowable, if the taxpayer can establish adequate records, the amount allowed for any taxable year was less than the amount allowable, the amount to be added for such taxable year is he amount allowed. Example page 783
The gain to which 1245(a) applies is eh amount by which the fair market value of the property on the date of disposition or its recomputed basis, whichever is lower, exceeds its adjusted basis – see examples page 784
Revenue Ruling 69-487 – Page 786:
Individual taxpayer operating a business as a sole proprietorship converted to personal use an automobile that had been used solely for business purpose, at the time the fair market value of the auto was substantially higher than its adjusted basis.
Held: For purpose of §1245, the conversion to personal use is not a disposition of the auto. So there is no gain to be recognized by the taxpayer upon conversion for personal use.
E. Recapture of Depreciation on the Sale of Depreciable Real Property
1. Recapture Under §1250
§1250(a)(1)(A) and (B)(v); (b)(1), (3) and (5); (c); (d)(1) and (2); (g); and (h). See §64; 1222; 1231.
Regulations: §1.1250-1(a)(1) through (a)(3)(ii); -1(c)(1) and (4); -1(e)(1) and (2); -(2)(a)(1);-2(b)(1).
§1250 extends the recapture concept to dispositions of real property
Page 788 – general reasons for provisions
Explanation of Provisions:
Depreciable real estate sold after December 31, 1963, in certain cases a proportion of any gain realized upon the sale of the property is to be treated as ordinary income, that is, previous depreciation deductions against ordinary income are to be recaptured from the capital gains category.
Pages 908 – 910
Gain or loss has no tax significance as long as it is only a mere loss or increase in value something more must happen, for example a sale or exchange before a loss or gain is said to be realized.
Deferred reporting gains - §435
Dis-allowance of some allowances - §267 and §1091
Page 909 - Example where owner of property has 100,000, trades for yacht worth 175,000 exchange and realized gain, §1001(a), (c)
Now what if owner simply changed location, traded his 175,000 land for another 175,000 in different location, here special non-recognition rules apply.
Non-recognition provisions follow notion that realized gain, or loss is sensibly deferred when the taxpayer has retained the investment in property that is essentially the same type as the original property held.
Above example related to §1031
§1041 applies to transfers between spouses and former spouses incident to divorce
§1041(b)(2) – provides that the transferee who in essence steps into the show of the transferor, and takes the property with the transferred basis.
See also §1223(2) and 7701(a)(43)
Non-recognitions generally carry with it an exchanged basis (which is in essence a substituted basis) and a tacked holding period for a new property. §1031(d), 1223(1), and 7701(a)(44).
Non-recognition rules are so interrelated as to effect only a postponement of the tax on gain, but things like the date-of-death value basis rule §1014 offers an amnesty
§1231(a) limits the hotchpot ingredients to recognized gains and losses
Pages 921 – 940
2. Three-Cornered Exchanges
Regulations: §1.1031(k)-1(a), (b), (c)(1) and (4)(i), (f)
Revenue Ruling 77-297
Is item described an exchange of property in which gain or loss is recognized under 1031(a)?
Dealing to buy a ranch with offer to trade if suitable ranch found, see page 922-923 for details, but, A does qualify under 1031 non-recognition but B does not since the ranch offering to trade was not held by him for productive use in trade or business, acquired later for sole purpose of the trade, so see §1001 and regulations applicable to this section.
Note – Page 923 – Three-Corner-Transactions:
§1031 does not apply if property is sold and the proceeds are reinvested in property of like kind.
The basic 3-cornered-transaction: Sanctioned by 77-297
A has property (x), that B wants and C has property (y) that A wants. Assume C’s bases for property y is equal to its fair market value, but A’s basis for property x is much less than fair market value, assume properties are of like kind and of equal value. A could sell x to B and buy y from C, but then A would have a taxable gain realized from sale of x. So to avoid this, (1) have B buy the property y from C (without adverse consequence to C because basis of y is equal to fair market value) and (2) then have A exchange property x with B for property y, tax-free under §1031.
As regards to A who has a large realized gain on the exchange, the transaction is rendered tax-free by 1031, the fact that B acquired property y for the very purpose of making the exchange has no effect on A, A has held x for lets say investment purposes and A exchanges it for property y to be held for investment, this fits squarely within the statute.
B is not within 1031. B does not have property held for productive use or investment which is for kind property. B has newly purchased property y that B uses to make the exchange, so 1031 does not apply to B. But B does not care whether he is within or out of 1031 because B has a new cost basis for y, that presumably is equal to the fair market value of x that B received in exchange, so the transaction is neutral to B for tax purposes.
Revenue ruling 77-297 is a variation on the 3-cornered-transaction -
Because B transfers money into an escrow account prior to B’s acquisition of C’s property, the service sanctions the transaction because before the sale was consummated, the parties effectuated an exchange.
Page 925 – under §1031 simultaneous transactions are not necessary to in 1031 – Starker v. United States.
In 1984 this was limited by 1031(a)(3), limiting time of transactions, identified with 45 days.
The 3-property rule and/or 200% rule – (page 925) – If the taxpayer identifies multiple properties the maximum number is 3 without regard to fair market value, or any other number of properties as long as their aggregate fair market value of relinquished properties does not exceed 200%.
If one of the above rules not met then, 1031 not applicable.
3. Other Section 1031 Issue:
§1031 applies to defer both gains and losses, and is non-elective, if its requirements are met it automatically applies.
§1031(a) applies only to exchanges of like kind property- if some boot (cash, or other not like kind property) is received §1031(b), or (c) may apply
In general 1031 not applicable if like kind exchange is between related persons
C. Involuntary Conversions – Page 930
§1001(c); 1033(a)(1), (a)(2), (b)(2), (g)(1), (2) and (4), (h)(2); 1223(1). See §1231; 1245(b)(4); 1250(d)(4).
§1033 permits non-recognition when the conversion is involuntary, this includes, destruction, theft, seizure, requisition or condemnation or threat of imminence thereof.
In general, when property is involuntarily converted into money, if the taxpayer so elects, gain is recognized only to the extent that the amount realized as a result of conversion exceeds the cost of replacement property. This must happen within time stated by statute.
Provision does not apply to losses resulting from involuntary conversions and generally does not apply if property is acquired from a related person, related person restriction does not apply to taxpayer whose realized gain does not exceed $100,000.
The basis of replacement property is the cost of such property, reduced by the gain that is not recognized, except to the extent that §1014 intercedes, this is a deferral tax to the future.
Harry G. Masser (1958) – Page 931:
Masser (P) owned an interstate trucking business and utilized two pieces of property situated across the street from one another. The two pieces were used together as an economic unit. One of the pieces was involuntarily converted as a result of threat of condemnation by the city. Because of the fact that without the 2nd lot this made business very expensive, P sold the 1st lot and with the proceeds from both purchased a replacement lot in the same locality. P claimed both lots as involuntary conversion, which was dis-allowed by the commissioner, and Commissioner assessed a deficiency, P paid the assessment and brought suit.
Issue: If two lots are used in a business as an economic unit, if one if one of the lots is involuntarily converted, does this cause the other to also be involuntarily converted?
Holding: Yes, two lots were practically adjacent, were acquired for same purpose and were being used as a single economic unit, P sold and acquired replacement property.
Concise rule: When two lost are used in a business as a economic unit, if one of the lots is involuntarily converted, this causes the other lot to also be involuntarily converted.
Additional notes: As a general rule, involuntary conversion is a taxable transaction resulting in gain or loss, but if taxpayers replaces the destroyed or lost property with similar property he may elect to treat the gain or loss as not subject to recognition if is meets §1033 requirements.
Clifton Inv. Co. v. Commissioner (1963) – Page 932:
Clifton (P) was forced to sell an office building owned by it in New Your under threat of condemnation. The money was then reinvested in purchasing a hotel. The Commissioner assessed a deficiency tax on the proceeds from the sale of the office building. The Tax court rejected P’s contention that the transaction was an involuntary conversion of property involving a like-kind reinvestment, which was tax exempt under §1033. The Tax court applied the function or end use test. This approach only takes into account the actual physical end use of the taxpayer to determine whether §1033 treatment should be granted. The court denied tax exempt status under §1033.
Issue: should the court abandon the functional or end use test in favor of a more flexible focus on all relevant factors to determine if the purchase was of a like kind of property?
Holding: Yes, the functional or end use test is too inflexible and must be abandoned. Congress intended to grant tax-exempt status to investors who are subject to an involuntary conversion requiring reinvestment of their funds, but their intent was not to allow venturing into new areas of business. The reinvestment must be in substantial property, question here is whether a hotel if a substantial equivalent to an office building, considering all relevant factors, management, employees, nature of services, number of employees etc. Here, Clifton use to manage the hotel, here professional management was needed, hotel 130 employee here 2, services are different, so hotel was not a substantial equivalent to office and denial under 1033 affirmed.
Revenue Ruling 76-319 – Page 935:
Does the following qualify as replacement property under §1033?
Corporation had a bowling center destroyed by fire in June ‘74; it had alleys, lounge area and a bar. The corporation got insurance proceeds for the loss of the center, the proceeds exceed the basis. Taxpayer elected to defer taxes under 1033 and invested in a recreational billiards center, which included a lounge area and a bar. The ruling held the billiards center was not similar for purposes of 1033, the physical characteristics are not closely similar since bowling alleys and equipment not similar to billiard tables and equipment.
Revenue Ruling 71-41 – Page 937:
Does the following qualify for 1033 treatment?
Individual owned a warehouse, which it rented to third parties. The land was condemned by the state and a gain was realized, taxpayer used the proceeds to erect a gas station on anther piece of land of his and rented it to an oil company. The taxpayer did not qualify under 1033 because a warehouse and gas station are not properties of like kind. But, the fact that taxpayer did not qualify under 1033 under these facts does not preclude him from trying to qualify if he can prove the replacement property is of like kind.
Chapter 24 – Page 851 – 868
Deferral and Non-Recognition of Income and Deductions
The Interrelationship of Timing and Characterization
A. Transactions Under §453
See page 851 for code and regulation sections
Example of what 453 does – S bought land 10 years ago for 40,000, B wants to buy it for 400,000 today, and will borrow money and pay off in four years, and pay interest on it to do so, if not for §453 then S would have to recognize 360,000 of gain in current year, this is problem since S has not year received cash. What §453 does it allows seller’s gain to be included in gross income only as payments are received from buyer, thereby providing S will the necessary liquidity to pay the taxes.
§453 is essentially a timing provision available to both cash and accrual method taxpayers.
General rule – An installment sale of property occurs when at least one payment of the total purchase price is to be received after the close of the taxable year in which the disposition occurs. When the disposition occurs §453 allows the gain to be spread over the payment period by requiring a percentage of each payment to be included in gross income in the year of receipt.
§453(c) provides the method for calculating the percentage of each payment to be included in seller’s gross income. The percentage is the ratio of the gross profit to the total contract price.
The gross profit is the gain in selling price realized over the life of all payments, and the total contract price is generally the selling price of the property. Also, adequate interest must be paid on the obligation.
From the above example – the seller’s investment land was a capital asset because held longer than 1 year (10 years) – so the gross income constitutes long –term capital gain.
Taxpayer may elect not to use the §453 spreading; election must be made on or before the due date (including extensions) of the taxpayer’s income tax return for the taxable year in which the sale or other disposition of the property occurs.
As a general rule, installment reporting of gain from deferred payment is not available where all or a portion of the selling price is subject to a contingency, case law holds that the selling price must be fixed and determinable for §453(b) to apply.
Situations in which §453 does not apply:
Property sold as at a loss
Dealer dispositions – one who regularly sells personal property on an installment plan, or the disposition of real property which is held for the sale to customers in ordinary course of seller’s trade or business.
Recapture income – installment method is inapplicable to the extent of any section 1245 or 1250 recapture gain which is required to be recognized on the sale, such gain is required to be recognized in the year of sale.
If there is any remaining 1231 gain or long-term capital gain on the sale of recapture property, the remaining gain does not qualify for installment treatment under a recomputed gross profit to total contract price ratio that reflects the recognized recapture gain. Example page 857
§453 does not apply to related persons as defined in §1239(b)
If §453(g) is applicable, the rule effectively places the seller on the accrual method, and the gain is generally all ordinary income
§453 treatment denied on sale of publicly traded stock or securities, which are traded on an established securities market
Sales of personal property on a revolving credit plan
Non-recognition sales – to the extent a sale is treated as a non-recognition transaction under the code, only the gain required to be recognized is taxed and potentially may be subject to §453.
Special rules related to §453 – page 858:
If the property, which is sold on the installment method, is subject to a liability, under the Crane principle the liability is to be included in the amount realized on the sale.
Additional calculation needed, see section page 859
If real property is sold under the installment sales provision of §453, a repossession of the property by the vendor upon default by the purchaser constitutes a 543(b) disposition of the installment obligation. Page 861 for amount of gain reported calculation
But the repossession is essentially a continuation of the vendor’s property so §1038 a non-recognition principle applies here.
453(e) aimed at people who takes advantage even though there is liquidity available
Page 862 – Installment sales provision as a tax planning device – intra-family transfers and benefits thereof.
Pages 868 – 883
B. Transactions Elected Out of §453
1. Open Transactions
See page 868 for code and regulations sections
Burnet v. Logan (1931) – Page 868:
The shareholder of Andrews and Hitchcock Iron, including Logan (P) sold their shares to Youngstown Sheet and Pipe for a sum less than fair market value and an agreement to pay them 60 cents per ton for ore mined each year under a 97-year lease, the lease did not require a minimum or maximum amount of ore to be mined each year. P owned 250 of the 4,000 shares in Andrew’s and Hitchcock, for which she received the aforementioned compensation. She also was paid one half of the payment accruing to her mother’s estate, as such was the mandate of the will. This was value for estate purposes at $277,000 because she had not yet recovered her basis in her own stock or the assessed value on her mother’s stock, P did not pay taxes on the amount she received. Commissioner held that the iron ore payments to be made by Youngstown has an ascertainable value, the sale constituted a closed transaction, each payment must be allocated between income and return of capital. The court of appeals overruled the district court’s affirmation of commissioner’s position and allowed P to escape assessment, commissioner appealed.
Issue: If the compensation to be received for sale of property is indeterminate and speculative, is the seller entitled to recover his basis before any tax can be assessed on the transaction?
Holding: yes, where the value of the compensation cannot be determined as in this case, there exists an open transaction, which requires a return of basis before any taxes can be assessed. Not possible to ascertain what 60 cents/ton will be worth when no maximum or minimum is quoted, and Youngstown’s future needs are not predictable. Thus open transaction not subject to tax until basis is recovered.
Concise rule: Where the compensation received for a sale is partly or totally indeterminate and speculative, it is an open transaction whereby the seller has no tax assessed on the same until his basis in the property sold is recovered.
Note page 872 –
§1001(a) gain or loss is the difference between the amount realized on disposition and the adjusted basis of the property relinquished. If either of these is incapable of being measured then the gain or loss on a transaction is unknown as well – concept established by Burnet v. Logan.
The gain in an open or closed transaction is characterized by the original transaction but, if the amount actually realized over the years exceeds the initial determination, the excess is ordinary income and is not characterized by the nature of the original sale or exchange.
Warren Jones Co. v. Commissioner (1975) – Page 875:
Warren Jones (P) sold real property. P received $20,000 plus 8%, 15-year mortgage for $133,000. P claimed no profit form the transaction; the funds actually received being a return of basis. In the alternative, P elected to handle the transaction on the installment basis under §453. That section provides that where the taxpayer received less than 30% of the sales proceeds in the first year of sale, he may elect to pay taxes on an installment basis as received. The commissioner denied both contentions and assessed a tax on the difference between P’s basis and the cash received plus the fair market value of the mortgage, which could be discounted to a lender for $118,000. Jones brought suit challenging the commissioner’s contention. The court found that the mortgage was a liquid asset having a fair market value 118,000. It further found that Jones would have to place 40,000 in escrow under normal trade practice to guarantee payment of the first 40,000 of the mortgage. P actual realization therefore was 78,000. By subtracting its basis the taxpayer had realized a substantial capital gain under §1001. The court found than while the mortgage was cash equivalent under §1001, which would require recognition of the entire gain in the year of sale, because it could not be sold without taking a large loss (42%) the taxpayer could qualify for installment-payment treatment.
Issue: If an instrument given in exchange for a transfer of property can readily be sold for an ascertainable amount, may a taxpayer compute gain on the installment method?
Holding: No, §1001 requires that all gain must be reported in the year of transfer when cash equivalent is given in exchange. Since the mortgage has a fair market value and is readily saleable, it is cash equivalent within the meaning of the section. The fact that a taxpayer would suffer a substantial loss by selling, or chooses not to do so has no bearing on his tax liability. Once it is found that the exchange involves cash equivalent, the transaction is deemed complete and gain/loss must be reported for the year of transfer. The commissioners’ determination that the mortgage was cash equivalent was correct; its value plus the cash received less basis is the measure of Jones’ profits and taxes on this amount must be paid. Reversed.
Concise rule: Where a cash equivalent instrument having a readily ascertainable fair market value is given in exchange for a transfer of property, the value of the instrument must be included in the competition of gain from the transaction.
Note page 881 –
Example of cash method taxpayer in a closed transaction elects out of §453.
Chapter 7 – Page 155 –63
Annuities and Life Insurance Proceeds
See page 155 for code and regulations sections
§101(a)(1) excludes the proceeds of death policy insurance from the gross income of the recipients. See §102 and 1014.
The 101(a)(1) exclusions only apply to amounts “paid by reason of death of the insured.”
It is possible that an insurer will pay the policy, that is pay to be discharged of liability and this may be in excess of the paid in basis, this will be taxed as gain, it is not an amount paid by reason of death.
But there is an exception to above, 101(g), accelerated death benefits received from a life insurance policy on the life of a terminally ill person or chronically ill, see page 156 for difference.
No ceiling limit on amount paid to terminally ill, chronically ill are limited to costs of qualified long-term care or to payments of $175/day (63,875/year) both reduced by any reimbursements from medical insurance proceeds.
If a person elects not to take the entire face value of the policy all at once, say 100,000, instead elects to take payments over and expected life time, drawing on the interest so as to exceed the 100,000, then all the interest beyond 100,000 is taxable like interest earned on a bank account, but the 100,000 is not – page 158.
Annuity payment page 158 --- §72
Some annuities contain what is known as a refund feature – a refund occurs if any annuity is paid to an annuitant for her life, but if the annuity payments made prior to the annuitant death do not equal the premiums paid for the contract the excess is refunded, in such a situation 72(c)(2) requires the value of the potential refund be subtracted from the investment in the contract, which has of course the intended effect of increasing the income portion of each annuity payment.
Refunds may be totally or partially includable in income under 72(e) – page 162
Discharge of Indebtedness
See Page 164 for code sections and regulations
US v. Kirby Lumber Co. (1931) – Page 164
Kirby Lumber (P) issued bonds having par value of $12, 127,000 for that amount. Later in the same year it was able to repurchase a part of the bonds for a price below par. The aggregate difference in price between the par value and repurchase price was $138,000. IRS assessed a tax on the amount contending it was a taxable gain to Kirby, Kirby paid the tax and sued for refund.
Issue: Does retirement of debt for less than face value represent a taxable gain to a corporation?
Holding: Yes, §61(a) defines gross income as gains or profits and income derived frm any source whatever. Retirement of debt for less than face value represents a gain or income for the taxable year. Kirby made available $138,000 previously offset by the bond obligations.
Concise rule: The retirement of debt by a corporation for less than face value represents a realized increase in net worth to the corporation and is therefore a taxable gain.
Zarin v. Commissioner (1990) – Page 165
Zarin (P) was a compulsive gambler who frequented Resorts Hotel International, and held a line of credit there. As a valued gaming patron he head his line increased over the course of two year form $10,000 to 200,000 and above. Under this line P could write a check called a marker and in return received chips, which could, used to gamble at the casino’s tables. Although between June ’78 and December ‘79, P incurred $2.5 million in gambling losses, which he paid in full, in January 1980 he lost about gambling losses, which he paid in full, in January he lost about $3.435 million. To pay for these losses he wrote personal checks and counterchecks to Resorts, but they were returned dishonored. When Resorts filed a stat of action to collect the $3.435 million, P claimed the debt was unenforceable under New Jersey state regulations protecting compulsive gamblers. Resorts and P settled the claim for $500,000 in 1981. Although at first the tax commissioner assessed a deficiency based on recognition of $3.435 million of income in 1980 from larceny by trick and deception, upon challenge by P in the tax court the commissioner changed the basis of his assessment to recognition of $2.935 million of income in 1981 from cancellation of indebtedness.
Issue: If a taxpayer, in good faith, disputes the amount of a debt, will a subsequent settlement of the dispute be treated as the amount of debt cognizable for tax purposes?
Holding: Yes, the proper approach in viewing the Resort/Zarin transaction is as disputed debt or contested liability. Under the contested liability doctrine, if a taxpayer, in good faith, disputes the amount of a debt, a subsequent settlement of the dispute will be treated as the amount of debt cognizable for tax purposes. Here P incurred a 3.435 million debt while gambling at Resorts but in court disputed liability on the basis of unenforceability. The subsequent settlement of 500,000 served only to fix the amount of debt and no income was realized or recognized. P could not have recognized income from cancellation of indebtedness because his debt did not satisfy the requirements to §108, §108 requires that for a canceled debt to be recognized as income under 61(a)(12), it must be one for which the taxpayer is liable, or one subject to property which the taxpayer holds.
Concise rule: If a taxpayer, in good faith, disputes the amount of a debt, a subsequent settlement of the disputes will be treated as the amount of debt cognizable for tax purposes.
Page 476 – 504
See page 476 for code sections
Revenue Ruling 69-188 (1969) page 476:
States that interest cannot be a fee that is paid for any specific services that the lender had performed or had agreed to perform in connection with the borrower’s account. “Points” on a mortgage can qualify as interest. To qualify as interest for tax purposes he payment by whatever name called must be compensation for the use or forbearance of money per is and not a payment for specific services
J. Simpson Dean (1961) – Page 480
The Deans (P) formed a corporation, which was wholly controlled by them. The corporation loaned the Deans approximately two millions dollars in exchange for interest free notes. The IRS determined that this was a taxable event. It assessed a tax against the Deans for the prime rate of interest on the loan at the time it was made. Deans brought suit to have the assessment set aside alleging that an interest free loan was does not yield taxable income and that it is neither a dividend nor compensation
Issue: Is the granting of an interest free loan by a controlled corporation a taxable event?
Holding: No, an interest free loan does not produce income. If the loan contained a provision for interest, it would be fully deductible by the Deans. We see no reason to assess a tax where no interest was charged. This is not to same type of situation where the taxpayer is accorded the rent-free use of the corporate property. If any income is produced from the loan money it will be taxable.
Concise rule: the granting of interest-free loans by a corporation to its employees/officers/directors is not a taxable event as to them.
Note page 484 – 493
Below market interest rate loans – or loans given to avoid income taxation rules ---
§7872 divides loans with below market interest rates into two broad categories, gift loans and non-gift loans.
Treatment under 7872 depends much on factors of timing and nature of loan, but under this section all loans that carry a below market interest rate (or charge not interest at all) are re-characterized to impute the payment of interest – for example a $100,000 interest free loan for a father to son is transformed for tax purposes into a loan in which the father charges interest at a rate based on upon the Federal rate. Son is presumed to pay the interest, possibly generating an interest deduction for himself and generating interest income from the father – the transmittal of funds from the father to his son to permit the son to pay the constructive interest is another taxable event and, depending on the identity of the taxpayers and the nature of loan, generally characterized as either gift, dividend, or compensation
Gift loans – page 487
Gift loans are, lender is funding (foregoing) of borrower’s interest payments is characterized as a gift from the lender to borrower.
If gift loan to be paid back certain date – term loan, lender must recognize interest income and the borrower possibly earns an interest deduction
Example: father to son, 100,000 on Jan. 1 1995, for 4 years made with donative intent – we assume the federal rate on date is 12% - so this would be characterized as a gift loan with constructive interest taxed as a gift – the amount of constructive interest is the amount loaned less the present value of all principle and all actual interest payment to be made under the loan. In this example 100,000 @ 12% semi-annually which is 62,741 subtract that from 100,000, you get 37,258 this difference is constructive interest, the amount of the gift from father to son – gift deemed to be made on the date loan was made.
Foregone interest is treated as having been paid by the borrower to the lender on the last day of each calendar year during which the loan is outstanding.
Demand loans – page 489 – again constructive interest is deemed to be made here – but no separate calculation of the amount of the gift made here – both the amount of the gift and the borrower’s potential interest deduction are determined by subtracting any actual interest payment due under the loan from the interest that would have accrued under the applicable federal rate.
Treatment of non-interest or below market interest loans is on pages 484 – 493
§1272 creates both interest income (to the bondholder) and interest deductions for the corporation for bonds sold at a discount
§482 gives the commissioner limited authority to allocate gross income, deductions, credits, or allowances among organizations controlled by the same persons
§163(h) allowance for a qualified residence interest
§221 qualified interest deduction on qualified education interest
§264(a)(2) precludes a deduction for interest paid on debt incurred or continued to buy a single premium life insurance or endowment or annuity contract
Pages 806 – 839
B. The Charitable Deduction
Revenue Ruling 83-104
A contribution of the purposes of §170 is a voluntary transfer of money or property that is made with no expectation of procuring a financial benefit commensurate with the amount of the transfer
Revenue Ruling 67-246
To be deductible as a charitable contribution for Federal income tax purposes under §170 a payment to or for the use of a qualified charitable organization must be a gift. To be a gift for such purposes in the present context there must be, among other requirements, a payment of money or transfer of property without adequate consideration.
Gift must be made where the proof that the portion of the payment claimed as a gift represents the excess of the total amount paid over the value of the consideration received.
Regardless of any intention of the parties to qualify as a deductible gift it is shown to exceed the fair market value of any consideration received in the form of privileges or other benefits
Hernandez v. Commissioner (1989) – Page 815:
Hernandez (P) was a member of the church of scientology founded by L Ron Hubbard. Scientology’s mother church in California instructs laity, trains and ordains mimisters and created new congregations. Branch churches known as franchises or missions provide Scientology services at the local under the supervision of the mother church. One of the services provided is auditing a question and answer session during which the electronic E-meter measures skin responses and traches a persons increasing awareness of his immortal, inner spiritual being. Scientology charges a fixed donation set forth in schedures for each typoe of auditing intensive, this system of mandatory fixed charges I sbased on the doctrine of exchange, whereby the auditee maintains spiritual equilibrium by giving something for what he is receiving. These auditing sessions are the primary means of income for Scientology. Hernandez made payments to Scientology for auditing sessions and sought to deduct them as charitable contributions under §170. IRS disallowed these deductions, even though it admitted that Scientology was a religious organization. Tax court upheld the commissioner saying that 170 was synonomous with the word gift and P received consideration for his contribution. The first circuit affirmed. Supreme court granted cert to resolve the split with other jurisdictions.
Issue: If a taxpayer transfers money or property with the exception of a quid pro quo, will the transfer be considered a deductible charitable contribution under §170?
Holding: No, when congress made 170 it intended to differentiate between unrequited payments to qualified recipients and payment made to such recipients in return for goods and services. If give a payment with expectation of a quid pro quo then it is not a charitable contribution. Here the transaction was part of a quid pro quo exchange – in return for his money he got an identifiable benefit, auditing and training – the church established fixed prices and calibrated prices to the length of the sessions, the church refunded fees if services were not provided but would not provide services for free – the exchange was inherently reciprocal.
Concise rule: If a taxpayer transfers money or property with the expectation of a quid pro quo, the transfer will not be considered a deductible charitable contribution under §170 even if the recipient is a religious organization.
Revenue Ruling – Note page 825
Concluded that auditing or counseling payments for courses provided by the church of Scientology were not deductible under §170 – the ruling gave no reason though
See page 829 to see how to determine basis of property given to a charity
Page 835 –
The total deductions allowed to a corporation may not exceed 10% of the corporations’ taxable income subject to several adjustments
A deduction for a charitable contribution may be taken only for the year in which the contribution is actually made or when treated as actually made in a carry over year.
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