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FEDERAL INCOME TAX OUTLINE
General Notes on Federal Income Tax Basic Material The tax law is built around ability to pay Hierarchy of tax law The Constitution/16th amendment Internal Revenue Code Passed by Congress – the IRS only has authority to the extent they can reasonably interpret the statute
Treasury Regulations Again, the IRS only has authority to the extent they can reasonably interpret the regulation
IRS Revenue Rulings/Revenue Proceedings These are less binding than the previous examples – according to Evans, these are challenged fairly frequently and the odds of success are often reasonably good. (On the other hand, it takes brass cojones to challenge treasury regs, and even more to challenge the IRC)
IRS Private Letter Rulings
Also note a taxpayer can pay tax on either the calendar or fiscal year.
The Basic Tax Formula Personal Gross Income - “Above the Line” deductions Adjusted Gross Income (AGI) - “Below the Line” deductions Taxable Income x Tax Rate Tentative Tax Owed - Tax Credits Final Tax Due
Corporate – essentially the same, but without parts c) and d)
Tax Terminology Income (see also infra) Taxable Income – derived from gross income Gross Income – defined in §61; “all income from whatever source derived.” Any realized accretions to wealth is income Therefore, income need not be cash; income in-kind is also taxable.
Deductions – reduce taxable income and thus provide a tax benefit; the amount of benefit increases as the taxpayer’s marginal rate increases. “Above the Line” – Deductions taken prior to computing AGI; always beneficial. “Below the Line” – Deductions taken after computing AGI; may be beneficial depending on floors, phase-outs, etc. based on AGI.
Tax Credit – a dollar-for-dollar reduction in tax. Far more beneficial than a deduction. Fair Market Value (FMV) – the price paid between a willing buyer and seller with full information and no compulsion. Basis – generally, an item’s cost; also, adjusted basis is the basis after taking into account factors like depreciation, etc. Standard Deduction – in §63; inflation-indexed. Personal Exemption – in §151; inflation-indexed. Marginal Rates – each dollar over a given amount is taxed at a given level. Thus even a high-bracket married taxpayer’s first $36,900 of income is taxed at 15%; this is why it is a misnomer to say that moving into a higher bracket will make you worse off. Time Value of Money (TVM) – basically, a dollar is worth more today than tomorrow. Because of this, much of a tax lawyer’s work is in deferring recognition of income and gains, while accelerating the recognition of losses.
Tax Policy Types of tax systems Progressive (ex.: FIT) – marginal rates increase as taxable income increases. Proportional (ex.: flat tax) – same rate at any income level. Regressive (ex.: sales tax, VAT) – marginal rate decreases as taxable income increases.
There are three goals to any tax system: Economic Efficiency (minimal economic distortion) Simplicity (e.g., administrative ease) Fairness (e.g., ability to pay). horizontal equity (people in same situation pay same tax) vertical equity (progressivity)
Thus, a comparison of FIT, a VAT, and poll or head tax looks like figure 1 (see end of document)
Progressive Taxation vs. Non-progressive taxation Pro: Ability to pay (marginal utility of money declines) Encourages work via income effect Much wealth is from heredity, genetics, or luck
Con: Problem of interpersonal comparisons of utility (e.g., penny-pinching law firm partner) Discourages work via substitution effect (e.g., substitute leisure for work) Reduces property rights
Additional policy notes Sales taxes are regressive because they tax consumers and don’t tax savers, and low-income people tend to be consumers while upper-income people tend to be savers. Note the U.S. is the only country without a integrated corporate income tax, e.g., the only country that taxes dividends twice (once to the corporation as corporate earnings, then again to the taxpayer upon distribution) Who does the incidence of this fall to? The shareholders (e.g., progressive)? Or consumers (e.g., regressive)?
Also note the problem of bracket creep; left unchecked, a taxpayer could find his income increasing due to inflation (and thus in a higher tax bracket) without any real increase in spending power. This is mitigated to a very large extent by the indexing of the rate structure, standard deduction, and personal exemption. (§§1(f), 151(f))
Criminal And Other Sanctions Criminal Sanctions for: Willfully failing to file or pay tax (§7203) Attempting to evade tax (§7201) Committing fraud on the return (§7206)
Ethics of the preparer The taxpayer can be penalized and the attorney can be sanctioned (by both the IRS and the bar) for taking an overly aggressive tax position “Overly aggressive” means there is no substantial authority for your position; this is interpreted to mean you have at least a 1/3 chance of winning litigation on the merits Basically, you can’t play the “audit lottery” if you know you’d lose
The Tax Expenditure Budget Basically, a way of publicizing the “cost” to the treasury of various deductions, credits, etc. The idea is to make Congress just as accountable for credits as they are for expenditures Problems include: doesn’t account for behavior changes, numbers are projections (and thus not certain), some find it offensive (because it implies that your money belongs to the government, and only by their good graces can you keep it)
Characteristics of Income Definitions of Income Eisner v. Macomber – narrow definition; basically, capital gains and labor income Com’r v. Glenshaw Glass – broader definition; no real restrictions on taxable receipts Haig-Simons Income – Algebraic sum of: FMV of consumption + change in value of saved property rights. Ex.: Wealth at 1/1 = 100; at 12/31 = 120; Consumption for the year = 30. H-S Income = 20 + 30 = 50 Note change need not be positive; if in above example, wealth at 12/31 was 50, then H-S Income = (50) + 30 = (20)
Non-cash exchanges (e.g., bartering) In a barter situation, the income received is equal to the FMV of the property received in payment (RR 79-24); Basis is then equal to FMV. Today, barter clubs must register with the IRS by statute
Fringe Benefits Generally Other than the exceptions noted below, a fringe benefit is taxable as income. Why exempt fringe benefits? Pro It promotes the “right” behavior (e.g., health insurance)
Con It distorts economic behavior. Ex.: say an employee in the 28% bracket can receive $10,000 in cash or meals costing the employer $10,000 If she takes cash, then she nets $7,200 ($10k-28%) Thus, if she values the meals at $7,201+, then she will take the meals – her behavior is distorted by the tax code. A “non-mutual incentive” is in place. Note that this is wasteful – $10,000 of resources are used to fulfill only $7,201 of desire (utility).
It may be viewed as unfair (leading to compliance problems) It can encourage consumption at the expense of savings
Meals & Lodging (§119) These are excludable if they meet the following conditions: They are furnished on the premises of the employer The employee must live there as a condition of employment (for lodging) The meals or lodging are furnished for the convenience of the employer
Policy – it would be unfair to tax employee, since he has no choice; presumably, employee’s personal utility in the benefit is less than FMV cost. Ex.: Hotel manager required to be “on-call” 24 hours a day at Hawaiian resort (Bengalia) Also note this only applies if the meals or lodging are given in-kind – cash to be used for meals is taxed as income
Cafeteria Plans (§125) These are a way for employees to pay for certain items in pre-tax dollars by providing a deduction for them (e.g., child care, health insurance) Pro: Cheaper than buying them yourself Con: “Use it or Lose it” – if you haven’t spent it at year-end, the deduction is lost
§132 Fringe Benefits No-Additional Cost Services You can give away to an employee a service that incurs no substantial additional cost “No Cost” includes foregone revenue – if the employee is taking away from a paying customer, it’s not excludable Available to wife & kids, since the code includes them in the definition of “employee” for this section Line of Business requirement – must be in company’s main line of business. Conglomerates can’t give no-cost services from all their subsidiaries to its employees. Can’t discriminate in favor of executive suite; must be available to the rank-and-file
Policy: don’t want to waste resources Ex: Airline lets their employees fly standby for free
Qualified Employee Discount Discount to employee down to cost (e.g., price paid is ³ cost) is excludable from income If a service, can discount up to 20% of sales price No discount for investments are allowed If the discount goes below cost, the difference between cost and discount is taxable as income Also, Line of Business and Anti-Discrimination requirement (see above)
Ex.: Clothing store gives employees a discount on its merchandise
Working Condition Fringe If the employee could deduct the item as a business expense (under §162), the employer may provide it and it is excludable as income Independent contractors are included as employees for purposes of this (TR §1.132-1(b)(2)(iv))
Policy: doesn’t matter who takes it – tax effect (from IRS standpoint) is the same; why hassle with reporting? Ex.: Uniforms, bar dues, etc.
De Minimis Fringe Can exclude benefits from income that are so small that the hassle of accounting for them isn’t worth the trouble Ex.: Coffee, one-time use of company car for short emergency trip Note sports tickets and clubs are not considered de minimis
Qualified Transportation (not covered) Qualified Moving Reimbursement Expense (not covered)
Other Excludable Fringe Benefits §79 – Group term life insurance up to $50,000 (taxed on the excess over $50,000, if any) §106 – Disability & Medical insurance (no limit)
§127 – Education assistance from employer up to $5,250/yr. (but not for graduate school) §129 – Dependent Care up to $5,000/yr.
Imputed Income This is basically “do it yourself” income – that is, the “income” you have from doing things yourself instead of hiring someone else to do it. It is not included in income. Ex.: Owning your own home – you have “income” in the amount that you don’t have to pay rent; if you moved out and rented the house, you’d have dollar-income that would be taxable. Policy: Primarily, it’d be impossible to assess. Plus, it would be incredibly unpopular – it’s too ‘theoretical’ for most folks. Analysis: This can lead to distortions in people’s choices Ex.: The marriage penalty – it’s often cheaper for one spouse to stay at home and do housework (earning “imputed” income) than to earn money from a job. Ex.: Distorts choice between owning and renting; absent the tax favoritism for owning (from imputed income and deductions) many would choose to rent. Also note how this favoritism may increase the cost of housing – homebuilders are aware of the tax provisions and may increase their prices accordingly.
Windfalls Generally, a “surprise” increase in wealth; it is taxable at the time it occurs Ex.: You find a diamond bracelet. After turning it in to the police and waiting the requisite time, no one claims it. It is yours, and is taxable as income. Bargain Purchases Ex.: You buy a rare manuscript for $5 Theoretically, these could be viewed as a windfall; however, they are not. You are taxed when you later sell the manuscript. If you sell it for $10,000, you are taxed on $9,995 of income. This only applies if the exchange was bargained-for; thus, if you buy a painting, take it home, and find an original draft of the Declaration of Independence behind the canvas it is taxable as a windfall.
Gifts & Bequests These are not considered income for the Federal Income Tax (§102) They are picked up by the Estate & Gift Tax, though – be careful; Evans likes to throw in questions reflecting the E&G tax and ask “is this true under the FIT?” Also note the gift is not deductible by the donor (§262) The substance of the transaction, and not the form, controls
When is a gift a gift? Use the Duberstein test – look at the motive of the donor Must be “detached & disinterested generosity” judged by “life in all it’s fullness” This is essentially a jury issue
Basis Rules Gift Basis goes with the property – donee keeps donor’s basis (§1015) However, this is subject to the “goalpost rule” (see Fig. 2) Basically, if the gift’s FMV (when sold) is < Donor’s basis, then loss is only recognized to the extent the selling price is less than FMV. If basis is unknown, then basis = 0
Thus, you can shift a gain to a lower tax bracket, but you can’t shift a loss to a higher tax bracket Gift of appreciated property – if donor is in higher tax bracket, then give gift; otherwise sell and give cash Gift of depreciated property –regardless of tax bracket, sell (and take the loss) and give cash (b/c loss can’t be passed)
Bequest Basis is “stepped up” to FMV on date of death (or 6 months after) (§1014) Thus: Bequest of appreciated property – hold until death (donee gets tax advantage from step-up) Bequest of depreciated property – sell (and take loss), and bequeath the cash
A brief summary of the Federal Estate & Gift Tax It is a tax on the transfer of wealth (e.g., not on income) §2001 in the Code; 55% is the top rate; it is levied on the donor (not the donee) Rate is graduated cumulatively over donor’s lifetime However, there is a credit of $192,800, which is the equivalent of a $600,000 cumulative lifetime exemption There is also a $10,000/yr. gift exemption per donee (this doesn’t count toward the total above; it is effectively doubled if you are married) Tuition costs are exempted (even if you’re not paying for your own kids), as are medical costs and gifts to charity There is a common-law exemption for support There is an unlimited marital deduction
Basic Policy: Large concentrations of wealth are dangerous and should be “whittled down.” (populist sentiment)
Recovery of Capital Recovery of capital is not taxes (only the gain) Principal difficulty arises when selling a portion of a nonhomogenous thing (e.g., land). How to calculate gain? (ex.: % sales price [as in gold mine])
Life Insurance & Annuities Annuities permit tax-free accumulation of interest via insurance The only thing better are pension plans, which allows the same accumulation, but also allows you to pay for them in pre-tax dollars (but there are caps on how much you can put in)
The question is, when the annuity is paid how do you determine what part is return of capital and what part is interest income? §72(b) – take principal/total return to get exclusion ratio [P/R = ER] Principal = amount paid for annuity Total Return = Annuities promised payments per year multiplied by life expectancy derived from Table 5 (unisex table) of TR §1.72-9 [$/yr. x LE = R] This, of course, assumes you’re getting an annuity for life; if it’s only for a specified period of time, then that time is what the payments are multiplied by to yield R Also note that the shift to unisex tables hurts men and helps women (by accelerating women’s deductions and decelerating men’s)
Use this multiplier to determine how much of each of the annuities’ payments to exclude from income [$ x ER = Amount excludable]; [Amount taxable = $ x (1-ER)] Note that once all costs (principal) has been recovered, all of the annuities payments are taxable as income (e.g., if you outlive your life expectancy, it’s all taxable) Also note that if you die before recovering all of your principal, your estate can deduct the remaining principal as a loss (e.g., if you die before your life expectancy, then you get a loss)
A brief note on life insurance Pure Term Life Insurance – no savings component; it only pays if you die; if you outlive the policy, tough luck Whole Life Insurance – has a savings component – pays annuity on end of policy if you’re still alive Premiums are split into insurance and savings components – only the savings component counts as basis Note these policies are a lousy deal – the savings interest rate is low and the increased cost eats away the tax advantage. Best bet: buy term and invest the difference
Also note that payout on death is not taxed as income (§101(a)), but premiums are not deductible, either (but employer can provide some; see above)
Policy (for not taxing interest until payout): encourages savings, especially for old age (penalty for early withdrawal, e.g., prior to age 59 ½ (§72(q)) Also note that annuities are tax-favored when viewed with an amortization table – normally interest is paid early and principal is paid later. The exclusion ratio treats this as an even mix each year, and thus defers recognition of income (TVM). See Table 2 below
Recoveries for Injuries (Damage Awards) Business lost profits awards are taxable But note §1033 involuntary conversion rules below
Personal Awards (see also Table 3 below) Physical Compensatory Damages are not taxable However, lost wages should be taxable – since physical injury awards usually have a lost income component, it is inconsistent to exclude them from gross income Also note this may be a boon to defendants – if juries know the award isn’t taxed, the award will likely be smaller “Physical Injury” includes emotional distress resulting from a physical injury
All punitive damages are taxable Non-Physical Damages are taxable (e.g., libel, etc.)
Medical Insurance payouts aren’t taxable (even though premiums are deductible) Structured Settlements can give both plaintiff and defendant an advantage due to the tax system – plaintiff doesn’t have to worry about being taxed on investment proceeds, and defendant generally doesn’t have to pay as much for plaintiff to get what he wants due to those tax savings. Contingency Fees can reduce the amount included in income, but you have to show what portion of time the attorney spent working on compensatory damages, etc. (sometimes the IRS will let this be handled pro-rata)
Cancellation of Debt (COD income – §61(a)(12)) The discharge of indebtedness is a taxable gain Kirby Lumber – establishes “freed-up assets” theory – that debt forgiveness frees up assets and is thus a taxable event Thus, when Kirby bought back its $1,000 face bonds for $950, the $50 forgiveness was a taxable event If a company swaps equity for debt, the stock is viewed as a cash payment equal to the FMV of the stock (§108(e)(8))
Diedrich – paying off another’s tax liability is the same as COD income (you’re canceling their debt with the IRS) This creates some ambiguities – does forgiveness of a loan that was a gift free up any assets? What if a corporation issues bonds in lieu of dividends?
§108 exceptions Bankruptcy Debts discharged in bankruptcy are not considered COD income Policy: don’t want to kick people when they’re down; ability to pay This is only true to the extent of the bankruptcy; thus, with $100k of debt and $60k of assets, only $40k of debt is dischargeable in bankruptcy tax-free You must reduce your basis in your assets (defers taxation)
Brief summary of the types of bankruptcy Chapter 7 – “Straight” bankruptcy – liquidate all assets to satisfy creditors; any remaining debt is discharged; usually used by individuals Chapter 11 – “Reorganization” bankruptcy – debt is scaled down, operations continue; used by large business Chapter 13 – Lets you keep your assets and pay creditors over time; used by small businesses
Insolvency You may reduce debt to the point of solvency and not incur income You must reduce your basis in your assets (defers taxation)
Farm Debt Forgiveness is excluded from income, but reduces the basis of the farm (thus deferring taxation)
Tax Exempt Interest (§103) Interest on state, municipal, and other sub-federal government bonds are excludable from income. Policy: federalism – two separate, concurrent sovereigns – an IRS attempt to stay out of the state’s hair; allows local government to finance projects cheaper
Higher tax brackets favor these bonds (A 10% taxable bond only pays 6% to a 40% taxpayer; it pays 7.2% to a 28% taxpayer) Thus, if the tax-exempt bond pays ³ 6%, a 40% taxpayer will favor it; it will have to yield ³ 7.2% for a 28% taxpayer to favor it
Also, U.S. Treasury Bonds are excludable if used for higher education, but exclusion is phased out as income rises over $40k/single, $60k/married
The Putative Tax A “putative tax” is paid on these investments in that you aren’t making as much as you could on a taxable investment since the interest rate is lower (and often the price is higher). This isn’t a tax in the true sense; rather, it just means you’re making less on your investment. Depending on your tax bracket, the exclusion may or may not offset this “tax”
Arbitrage “Riskless Profit” – using the spread between tax-free and taxable bonds to make a sure profit. §148 prohibits arbitrage by a governmental entity – e.g., a city issuing debt to but private bonds and profiting on the difference Ex.: city issues 6% municipal bonds; uses proceeds to buy 10% corporate bonds; clears 4% effortlessly §148 denies the exclusion on a bond issued for this purpose
§265 prevents “personal” arbitrage – e.g., borrowing at a certain rate that is higher than the municipal bond’s coupon, but still profiting from the tax exclusion – by prohibiting a deduction for the interest expense on the loan Ex.: Borrow at 8%, buy 6% municipal bonds; If you could deduct the interest on the loan (and you’re a 40% taxpayer), you would profit – you’re only paying the bank 4.8%, and thus clearing 1.2%) The IRS uses “tracing rules” to enforce this; it is crude and easily avoided (but banks use “averaging rules”)
Transactions in Property Realization of Gains/Losses The Realization Doctrine – for gain to be recognized, it must be realized – i.e., there must be a change in the form of the investment (typically, a sale for cash) Therefore, under the realization doctrine, paper gains/losses aren’t recognized Thus, the realization doctrine favors capital gains by allowing untaxed inside buildup of non-dividend paying assets, and thus reduces the effective rate of tax paid (e.g., the ‘true’ tax rate – tax paid/pre-tax income) Cottage Savings v. Com’r – a swap of property is “realized” if there is a material difference in the legal entitlements of the property Thus, in Cottage Savings, a swap of loans is a taxable event (even though the loans were of the same type, they were different legal obligations on different homes – and thus different legal entitlements) (see also like-kind exchanges below) A note on Net Operating Losses (NOL): the banks in Cottage Savings were trying to create NOL’s. An NOL is first carried back to the past 3 year’s tax returns (generating a refund, if any), and then is carried forward for 15. It would also have generated a tax loss without hurting their financial accounting income
Eisner v. Macomber – stock dividend is not income because it is not a realization of gain (the stockholder has more shares, but his financial position hasn’t changed – he still has the same percentage interest in the company, and thus no increase in wealth has occurred) Eisner was codified in §305
Policy behind the Realization Doctrine – difficulty with valuation, liquidity problems (e.g., ability to pay)
“Mark-to-Market” – an alternative to realization This includes the year-end increase in value in income, whether realized or not It is used in commodities futures markets (§1256) and for securities dealer’s inventory (§457) (because valuation and liquidity concerns are lesser for these) Many academics say this would be a better system generally, since it prevents the deferral of tax – this system is more closely aligned with the Haig-Simons theory of income than the realization doctrine
Like-Exchanges (§1031) A like-kind exchange is not recognized as a taxable event Policy: to permit continuation of investment Limitations: Property must be held for trade, business, or investment This is looked at from the taxpayer’s point of view (the other party’s intended use of the property is irrelevant)
Must be a “continuing investment” (e.g., must be sufficiently similar) Thus, a land-for-land swap is a like-exchange However, a stock swap is not a like-exchange (different legal entitlements) A swap of land for personalty is not a like-exchange (in fact, any exchange of personalty must be very similar) RR 87-166 – Gold for silver swap is not considered similar enough (because gold is “not industrial” while silver is) (Evans thinks this is a dumb ruling that could be challenged)
Taxpayer retains his old basis; thus, if taxpayer swaps property A for property B, his basis in B is whatever his basis in A used to be This is done to preserve gain for recognition when taxpayer sells the property Note, however, that this is “forgiven” upon taxpayer’s death by the basis step-up rule (§1014; see also above)
Handling a mix of cash and like-kind exchange Additional cash (or other additional consideration) is called “boot” General rule: gain is recognized to the lesser of boot received or gain realized Essentially, every dollar of boot given that is in excess of realized gain is recognized Ex.: X sells land A (basis $10k, FMV $200k) to Y for land B (FMV $150) plus $50k boot. X has $190 realized gain. $50 is recognized (because boot is the lesser of boot/gain) Ex.: X sells land A (basis $180k, FMV $200k) to Y for land B (FMV $150) plus $50k boot. X has $20 realized gain. $20 is recognized (because gain is the lesser of boot/gain) X sells land A (basis $240k, FMV $200k) plus $50 boot to Y for land B (FMV $240). X has $40 unrealized loss.
New Basis = Old Basis + Gain Recognized - Boot Received In b2 above, new basis = $10k + $50 - $50 = $10 In b3 above, new basis = $180k + $20k - $50 = $50 In b4 above, new basis = $240 + $0 - $50 = $190
Note these rules only apply to the recipient of boot; the giver of boot has basis equal to his basis in the old property plus boot given (see last examples above)
Involuntary Conversions (§1033) If property is destroyed from fire, storm damage, etc., and insurance proceeds are immediately reinvested (within 2 years), no gain is recognized Ex.: Restaurant (Basis $100k, FMV $500k) burns down; Insurance pays $500k; if restaurant is rebuilt within 2 years, then no gain is recognized
This rule applies to personal-use property as well as business property This rule is elective – you can just take the cash and recognize gain if you want; you can also recognize a loss, if that is the case Policy: like §1031, the continuation of investment
Home Sales (§1034) No recognition of gain on sale of principal residence if new home is bought within 2 years before or after sale (“rolling over the gain”) Amount not rolled over is a capital gain Ex.: Old home (Basis $65k, FMV $100k) sold and new home bought (FMV $95k); CG = $100k - $95k = $5k
Basis = Price of new home less the gain not recognized on the sale of the old home Ex.: Old home (Basis $65k, FMV $85k) sold and new home bought (FMV $100k). New basis = $100k - ($85k - $65k) = $80k
You cannot use this provision more than once per 2 years (unless you are relocating to a new city) Must be primary residence (no summer homes) This provision is not elective
§121 One-Time Exclusion Permits a taxpayer over 55 to exclude gain on home sale up to $125k A one-time deal – once it’s used, that’s it (even if you don’t use the full $125k) (don’t marry someone who has used it!) You must have lived in the old house 3 of the last 5 years
Gains are taxable (but can be deferred as per above), but losses are not deductible (because home is personal consumption)
Wash Sales (§1091) Sale and repurchase of security within same 30-day period Loss from such a transaction is not recognized
Installment Sales (§§453, 453A, 453B) Provides relief from having to pay tax on accrual when payments are received in installments by allocating a portion of each payment to gain and a portion to basis recovery (and a portion for interest) The installment method is elective – you can pay tax up front if you wish (but why would you?) (§453(d)) (Installment method is the default)
Steps Apply rules for unstated interest (§483) or OID (see below) if applicable Compute ratio of gain-to-payment Ex.: Property sold for $300k; Basis is $100k; Ratio = 2/3 ([300-100]/100) (assuming no interest)
Apply ratio to each year’s payments Ex.: If above sales’ first year payment is $60k, then $40k of gain is recognized
§453(e) prevents loophole of using relatives (e.g., selling by installment to lower-bracket relative, then having them sell for full price) Installment method cannot be used for: Personal property on a revolving credit plan (§453(k)(1)) Sales of publicly traded property (§453(k)(2)) Sales of inventory items (§453(b)(2)) Time/share residential lots (not a total prohibition, but must pay interest on all tax deferred) (§453(l)) Interest is also owed on deferral if sales price is greater than $150k
Publicly traded debt instruments and demand notes (because they are the functional equivalent of cash) (§453(f)) Depreciation recapture (also, recapture is taxed as ordinary income to prevent tax arbitrage)
Contingent installment payments can be handled by (TR §15a.453-1(c)) If you can determine a maximum amount to be paid, that amount is considered the selling price If you can’t do the above, but can figure a maximum length of time, then basis is allocated evenly over that time period If you can’t do either of the above, allocate basis evenly over 15 years
Original Issue Discount (OID) and Market Discount Imputes an interest rate when either there is none or when the stated rate is not a true reflection of interest (e.g., zero-coupon bonds, and bonds issued at a discount) It applies to any debt instrument, however – bonds, debenture, note, certificate, or other evidence of indebtedness (§1275(a)(1)(a)) §467 also makes OID rules applicable to deferred rent payments (for these, take PV of payment at 1.1 (110%) of the applicable rate)
Note a tax-exempt bond’s discount is taxable
Tax treatment Each year, look at Net Present Value (NPV) of bond; the increase is taxable as income (not capital gain) NPV = par value/(1+ rate)#years to maturity Gross income year 1 = NPV1 - NPV0 Gross income year 2 = NPV2 - NPV1, etc. See Table 4 below
If bond with coupons is sold at a discount, must tax both OID income and interest income from coupon payments If bond is given for property (instead of cash), the interest payments must meet the applicable federal rate (§1274(d)); the property is considered to be sold for the present value of the bond’s face amount Basis and early disposition Discount/ # years to maturity = accrued market discount per year Ex.: 5-year $1,000 bond sold for $800; $200/5 = $40/year
The discount amount accrued is ordinary income when bond is sold; any excess is capital gain. This prevents taking the preferred CG rate by selling the bond shortly before maturity. Ex.: Same as above. 3 years after purchase, sell bond for $920 (gain = $920 - $800 = $120); $40 x 3 = $120; all of the gain is ordinary income Ex.: sell for $950 (gain = $950 - $800 = $150) of ; $40 x 3 = $120; $120 is ordinary income, $30 is CG
Market Discount This is not the same thing as OID; it is discount after original issue caused by market conditions (interest , price ¯, and vice versa) Market discount is fully deferred until maturity Ex.: A buys 20-year bond at par ($1,000); 5 years later he sells it for $800 Seller – gets a $200 capital loss Buyer – recognizes coupon payments as income each year, but does not recognize the $200 in income until maturity (a total deferral of discount)
Note if OID bond is sold, the OID must be recognized as income by the buyer
Taxation of the Family Marriage Brief history of joint returns Lucas v. Earle – held that husband could not shift his income to his wife to take advantage of marginal rates Poe v. Seaborn – community property state; court says that since husband and wife each own ½ of income, the income should be split between husband and wife Congress permits joint returns to prevent favoring community property states over other states; effect is that for a married couple, it doesn’t matter who earns the income
The Marriage Penalty and Marriage Subsidy Penalty – when two high-wage earners marry, one spouse’s income is taxed at a higher marginal rate than it would be if they were single Subsidy – If there is only one wage earner in a family (or one is a very low-wage earner), there is a marriage subsidy since the wage earner is taxed at a much more favorable rate than if he/she were single It is impossible for a tax system to have progressive rates, joint returns, and neutrality toward marriage. One of the first two would have to go to eliminate the penalty/subsidy
Divorce Some payments are taxable (§71(a)) to payee and deductible (§215) to payor Taxable/Deductible Alimony Maintenance
Not taxable/deductible Child Support Property Settlements (§1041 – no tax on transfers between spouses, even as an incident to divorce)
The basic rationale is that the nontaxable expenditures are those that would have to be made even if the couple had stayed married (child care) or is just a division of what is already owned (property) Note alimony is an “Above The Line” deduction Therefore, there is an incentive to make payments alimony – if payor is in high tax bracket, and payee is in lower tax bracket, payor gets valuable deductions while payee gets cash that is taxed at her lower rate Difference between rates x amount = tax savings (40% - 15%) x $140 = $35 Say both parties want settlement to be $100 Payor gets $16 savings: $140 - 40% = $84; $100 - $84 = $16 savings Payee gets $19 bonus: $140 - 15% = $119; $119 - $100 = $19 bonus $16 + $19 = $35 total tax savings
You can elect to treat alimony as a nondeductible/nontaxable property settlement, but not vice-versa
Requirements to classify a payment as alimony (§71): Must be paid in cash (no in-kind transactions) Must be an instrument of divorce or other maintenance (no oral agreements and no single people) Note that separation is OK too (“other maintenance”)
Parties must not have agreed that it won’t be taxable/deductible Can’t be member of same household (must actually split up) Can’t have payments after death of payee (usually wife); have to break out alimony portion from property settlement portion Can’t be for child support Can’t cease upon child reaching a certain age, marrying, dying, etc. If the payments cease within 6 months of the child reaching the age of majority, then it is presumed to be child support
Must be roughly equal payments for the first 3 years (e.g., no property settlements) The payments are recaptured if the first or second year payments are more than $15,000 than subsequent year’s payments Note that even if deductions are recaptured, you still have gotten a TVM advantage from the delay
The Kiddie Tax (§1(g)) Child under age 14’s unearned income is taxed at the parent’s marginal rate Tax is levied on the excess of $500 (plus either expenses or $500 of the standard deduction) Only applies to unearned income – paper routes, etc. are taxable to the child at his own rate. This only applies to interest, dividends, etc.
Policy Age is < 14 because presumably once child is 14 the parents may be saving for college Not concerned with earned income because there is little chance for fraud Basically is designed to prevent parents from shifting income to their children (who are in lower tax brackets)
Planning – give property to kids that won’t realize taxable gains until after they turn 14 (like real estate, stocks that don’t pay dividends, etc. – anything with a built-in deferral)
The Earned Income Credit (§32) A “negative” income tax – pays to poor, even in excess of taxes paid Rises up until income reaches $8,425, then plateaus until income is at $11,000, then is phased out to zero at an income level of $27,000 Operates as a percentage of earned income; more kids means a higher percentage (up to two); Most you can “make” is $3,370 The credit is 40% of earned income until the “peak”, then after the plateau it is phased out at 21.06% of earned income over $11,000
Policy: makes transfer payments less demeaning; encourages work Problems: fraud, adds to marriage penalty
Personal Deductions
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