Federal Income Taxation Chapter 2 What is Income?

Transcription

1 Presentation: Federal Income Taxation Chapter 2 What is Income? Professors Wells August 28, 2013

2 What is Income? Code Structure & Tax Base Definition p.45 Code 1 the tax imposing provision (for individuals) & Code 11 (for corporations) statutory definition of gross income 61(a)(1) compensation 61(a)(2) business income 61(a)(3) property gains 61(a)(4) interest, etc. 63(a) defining taxable income 2

3 WHAT IS INCOME? p.46 How is the concept of income defined? Consider the Haig-Simons definition: Y = C + ΔW Accession to wealth consisting of 1) Consumption (during the measurement period), and 2) Increase (if any) of value of property rights (during the measurement period). 3

4 NONCASH BENEFITS p.48 Treas. Reg (a): gross income includes income in any form, whether in money, property or services Treas. Reg (d)(1): if services are paid for in property, the fair market value of the property taken in payments must be included in income as compensation Example: Atticus Finch paid legal fees with by Walter Cunningham in hickory nuts. (p. 47) Example: Client repays lawyer for drafting a will by painting the lawyer s house. (p. 50) 4

5 Old Colony Trust Co. (Supplement pages 22-23) Discharge of an Obligation Discuss Facts Where was the tax gross-up paid? 1918 IRS What was holding Discuss pyramid problem Old Colony $978,725 salary IRS Assesses Executive $854,782 Executive 1918 Tax Gross-Up 681,169 Add l Tax 474,077 (70%) Add l Penalties 380,705 Total Tax 1,535,951 5

6 Alice Examples p Base Case: Alice is paid $5,000 per month. Alice pays rent and living expenses. Variation #1: Alice paid $4,000 per month. Unitek pays $1,000 to Alice s landlord. Variation #2: Alice is paid $1,500 per month. Unitek pays $1,000 per month to Alice s landlord and pays $2,500 to shops/restaurants/grocery stores as Alice directs. Horizontal Equity Question: Is Alice more like the Base Case or more like the person who earns only $4,000 (Variation #1) or the person who only earns $1,500 (Variation #2)? 6

7 Meals & Lodging Provided By Employer p.52 Benaglia v. Commissioner Facts: Hotel manager receives cost meals and lodging at no cost. 7

8 Royal Hawaiian Hotel: A Starwood Five Star Hotel 8

9 Lodging in the King Kamehameha Suite p

10 Lodging in the King Kamehameha Suite p

11 Lodging in the King Kamehameha Suite p

12 Dining at the Jewell-Toned Azur Restaurant p.52 12

13 Work-related Fringe Benefits Should consumption items provided by the employer be excluded from gross income when motivated by the convenience of the employer, e.g., meals onsite to keep the employee on location for the lunch period? Consider horizontal equity issues if employers furnish many inkind benefits to some employees. Are working conditions not consumption substitutes? Enable partial exclusion only? 13

14 119 p.52 Requirements for 119 gross income exclusion eligibility: 1) Meal issue 2) Furnished issue 3) Convenience of the employer issue 4) On the business premises How negotiate the manager s employment contract (considering 119)? 14

15 Code 119 & the Kowalski Sup. Ct. case p. 59 Kowalski case - meal cash allowance not furnished in kind and not fitting within the Code provision (& legislative history). Is, however, a tax common law exclusion available? No. What are the business premises for purposes of state troopers? Other taxpayers? Supper money for law firm associates? 15

16 Code 132(a) Fringe Benefits p. 59 No additional cost service. 132(b) Qualified employee discount. 132(c) Working condition fringe. 132(d) De minimis fringe. 132(e) Qualified transportation fringe. 132(f) Qualified moving expense fringe. 132(g) Qualified retirement planning services. 132(m) Certain on-premises gyms and other athletic facilities. 132(j)(1) 16

17 Other Employer Provided Excluded Benefits p ) Moving expenses - 132(a)(6) 2) Dependent care ) Educational benefits ) Adoption assistance (subject to phase-out) 5) Group Term Life Insurance 79 6) Medical Insurance payments - 105(b) 7) Cafeteria plans

18 Questions p.60 1) Airline offers free seating to employees. Is exclusion justified on basis that employee does not subjectively value this seating as much as full air fare? What is the concern over misvaluation? 2) Why limit tax-free no-additional-cost services and qualified employee discounts to the employee s line of business of the employer in which the item at issue is ordinarily offered for sale to customers? 3) Why deny the exclusion for a no-additional-cost service or a qualified employee discount to highly compensated employees when the employer discriminates in favor of highly compensated employees? 18

19 Retirement Income Plans ( 401(k) Plans) p. 62 Employee gets benefit of income exclusion for (1) employer s contribution to plan, and (2) employee s contribution to plan Employer gets immediate deduction for contribution to the plan. Tax whipsaw effect? No gross income for income build-up during accumulation/ investment phase Tax Expenditure impact is $142.2 billion (see page 17) 19

20 Employer Paid Life Insurance p.62 Employer s payment of premiums gross income inclusion (unless employer is the beneficiary). Same as Old Colony? But, 79 exclusion from gross income for first $50,000 of group term insurance provided by employer. What is term life insurance? Employer deduction available? Tax Expenditure impact of this exclusion is $28.9 billion (see p. 17) 20

21 Treatment of Frequent Flyer Miles p.63 Inclusion in gross income? What if sale (or equivalent)? What if miles attributable to business travel and miles not credited to the employer? Why is the IRS not acting administratively on this issue? 21

22 Non-Employer Benefits; Gross Income Inclusion? Haverly p.65 Free textbook samples - Gross income? When samples received? Why treat as income samples received only when deduction claimed for income tax? Necessity for symmetry in the tax system? Correct approach utilized here? Why not include in gross income when the books were received? A valuation dilemma? Other possible argument? 22

23 Code 132(a) Fringe Benefits Questions p F, a flight attendant in the employ of A, an airline company, and F s spouse decide to spend their annual vacation in Europe. A has a policy whereby any of its employees, along with members of their immediate families, may take a number of personal flights annually for a nominal charge, on a standby basis. F and F s spouse take advantage of this policy and fly to and from Europe. 2. P is the president of C, a corporation that has its executive offices situated in New York City. P is planning a week-long business trip to Los Angeles and will fly there and back on C s corporate jet. P s spouse intends to accompany P on the roundtrip flight for personal reasons. 3. S, a senior vice president of D, a retail department store, purchases a re- frigerator from D s appliance department. D has a policy whereby all employees are entitled to a 20 percent discount from the ticketed sales price of any item sold by the store so long as the resulting sales price, on average, approximately covers D s costs. See 132(c), Regs (c). 4. The facts are the same as in Question 4 except that D s profit margin on ticketed items is only 10 percent, so the resultant sales price does not cover D s costs. 5. The facts are the same as in Question 4 except that the discount is avail- able only to S and other officers of D. 6. A, an assistant manager in the employ of D, a department store, is oc- casionally required to work overtime to help mark down merchandise for special sales. On those occasional instances, D pays for the actual cost of A s evening meal. Such payment is pursuant to company policy whereby D will pay the actual, reasonable meal expense of a management-level employee when such an expense is incurred in connection with the performance of services either before or after such an employee s regular business hours. 7. S, a senior partner of L, a law firm, is provided free parking by the law firm. This benefit is provided by L to all partners, associates, and other employees. The parking privilege has a value of $75 per month. See 132(f) (5)(E). 8. A, an attorney in the employ of C, a corporation, works at C s national headquarters. C maintains an on-site gymnasium that is available to all employees during normal business hours. A uses the gymnasium each working day. 23

24 Health Insurance Benefits to Employees p exclusion for employer s contribution to health care plan 105 exclusion for benefits paid under employer s health plan for employees and family members Tax Expenditure impact of (1) exclusion and (2) medical expense deduction is $144.1 billion (see page 17). 24

25 Fringe Benefits p.67 Economic Inefficiency of Tax Preference for Fringe Benefits Initital Eventual Compensation Compensation Cash Non-tax fringe Cash Non-tax fringe Dead weight loss < $

26 Turner v. Commissioner p.67 Discuss Facts 1. Retail first-class ticket price: $2, Exchange first-class ticket plus $12.50 for 4 round trip tourist tickets to Rio de Janiero. What amount in income? Court Holding: $1,400 26

27 Notes to Turner p Suppose there had been evidence that nonrefundable, nontransferable tickets, precisely identical to those awarded to the Turners had a retail price of $1,900. Would this have made it an open-and-shut case? 2. Why exactly could the Turners argue that the tickets value to them was less than the retail price? Should it have mattered that they were able to exchange two first-class tickets to Buenos Aires for four tourist-class tickets to Rio de Janeiro, thus permitting them to take their children and visit the country where Mrs. Turner was born? 3. How do you think the court determined that the value of the tickets to the Turners was $1,400? 4. How administrable is the court s subjective $1,400 value determination? 5. Discuss McCoy v. Commissioner, 38 T.C. 841 (1962), acq., and Rooney v. Commissioner, 88 T.C. 523 (1988). 6. Carla, a contestant on a game show, wins a new car. The show s producer received the car free from the manufacturer because of the advertising value of its use on the show. The ordinary dealer cost of the car is $20,000 and the sticker price is $25,000. Carla tries to sell the car, but the best offer she gets is $16,000 and she decides to keep it even though the value to her is more like $12,000. She hires you for professional tax advice concerning the amount, if any, that she must include as income on her federal income tax return. Her exact words to you are Just tell me the answer. What sort of advice should you give her? 27

28 Home Run Ball and Treasure Trove p.70 Treas. Reg : Treasure trove, to the extent of its value in United States currency, constitutes gross income for the taxable year in which it is reduced to undisputed possession. IRS press release states that no gift tax if ball given back to McGwire but the tax consequences may be different if the fan retained the ball for sale. Cesarini v. U.S. (page 81) cash found in a piano. Included in gross income upon discovery because this was income from whatever source derived, citing Treas. Reg (a). What if discovered that the piano was a famous Cristofori piano that was purchased for $15 at a garage sale? What if you discover oil on your land? 28

29 Imputed Income p Imputed Income from Self- Provided Services imputed income from a self-created economic benefit? 2. Imputed Income from the Ownership of Consumer Assets homes, vehicles & consumer durables? How value? Cost of consumer assets would not be deductible under a cash flow consumption tax. 3. General Psychic Benefits the happy life as a gross income item. Value of leisure? 29

30 Imputed Income p.76 Rev. Rul In return for legal services, housepainter paints the lawyer s house. 2. Landlord receives work of art from painter in return for rentfree use of an apartment for six months. 3. Barter exchanges are required to be reported to the IRS. See 6045(c)(1)(B) 30

31 Windfall Gains p.197 Eisner v. Macomber Discuss Facts Lay out majority and dissenting opinions Analyze opposing views and implications Who was right? 31

32 Windfall Gains Glenshaw Glass p.78 Punitive portion of a treble damage antitrust recovery is includible as gross income under [now] Code 61. Income is to be determined based on accession to wealth, clearly realized. No requirement of source-based taxation (cf., Eisner v. Macomber re stock dividends). Can be recurring or non-recurring receipts. 32

33 Gifts & Bequests p.83 Commissioner v. Duberstein Duberstein case: Gift of a Cadillac from Berman to Duberstein for providing good business information. Stanton case retiree receives cash. Gift exclusion treatment for income tax purposes requires "detached and disinterested generosity". Measured by: (i) maxims of experience, and (ii) the mainsprings of human conduct to the totality of the facts of each case. 33

34 Business Gift Taxation Decision Options p.90 Choices for deciding these cases: 1) Factual analysis for each situation. 2) Rebuttable presumption that not gifts, but rather income derived in a business transaction exchange. 3) Non-rebuttable presumption that compensation received. Cf., 102(c). Note 274(b) concerning limit on the donor s deduction for 102(a) gift transfers. 34

35 Fees for Other Services? U.S. v. Harris p.91 Tax evasion criminal convictions for two sisters receiving gifts from older man. Gift tax returns by the donor, but only for small amounts. How prove criminal intent by the recipients when failure to report the receipts as income? Court says should have been permitted to include the donor's letters in evidence. Law too uncertain to support a criminal conviction in this situation. Where is the dividing line for criminality? 35

36 Olk v. United States p. 100 Tokes Trial Court held tokes were gifts. Did "tokes" constitute (1) taxable income or (2) gifts within Code 102(a)? Note the findings of fact (legal conclusion?). The receipt of tokes is not a result of detached and disinterested generosity. Held: includible in recipient s gross income, similar to the required inclusion of a waiter s tips in gross income. 36

37 Aaron s Last Wish (website: July 6, 2012, Aaron Collins died at the age of 30 years of age. After his death, his family discovered that his will asked them to leave an awesome tip (and I don t mean 25%). I mean $500 on a... pizza for a waiter or waitress. "Collins didn t have the financial means to honor the request, so his family set up a website (Aaron s Last Wish) to help attract donations, and it has gone viral attracting over $60,000 of donations. Seth, Aaron s brother, has going around the country providing $500 tips, and the reactions of the wait staff are posted on Aaron s Last Wish website. Question: What are the tax consequences to the waitresses in this video clip?

38 Prizes p.100 Code Section 74 GI inclusion required under Code 74. Possible exception (under limited circumstances) if the prize is assigned to charity by the prize winner. Code 74(b). Why provide this exception? Remember Hornung and his Corvette? What about the Nobel gold medals? Or, Olympic medals? Treatment of a Texas lottery winner? When (if deferred payments)? 38

39 Scholarships as Gross Income p. 100 Code GI exclusion for scholarships. No exclusion is available where services are to be provided to the scholarship provider. Must be pursuing a degree program to enable gross income exclusion. Scholarships for room and board are taxable. Consider the tax result to "student athletes"? However, no tracing is required. 39

40 Government Transfer Payments p.101 Welfare benefits excluded from GI. Why? A. Disaster relief payments exclusions (under IRC 139) for: 1) Personal and living expense 2) Repair of personal residence 3) General welfare payments Rev. Rul , C.B. 18 (Awards by the Crime Victims Compensation Board to victims or to their surviving spouses or dependents are not includible in the gross income. Medical expenses incurred by a recipient that are compensated for by such award are not deductible; further, an award for medical expenses previously deducted must be included in income in the taxable year of receipt to the extent that the expenses resulted in a tax benefit in the prior taxable year). B. Notice 99-3: Temporary Assistance for Needy Families & the general welfare exemption Unemployment compensation is includible in GI. Historically not, but 85 was added to make it fully taxable. 40

41 Unemployment and Social Security p.102 Code 86 - Up to 85% of Social Security benefits is includible in GI. Why include in gross income when the taxpayer has a possible tax basis in prior social security contributions? In what amount? Is the Social Security tax merely another tax (rather than a retirement account held by each taxpayer/individual)? 41

42 Cost Basis p Tax basis is cost even if the purchase was a good deal or a bad deal. This assumes not a bargain purchase, i.e., a price differential attributable to another relationship, e.g., as an employee or a child. Basis determined in a taxable property swap: fair market value of the property received. Basis when property received for services: fmv at time of receipt. 42

43 Windfalls and Gifts p.104 Taft v. Bowers Facts: : A purchased 100 shares for $1, : A gifted shares to B at a time when worth $2, : B sold shares for $5,000 Taxpayer Position: B s gain for the period B held stock was $3,000 IRS Position: B has gain of $4,000 43

44 Gifts, Bequests and Inheritances p.107 Code 102(a) excludes gifts, bequests and inheritances from the gross income of the recipient; and, no deduction is available to the donor upon the gratuitous transfer to the donee. An aftertax transfer. Taxing options: (i) Income to the donee and a deduction to the donor, or (ii) income to the donee and no deduction to the donor. Who should be taxed? Either? Both? Should tax occur: (i) once (thereby assuring symmetry between taxpayers) or (ii) to both (assuring symmetry for tax system)? 44

45 Gross Income Inclusion of a Bequest p.107 Code 102 provides for exclusion from gross income of gifts and bequests. What is a bequest? Wolder case (p. 101) - attorney provided lifetime services in exchange for a promise to bequeath certain shares of stock. Cf., contingent fee attorney. 45

46 Income Tax Basis for In-Kind Property Gifts p tax basis carryover in the event of gift of appreciated property; depreciated property - tax basis to donee is the property s FMV, not its tax basis to the donor; the donor cannot transfer losses. 1015(d) provides for upward adjustment of donee s basis but limited to gift tax paid on the appreciation of the property ( 1015(d)(6)). Example: Donor s basis was 100x; fmv at gift to donee was 90x. What if later sale by donee at: (i) 85x; (ii) 105x; or, (iii) 95x? Cf., 1041 carryover basis; not loss limiting. 46

47 Income Tax Basis for Gifts at Death p tax basis is the fair market value on date of death to donee. Why the basis step-up? Tax Expenditure cost is $39 billion (p.17) Income in respect of a decedent (p. 109) 47

48 Tax Basis for Gratuitous Transfers at Death p.108 Tax basis step-up occurs as of death (a). What happens to the accrued appreciation? Could be a step-down in tax basis if the property is depreciated as of the time of death. Tax basis step-up at death is not applicable to IRD - income in respect of a decedent. See 691. Relevance of estate tax alternative valuation date? Tax policy option: gain realization at death. What cost of 1014(a) to the US Treasury? See Tax Expenditure list. 48

49 Problems p Suppose A purchases stock for $1,000 and gives the stock to his son, B, at a time when the fair market value of the stock is $2,500. How much gain does B recognize if he sells the stock for $3,500? For $1,500? 2. Suppose C purchases stock for $2,000 and gives the stock to her daughter, D, at a time when the fair market value of the stock is $1,000. What amount of gain or loss (if any) is recognized by D on a sale for $2,500? For $500? For $1,500? 3. Ernesto s daughter, Ana, will require a total of $80,000 for college tuition and expenses. What is best alternative for each of below: (a) Stock with a basis of $20,000 and a fair market value of $80,000 (b) Stock with a basis of $120,000 and a fair market value of $80,000 (c) Stock with a basis of $20,000 and a fair market value of $80,000, plus $80,000 in a savings account. (d) Ernesto has stock with a basis of $20,000 and a fair market value of $80,000, plus stock with a basis of $120,000 and a fair market value of $80,000. (e) The facts are the same as in (a) except that Ernesto is 88 years old and is in poor health. 49

50 CH 2-4 Capital Appreciation Tax Basis Recovery p (a)(3) gross income includes gains derived from dealing in property; Reg (a) (sales less cost of goods sold). Reg (sales price less basis to determine gain ) determining the amount of gain (amount realized less tax basis) 1012 identifying cost basis - Should a person recover investment in a property without gross income inclusion? 50

51 Inaja Land Co. p.111 Open Transaction Treatment? Consideration received for an easement in land. The amount received was less than the tax basis for the property. How allocate tax basis to the amount received? Exclude entire proceeds received and reduce basis by that amount received? Note: Burnet v. Logan case (p.733) re basis recovery first before any gain recognition. & see Reg (a). 51

52 Recoveries for Personal p.112 and Business Injuries Issue: What are the damages a substitute for? Raytheon case: damages in antitrust action ordinary income where damages represent payment for a loss of profits. Damages as a return of capital where destruction of the business and goodwill. Here: destruction of goodwill but no tax basis proved and, therefore, assumed to be zero (and all proceeds as income CG?). 52

53 Annuities & Life Insurance p.113 What is an annuity? A payment for living often paid periodically. How is an annuity purchased? From whom? What is life insurance? A payment for dying ordinarily paid in a lump sum. If paid at death, why not call it death insurance, rather than life insurance? 53

54 Life Insurance - Code 101 GI Exclusion p.113 Gross income exclusion ( 101) is available when proceeds are paid at death for both: (i) the pre-death interest buildup, and (ii) the mortality gain (i.e., the windfall because of an early death). The transfer for consideration limitations may apply. 101(a)(2). Purpose of limits? The gross income exclusion is not applicable to any post-death interest accumulation. continued 54

55 Life Insurance, cont. p.116 No income tax deduction is available for policy premiums paid. 264(a)(1). Policy loans are not treated as distributions. Code 72(e)(5)(A). Policy settlement options after maturity at death: a deferred receipt produces taxable interest income; see Code 101(c) & (d) (concerning the annuity option). continued 55

56 Life Insurance, cont. p.116 Defining Life Insurance What is life insurance? Cf., mutual fund investments. If not treated as life insurance, then taxed as if a savings account : i.e., inclusion in current income of: (i) increase in cash surrender value of the account, and (ii) value of current insurance coverage. 56

57 Annuities p.117 Level Payment Contract Annuitant can have a contract providing for the receipt of level payments for: a) A specified term (e.g., ten years) b) One life or several lives c) One life plus a specified term. An annuity recipient is in a similar position to the lender in a level payment mortgage loan. Amounts realized periodically, i.e., in pieces. 57

58 Annuity Income Taxation Timing Options p.118 Tax policy choices for determining the timing for the inclusion of annuity income: 1) As the value accrues within the contract? Cf., amounts credited to a bank account or a mutual fund account or OID concepts. Tax shelter benefit with an annuity? 2) Only as amounts are paid under the annuity contract either (i) before or (ii) after the annuity starting date. 58

59 Distributions made Before the P.119 Annuity Starting Date 1) Pre-starting date annuity contract withdrawals are sourced first from accumulated income. Code 72(e)(2)(B). 2) Loans are also treated as withdrawals (& sourced from income?). Code 72(e)(4)(A). 3) A penalty tax of 10 percent (of the distribution) is applicable for pre-age 59 1/2 distributions. Code 72(q). 59

60 Annuity Income Amount p.119 Measurement Options Choices for determining includible amount: 1) Recovery of the entire tax basis first. 2) A specified percentage of each payment as the includible interest income equivalent. 3) Current method - proportionate amount of each payment, based on the anticipated return (straight-line approach is beneficial). 4) Constant interest rate (but how deal with the life expectancy factor?) continued re: current method 60

61 Annuities, cont. p.119 Current Method - 72(b) 1) Determine the total income tax basis. 2) Determine the expected return - i.e., the payment amount times the anticipated number of payments (how determine?). 3) This ratio is applied to each payment when received. The formula is: (i) total basis/expected payment times (ii) each payment equals (iii) amount excluded from gross income. continued 61

62 Annuity Income Calculation p.119 for Term Contract Purchase for $100,000 of a single premium annuity. Assume15 payments of $12, exclusion computation: 100,000 (investment in contract) 180,000 (12,000 per year x 15 yrs) Equals: 55.55% times $12,000 (= $6,667). Equals: 6,667 to be excluded and 5,333 to be included in gross income (12,000 less 6,667). continued 62

63 Problem cont. - Life Contract p.119 Anticipated 15 Year Life Death occurs before reaching life expectancy (e.g, after only 9 payments). The tax basis recovered was $60,003 ($6,667 times the 9 payments made). The unrecovered basis in the contract is $39,997 of the $100,000. Deduction of this amount on final income tax return is permitted (if expiration of contract at death). 72(b)(3). 63

64 Annuities, cont. p.119 Impact of Death What is the impact of death? Termination of the annuity contract - if based on life expectancy. If tax basis is not recovered? Deduction on annuitant s last return for unrecovered basis. 72(b)(3). If tax basis is recovered prior to death? All subsequent proceeds are includible in gross income. Code 72(b)(2). What happens at death with a term annuity contract? 64

65 Gambling Winnings p.120 Gambling gains are income Gambling losses are deductible only to the extent of gambling gains per 165(d). Why? 3402(q) requires every person making a payment of winnings to withhold and remit tax at a rate of 20%. 65

66 Clark v. Commissioner p.122 Facts: Clark paid $19, by tax counsel to compensate Clark for consequences of advising to file a joint tax return and not separate returns. IRS Position: What is their argument for income? Court s holding: What is the underlying theory? 66

67 Sanctity of Annual Accounting Period p.127 Burnet v. Sanford & Brooks For the period had reported gross income for receipts and offsetting expenses. The expenses exceeded income during this period. Work abandoned & suit to recover. In 1920 taxpayer received $192,578 (176,272 for return of losses and accrued interest of 16,306). Held: Inclusion in gross income of the amount received in

68 Claim of Right Doctrine p.132 North American Oil Consolidated v. Burnet FACTS: In 1916, $171, placed with receiver. In 1917, funds paid to taxpayer but government continues to contest liability. In 1922, government claims are terminated. Tax Rates: 1916: 2% 1917: 6% plus 20%-60% surtax 1922: 12.5% with no surtax Issue: When are the funds taxable to North American Oil Consolidated? 1) Taxpayer receives earnings under a claim or right (and, therefore, to be included in gross income) 2) Deduction if subsequently repaid. 3) What if tax rates changed in the interim? 68

69 Claim of Right Doctrine p.136 United States v. Lewis Consider: 1) Taxpayer receives earnings under a claim or right (and, therefore, to be included in gross income) 2) Deduction if subsequently repaid. 3) What if tax rates changed in the interim? See 1341 re claim of right doctrine (p. 137) 69

70 The Inconsistent Events Rule Supplement p. 29 Hillsboro and Bliss Dairy cases 1) Repayment to bank shareholders of taxes on shareholders paid by bank corporation. No recognition required of the bank when refunds to shareholders. 3) Distribution of previously expensed assets (cattle feed) in a corporate liquidation. Recovery required to the corporation on the distribution. Dissent: file revised returns 70

71 Alice Phelan Sullivan (Supplement p. 35) Charitable Contribution Deduction & Gift Returned 1) Property transferred to charity 2) Charitable deduction claimed for tax 3) Property returned to donor 4) Inclusion in donor s gross income? Yes to extent of lesser of earlier deduction or fair market value of property 71

72 Modifications The Tax Benefit Rule p.139 Transactions treated as closed and completed transaction but the tax treatment of the subsequent transaction will be colored in light of the earlier transaction. Two Prongs: Inclusionary Prong (Alice Phelan/Hillsboro): A recover in later year is included in gross income if the loss in the earlier year provided a tax benefit. Exclusionary Prong ( 111): A recovery of a loss in a later year is excluded from gross income to the extent the earlier deduction produced no tax benefit. 72

73 Damages for Personal Injury p.142 Attn: Tort Lawyers Code 104(a)(2) exclusion for damages received for personal physical injuries. Exclusion whether received as a lump sum payment or in periodic payments. Not including sex/race/age discrimination lawsuit proceeds. Not including payments for emotional distress (unless distress attributable to physical injury). Punitive damages are includible in Gross Income. 73

74 Amounts Received for Nonphysical Injuries p.144 Do amounts received for nonphysical injuries (e.g., emotional distress) even constitute gross income? Even constituting income within the meaning of the 16 th Amendment? What about U.S. Const., Art. 1, 8, taxing power (if not a direct tax, Art. 1, 9[4]). I.e., is the 16 th Amendment necessary? 74

75 Structured Settlements p.144 What is a structured settlement? Code 104(a)(2) provides for exclusion whether amount received as lump sums or as periodic payments for amounts received for personal physical injuries. 1. What about the interest income component inherent in the delayed payments? 2. How assure that the agreed deferred payments will actually be made? EXAMPLE: Assume court petition/ complaint specifies $1 million compensatory and $9 million punitive. Parties then settle for $2 million: how allocate this amount to excluded and included amounts? Amend the petition prior to effective date of the settlement agreement? EXAMPLE: What is the result result of the NFL s $765 million concussion settlement with former players reached on 8/29/2013? 75

76 Medical Expense Recoveries p : Employer payment of medical insurance premiums are not taxable to employee. 105(b): Employer payment of medical bills under a self-insured plan do not represent income to the employee. Does the nontaxation represent a government subsidy? 76

77 Transactions with Borrowed Funds p.145 No income realized upon the receipt of loan proceeds. Why? No accession to wealth? Remember personal balance sheet calculation: Assets minus liabilities = net worth When borrowing occurs what happens to (1) assets and (2) liabilities on one s personal balance sheet? Deduction when loan repaid? No. 77

78 Debt Cancellation p. 147 What income tax treatment occurs when debt is cancelled by the lender (rather than being repaid)? Does an accession to wealth arise? United States v. Kirby Lumber 78

79 Debt Cancellation: Relief Provisions p.149 What income tax treatment occurs when debt is cancelled by the lender (rather than being repaid)? Does an accession to wealth arise? See 61(a)(12) providing that cancellation of indebtedness income is included in gross income. But is this always the case? Example: Parent s forgive college loan to children. Is this income? Employer forgives employee loan? What is this? 79

80 Code 108 p.149 Insolvency / Bankruptcy Exceptions 108(a)(1)(A): exception to 61(a)(12) for debt cancelled in bankruptcy. 108(a)(1)(B): an exception from 61(a)(12) for debt cancelled to the extent of taxpayer s insolvency. But, 108(b) requires tax attribute reduction including potential basis reduction under Question: Do you see for symmetry reasons we must have attribute and/or basis reduction if an exception is given for COD Income? 80

81 Code 108 p.149 Purchase Price Reduction An exception from COD income treatment exists for purchase money debt. Code 108(e)(5) no COD income resulting from a purchase price reduction. What effect on tax basis of the acquired asset? Cf., a third party rebate and eligibility under 108(e)(5). 81

82 Qualified Principal Residence Indebtedness p.149 Home owner mortgage debt is cancelled (usually in part). Code 108(a)(1)(E) & (h) provide for exclusion of debt discharge from gross income; basis reduction occurs. Limit is $2 million. Expires at end of 2013 (extended from 2009). 82

83 Student Loan Forgiveness p (f)(2) provides GI does not include forgiveness of certain student loans. Student loans as made by US or other government (or an intermediary). Public interest job required? See Rev. Rul regarding law school loan forgiveness programs. 83

84 Zarin case Gambling Debt Compromised p.150 Discharge of gambling indebtedness. Taxpayer delivered his personal checks for $3.435 million and the checks were invalid. State court collection action was filed. Settled action for $500,000 and IRS asserts $2.9 million COD income to the taxpayer. Was the debt enforceable???? Tax Court: Inclusion as debt cancellation income (but reversed on appeal). Note: Tannenwald dissent no genuine debt. 3rd Circuit reverses Tax Court and treats the cancelled debt as a disputed debt or a contested liability. Treated as if the initial loan were for the eventual settled amount. 84

85 Net Gifts p.159 Diedrich v. Commissioner Gift of property subject to an obligation on the donee to pay gift tax arising from the transfer. A satisfaction of a taxpayer s liability by a 3 rd party. Does the donor have (capital gain) income to the extent the gift tax amount paid exceeds tax basis for the transferred property? 85

86 Problem re p.162 Net Gift Transaction Gift to Non-Charity Basis=$15x; fmv=$100x. Gift conditioned on donee paying $20x of gift tax. Gain of $5x ($20x of amount realized less $15x of basis) Donee s Basis: Greater of Donor Basis ($15x) or Amount Paid ($20x), so $20x. See Reg Gift to Charity Basis=$20x; fmv=$100x. Sold to charity for $20x. Gain of $16x (i.e., $20x [$20x basis * $20x/$100x] = $16x) Cf., bargain sale to charity rule. 1011(b). 86

87 Questions p (a) Parent, P, transfers to child, C, shares of stock with a value of $10,000 and a basis of $1,000. No gift tax is payable. P tells C that C is free to do what she wants with the property. C sells the shares. (b) P transfers the shares to C and tells C to sell the shares for her and use the proceeds to pay P s $10,000 bill at the country club. (c) P transfers the shares to C and tells C that she can do as she wishes with them provided that she pays P s $10,000 bill at the country club. (d) Same as (c) except that C must pay P s $10,000 debt to the United States Treasury for income taxes. 3. Would the result have been different if the gift tax liability were imposed on the donee and not the donor? Would it matter whether the donee had funds with which to pay the tax without selling any of the shares? 87

88 Effect of Debt on Basis and Amount Realized p.163 Identifying types of debt: 1) Recourse personal liability 2) Nonrecourse debt secured only by the pledged asset. Crane case p. 165 recourse and nonrecourse debt is treated similarly for federal tax purposes. Here, taxpayer claimed debt (1) in basis but (2) not as amount realized upon disposition/debt relief. 88

89 Debt and Property Purchases p.164 What is the effect of debt on the income tax basis of an acquired property? Acquisition debt is to be included in the buyer s tax basis for acquired property. This can include seller financing debt. Also, property can be acquired with debt attached, i.e., either (1) assumed debt, or (2) non-recourse debt, with property subject to debt (but no personal liability). Cf., post-acquisition debt (i.e., borrowing with existing property as collateral). 89

90 Crane v. Commissioner p. 165 Facts: 1932: Property worth $262, inherited subject to non-recourse debt of $262, : Property depreciated by $25, : Property sold subject to mortgage for $2,500 Taxpayer Position: Amount Realized of $2,500 less Zero Basis. IRS Position: A/R of $257,500 Basis $233, = Gain $23, Court Holding: Taxpayer gain is $23, Relief of mortgage is as real a benefit as the receipt of cash. How do you read Footnote 37? 90

91 Estate of Franklin p.172 Purchase money debt includible in basis? Purchase of motel for only prepaid interest and a nonrecourse debt (with balloon payment). Warranty deed in escrow. Leaseback to sellers & lease payment equal to P&I amount. Value of property not shown, but presumably far less than the promissory note amount. Held: No investment in the property and no depreciation deduction and no interest expense deduction. 91

92 Pleasant Summit Land p. 172 Different approach than Franklin case. Deprecation deduction allowed to the extent that nonrecourse debt not exceeding FMV of the property that amount effectively recognized as tax basis on the acquisition. Consider the tax basis to Bayse the purchaser in the Tufts case. Basis limited as in the Franklin or Pleasant Summit cases? 92

93 Tufts case p.173 Debt Exceeds Property FMV Facts: Property purchase for $1.85 million nonrecourse debt & initial tax basis of $1.85 mil. $400,000 depreciation claimed. Tax basis is reduced to $1.45 million ( 1016). Property FMV at disposition was $1.4 million - $1.850 debt exceeds tax basis and the FMV of the property. Tax issues: Gain or other income? Loss? Tax character? How much? 93

94 Tufts choices for decision One or Two Transactions? Integrated transaction Two transactions debt basis 400 gain 1) debt relief value 450 COD income. (capital gain?) OR 2) basis value 50 capital loss. 94

95 Treasury Regulations & p.181 Nonrecourse Debt Reg (a)(1) - the amount realized includes the amount of liabilities from which the transferor is discharged. Reg (a)(4)(i) - the sale of property that secures a nonrecourse liability discharges the transferor from the liability. Reg (b) - the fair market value of the security is not relevant for determining the amount of liabilities being discharged. 95

96 Revenue Ruling Bifurcation p.181 Acquisition of property with recourse liability, i.e., personal liability. Property was transferred to lender and borrower was released from liability. Debt Property FMV Basis 45x 30x (15x COD income?) 10x (20x property gain?) Foreclosure proceeding: same result. 96

97 Rev. Rul Debt Reduction - No Transfer Lender agreed to reduce the nonrecourse debt when the value of the building ($800,000) was less than the outstanding mortgage debt ($1 million). No insolvency. Reduction of the principal amount of the undersecured nonrecourse debt was made by the holder of debt who was not the seller. This debt reduction constitutes realization of COD income (even in the non-recourse debt context) - since no disposition of the collateral has occurred. 200x COD income. Or, should a tax basis reduction result? 97

98 Woodsam Associates p. 213 Post-acquisition borrowing, using the appreciated property as collateral for a nonrecourse loan. Borrowing in excess of tax basis. Borrowing is not a realization event. 98

99 Summary p.181 Non-Recourse 1. Acquisition NR Debt < FMV of Property: NR Debt gives basis (Crane) NR Debt > FMV. Split Estate of Franklin: Option to Purchase. No basis for NR debt Pleasant Summit Land: NR debt basis to extent of FMV. 2. Post-Acquisition Pledge: No Basis increase in pledged property (Woodsam) 3. Disposal Integrated Approach (Tufts result) Amt. Realized = NR Debt + Other (Tufts) Recourse 1. Acquisition R. Debt gives basis (Crane) 2. Post-Acquisition Pledge: No Basis increased in pledged property (Woodsam) 3. Disposal Bifurcated Approach RR 90-16, Reg (c) Example (8) Amt. Realized = COD Income = FMV of Property Debt discharge above FMV 4. Forgiveness of portion of R. Debt: CODI or does a 108 exception apply? 4. Forgiveness of portion of NR Debt: CODI or does a 108 exception apply? Rev. Rul

100 Illegal Income p.181 Gilbert case Use of Corporate Funds Do proceeds from embezzlement constitute gross income? Note Kirby Lumber (p. 181) that purchase by issuer of its own corporate bonds for less than the issue price constituted GI. But, embezzlement an obligation to repay? James Sup. Ct. case (p.200): unlawful gains are GI. 100

101 Tax Exempt Interest p. 186 Code 103 exclusion from gross income for interest on state and local debt obligations. Economic effect: reduce the amount of interest payable by the state/local govt. obligor. Note the leakage for this gross income exclusion between (1) benefit to local govt and (2) cost to U.S. Treasury. Tax Expenditure cost is $23.1 billion. 101

102 Private Activity Bonds, etc. P.186 Code Use of muni-bonds (1) for government functions and (2) to assist private industry (by acting as intermediary). Code 148 re arbitrage bonds. 102

103 U.S. Constitutional Authority to Tax p.189 Muni Bond Interest? Would taxation of muni-bond interest by U.S. Government be constitutional? Consider the rights of states as being impaired if federal taxation occurs. Cf., South Carolina v. Baker (p. 189) that muni-bond interest is taxed if bonds are not in registered form. Code 103(b)(3) & 149. Why this rule? 103

104 Sale of Home p excludes gain on sale of home of up to $250,000 ($500,000 for married filing jointly) The benefits of this exclusion arguably changes taxpayer behavior on where they have their wealth. Is this a good thing? The Tax Expenditure cost of this benefit is $17.5 billion. 104

105 Dividend Income p (a)(7) treats dividends as part of gross income 1(h)(11) provides a preferential tax rate for dividends and capital gains. The Tax Expenditure estimate for this benefit is $65.9 billion. The Warren Buffet rule. Why should this form of income be taxed preferentially over ordinary income? 105