Presentation:
Federal Income Taxation
Chapter 8 Capital Gain and Losses
Professor Wells
November 15, 2012
1 Chapter 8
Capital Gains and Losses
Issues in this Chapter:
1)  Meshing capital gains and losses
2)  Capital gains policy issues
3)  Sale or exchange requirement
4)  “Capital Asset” definition
5)  Depreciation recapture
6)  Code § 1231 property defined
7)  Hedging transactions
2 Mechanics of the Treatment of Capital
Gains & Losses
§1001(a) – determine the amount of the gain realized;
how determine tax basis?
See §6045(g) re brokers to report basis re securities
transactions.
§1001(c) - gain to be “recognized” - unless otherwise
provided
3 Tax Benefits and Planning Objectives re
Capital Gains
1.  Beneficial rate treatment - §1(h) provides for a 15% tax
rate for long term capital gains, subject to certain
exceptions (e.g., collectibles).
2. Capital losses cannot be used to offset ordinary income
(except for individuals to the extent of $3,000 per year).
How maximize the use of capital losses?
3. Definitional consideration: what is a capital asset?
4 When Capital Gains Exceed Capital Losses
p.699
Capital gains - §1(h) - lower tax rates.
Code §1222(11) - the excess of net long-term capital gain
over net short-term capital loss is “net capital gain”.
Meshing of (i) long term capital gains and losses and (ii)
short term capital gains and losses is required to preclude
arbitraging the tax rate structure.
5 Capital Losses Exceed Capital Gains
1) Deductible losses are available only to the extent of
aggregate capital gains, but each year individuals can
deduct $3,000 excess capital losses against ordinary
income. Code §1211(b).
2) Code §1212(b) allows an indefinite carryover of capital
losses for individuals. Code §1212(a) provides a five
year carryover limit for corporations, but a carryback
is available for three years.
6 Problem - Cathy & John
Original Problem:
W stock $10,000 LTCG
X stock $3,000 LTCL
Y stock $4,000 STCG
Z stock $9,000 STCL
Revised Problem
W stock $10,000 LTCG
X stock $3,000 LTCL
Q stock $5,000 STCG
Y stock $4,000 STCG
Z stock $9,000 STCL
$7,000 Net LTCG
p.610
$2,000 Net Cap. Gain
$5,000 Net STCL
$7,000 Net LTCG
$7,000 Net Cap. Gain
$0 Net STCL
7 Planning considerations –
“Harvesting losses”
Sell gain and loss assets in the same year? No (except for
those individuals regularly having significant capital gains
and losses); stagger gains and losses so as to (a) first use
capital losses against $3,000 of ordinary income, and (b)
then have long term gains taxed at the preferable 15% tax
rate (or in reverse chronological order).
8 Defining the Term “Capital Asset” –
Code § 1221
p.615
Code §1221 provides a definition of “capital asset” as not
Including:
(i)  inventory and property held primarily for sale to customers
(ii)  Real property or depreciable property used in a trade or
business, but see §1231.
(iii)  Copyrights and similar property
(iv)  Accounts receivable
(v)  US government publications
§1231 property– Losses ordinary. Gains capital.
9 Capital Gains Tax Rate Policy Issues
p.616
1)
Will lowering the capital gains tax rate increase tax
revenues by unlocking gains and causing gain recognition for
income tax purposes?
2)
Relief for possible income bunching effect (because multiple
years value accrual is taxed in one year)? Is the indexation of
tax basis to reflect inflation a better option?
3)
Relieve the impact of inflation (but cf., assets held (i)
one year+ or (ii) 10 years);
4)
Consider the “lock-in” effect of the impact of capital
gains tax rates & Code §1014. Avoid by eliminating the
realization concept? Some Code provisions do this, e.g., §475.
5)
The “realization” concept itself does enable (i) tax
deferral (cf., Haig-Simons) & (ii) income tax benefits
10 Capital Gains Tax Rate As Enabling Tax
Regressivity?
Who owns most capital assets which produce capital gains?
The highest income individuals?
Should capital gain income be subject to the same rate as
wage income? Or, reward risk-taking?
Does the lower rate represent implementation of a quasi
consumption tax approach?
11 Why the Limit on Capital Loss Utilization?
P.618
Taxpayer cannot realize losses to offset against ordinary
income (while not realizing economically accrued gains).
The limited $3,000 deduction for individuals does permit low
level “cherry picking” for loss utilization.
See §1211(b) re $3,000 capital loss allowance.
12 Differentiating: Capital Asset or Wages?
Note the discussion concerning compensation paid to hedge
fund & private equity fund managers: i.e., the “2 & 20”
formula.
The 2% of amount invested constitutes compensation.
But, what about the 20% participation in the upside gains?
Particularly, when no cash investment is made by the
managers.
Cf., growth of the value of a private company from “sweat
equity.”
13 Bielfeldt v. Commissioner
Sale to “Customers”
p.620
§1221(a)(1) provides for exclusion from capital asset status of
property held for sale.
Here: Taxpayer held property for as a “trader” but not a
dealer
Note §475(f) would have given ordinary treatment. Why?
14 Biedenharn Realty Co. v. United States
p.624
Property held for investment or held for sale? Dual use.
Court held that property held for sale. Factors considered:
1) Frequency and substantiality of sales
2) Development and improvement activities for the land
3) Seller’s solicitation and advertising efforts in sales
4)
Relative earnings – property sales vs. earned income
5) Bulk sales
6) Liquidation of investments?
15 Corn Products Case
p.635
Were purchases and sales of corn
futures contracts capital asset
transactions?
Taxpayer says futures trading was
separate from its manufacturing
operations. And, therefore, capital
gains (and losses) from the futures
contracts.
Sup. Ct. says futures contracts are
equivalent to inventory and,
therefore, ordinary income (and
loss) realized
on disposition.
CBOT
CBOT
1
2
Grain
Elevator
Farmer
16 “Corn Products” Doctrine
Arkansas Best Case p.638
Issue: Was corporate stock a capital asset?
Facts: Taxpayer acquired stock in a Dallas bank. The stock was
sold at a loss after the bank became a problem bank (&
ordinary loss?).
Tax Court held the stock purchases during bank's “problem
phase” were made exclusively for business purposes.
Reversed by 8th Cir. and Supreme Court affirmed. Acquisition
purpose not deemed relevant.
17 Sequels to Arkansas Best
p. 641-642
No tax “common law” definition of a capital asset
(assumed after Corn Products case). But, a broad
construction of §1221(a)(1).
Regulatory response: Reg. §1.1221-2 which limits non
capital asset treatment to hedging transactions/ “risk
reduction.”
18 Changes to IRC §1221 (1999)
Exceptions to capital gains definition:
§1221(a)(6) – commodities derivative financial instruments
§1221(a)(7) – hedging transactions (timely identification
required)
§1221(a)(8) – supplies of a type consumed by the taxpayer in
ordinary course of business
(e.g., airlines purchase of fuel).
19 Common Law: Substitute for Rent
Hort v. Commissioner
p.642
Lump sum payment received by owner upon cancellation of lease
as a substitute for future rent.
“Substitute for Ordinary Income” proves too much.
20 McAllister v. Commissioner
p.647
Facts: Richard McAllister (Richard I) by will created a trust fund of
$100,000. The income was to go to his son John for life, then to
John’’s widow for life, then to John’’s brother, Richard II. When
John died, his estate needed cash, so his widow, the taxpayer in this
case, sold her life estate to Richard II for $55,000. She reported a
capital loss of $8,790.
Held: The taxpayer’’s position is sustained. She sold a property
interest or right. This was not an assignment of income.
Consideration received characterized as capital gain.
What is the life tenant’s tax basis? See §1001(e).
Cf., Blair case re assignment of income.
21 Lottery Winner
Womack v. Commissioner
p.651
The Womacks won the right to twenty annual payments of $150,000
from the Florida State Lottery. After they received annual
payments for four years, the total remaining amount of payments
was $2,400,000. They sold the right to those remaining payments for
$1,328,000, which they claimed was capital gain and the
Commissioner treated as ordinary income.
Held: The Third Circuit affirmed the ruling of the Tax Court “that
Lottery Rights are not capital asset under the judicially established
substitute for ordinary income doctrine.” Rationale:: a substitute
for the regular receipt of ordinary income and, therefore, ordinary
income. Equivalent to earned income.
22 Oil Payments
Commissioner v. P.G. Lake
p.656
Corporation transferred a 600x oil payment to officer to pay
loan. Treatment of assignment as a capital asset transfer.
Held taxable as ordinary income since a substitute for
ordinary income.
Response is Code §636 – treat the transaction as a loan.
23 Bootstrap Sale to Charity
Commissioner v. Brown
p.659
Insert Facts:
Clay Brown and family owned all the shares of Clay Brown & Co. (CB Co.). Clay
Brown sold their shares to the California Institute for Cancer Research for
$1,300,000, payable $5,000 cash at the outset and the rest in deferred payments
over not more than 10 years. The agreement called for the Charity to lease the
assets to a Fortuna Sawmills, Inc. which was in turn owned by Clay Brown.
Fortuna paid rent equal to 80 percent of its operating profits (before
depreciation). Fortuna deducted the lease payments and the Charity was
nontaxable on its receipt. The Charity used the proceeds to pay Clay Brown the
purchase price, and Clay Brown claimed Long-Term Capital Gain Treatment on
the gain from the contingent sales price.
Held: Clay Brown wins
24 Lattera Synthesis
“Family Resemblence Test”
p.653
.
Judge Ambro Posits this synthesis:
Step One: Look to Type of Carve-Out First. Horizontal carve-out leads to
ordinary income. Vertical carve-outs lead to step #2.
Step Two: Because a vertical carve-out could signal either capital gains or
ordinary income, we then look to the character of the underlying asset and apply
the “family resemblance test.”
A.  Assets gives a right to Earned Income create ordinary income when
sold (examples: landlord’s leasehold rights in rental, annuity rights, right
to interest income return, contractual payment rights). All of these
resemble a right to already earned income. If the sale is of property that
has a “family resemblance” to an asset that represents a right to earned
income, then ordinary income treatment.
B.  Assets that represent a right to Earn Income create capital gain
(stocks, land, tangible personal property). If the sale is of a vertical
interest in an asset that has a “family resemblance” to an asset that earns
income, then capital gain treatment.
25 Abandonment or Terminating Rights
Baker v. Commissioner
p.670
Abandonment of property can constitute a “sale or
exchange.”
Termination of a contract can constitute a sale or exchange
but not where merely terminating a right to ordinary
employment income.
Note Code §1241 re capital gain to lessee for payment to
terminate a lease.
26 Theatrical Production Rights
Commissioner v. Ferrer
p.679
1)
Surrender of the lease of the play is not excluded from
capital gains treatment.
2)
Negative power to prevent disposition or motion picture
rights until after play production – capital gain
proceeds.
3)
Right to receive portion of motion picture proceeds – not
capital.
27 Right of Privacy
Miller v. Commissioner
p.687
Facts: The widow of famous bandleader Glenn Miller entered into a
contract with Universal Studios granting it the exclusive right to
make a movie based on Glenn Miller’s life. At the time the case
arose it was unclear what, if any, rights Mrs. Miller might have had
in respect of her deceased husband’s story (or her own). The movie
was a hit and Mrs. Miller collected $409,336, which she claims was
from the sale of property and therefore was capital gain.
Held: Ordinary income. Whatever it was that she had that resulted
in the payment, it was not “property.”
28 Patents
§1235
p.690
§1235 provides capital gain treatment on the sale of a patent
by an individual inventor.
Even where consideration is based on royalties.
All substantial rights in the patent to be transferred to enable
capital gains treatment.
§§1221 and 1231 apply to other patent transfers
(But see 1221(b)(3) for musical copyrights).
29 Prior Related Transaction
p.697
Merchant National Bank v. Commissioner
Facts: The taxpayer bank held promissory notes for loans that
turned sour and wrote them off completely as ordinary losses in
1941 and 1943. It 1944 it sold the notes for $18,460.
Held: Ordinary income.
30 Prior Related Transaction
Arrowsmith v. Commissioner
p.698
Taxpayer liquidated a corporation.
Gain reported on stock redemption as capital gain.
Later taxpayer required to pay a judgment against the
corporation.
Payment treated as a capital loss, not as an ordinary and
necessary business expense.
Skelly Oil (page 700) in Note
31 Hypothetical: Sale of Business
FACTS: Seller sales a business for
$5 million in cash and has a basis of
$4 million. Assume only asset is a
§1231 asset that has $300,000 of
depreciation recapture.
1
Sell of Asset for $5 million
$5 million of cash
Seller
Buyer
QUESTION #1: What is the tax
consequence on the sale?
QUESTION #2: Now assume that
there was a defect in the equipment
and Seller must reimburse Buyer
$1.2 million for this undisclosed by
reason of the indemnity clause of
the purchase & sale agreement.
What result?
§1231 Asset
2
Reimbursement of $1.2 million
$1.2 million of cash
Seller
Buyer
32 U.S. v. Skelly Oil
FACTS: Skelly sold natural gas at regulated price and claimed percentage
depletion on those sales of 27.5%. Skelly Oil had to repay a portion of these
proceeds ($505,536.54). Only $366,513.99 had been subject to tax in the
earlier year (i.e., $505,536.54 * 72.5%). Taxpayer claims a 100% deduction
on the $505,536.54 repayment while IRS claims that the repayment should
only give rise to a $366,513.99.
Holding: Deduction limited to only 72.5% of amount of repayment under tax
benefit rule principles, citing Arrowsmith.
33