Chapter 3
p.195
Problems of Timing
Possible relevance of timing considerations:
(1) acceleration or (2) postponement of (a)
income or (b) deductions.
Important factors:
1) Changes in tax rates (whether changes in
statutory tax rates or individual circumstances);
2) Time value of money, i.e., the interest rate
benefit on deferred income tax payments. What
is the present value of the future payment?
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1
The “Realization”
Doctrine
p.196
See IRC §1001(a) concerning realization
required to have an income event from a
property disposition transaction.
I.e, more than an economic increase in the value
of the property owned must occur.
Cf., Haig-Simons definition of income (not
necessitating a “realization” event).
Does the 16th Amendment require a “realization
event” for gain recognition on property? No.
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2
Eisner v. Macomber
p.197
Does the 16th Amendment permit taxation of a
“stock dividend” distributed by a corporation.
Thus, a U.S. constitutional inquiry: Does U.S.
Congress have power to require income
recognition for a distributed stock distribution?
After the distribution the total value of each
shareholder’s shares remained unchanged.
USG says GI inclusion is required to the extent
of par value (not fmv) of new shares.
Majority: income is “gain derived from.” cont.
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3
Eisner v. Macomber,
cont.
Majority opinion: Reference to the 16th Amend.
Income “from whatever source derived.”
A stock dividend represents a capitalization of
accumulated profits.
But, here nothing is received from the corp. in
the manner of recognizable income.
Held: 16th Amend. precludes this taxation.
Dissent: This proposed taxation does not violate
16th Amendment requirements.
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4
Include in GI Unrealized
Appreciation?
P.205
A constitutional requirement for a realization
event? Or, permit “mark to market”?
See §305 re corporate stock distributions.
Cf., Glenshaw Glass permitting inclusion in
gross income of a “windfall.”
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5
Bruun
p.208
Tenant constructs (in 1929) 50 year life building
on owner’s land. Term of lease is 99 years.
Tenant defaults and lease is cancelled in 1933.
Did owner realize income at lease cancellation
when owner has possession of the building?
Held: yes, gain realized in 1933.
Cf., Blatt case (p. 209): income from
improvements each year of lease until
expiration.
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6
Timing Choices &
Leasehold Improvements
1) Time lease is agreed, with lessee promise to
build improvement.
2) When building built – to extent of anticipated
FMV at end of lease.
3) Each year as lease is getting shorter.
4) When lease expires (Bruun)
5) When land and building are subsequently
sold. §§109 and 1019.
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7
Nonrecourse Borrowing
Exceeding Basis
p.212
Remember Tufts: Original nonrecourse
purchase debt is included in basis.
Cf., later debt incurred when borrowing exceeds
tax basis for collateralized property.
Woodsam Associates, p. 213: Taxpayer
borrowing nonrecourse in excess of tax basis.
Argues that was a gain event & basis then
stepped-up – to avoid gain treated as realized on
a mortgage foreclosure. Held: gain at later
disposition, and not when recourse borrowing.
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8
Cottage Savings Assn.Loan Package Swap p.166
Facts: Financial institution exchanges one
group of residential mortgage loans for another
institution’s mortgage loan package.
A swap of “participation interests” occurs.
Long-term low interest existing mortgage
obligations had declined in value due to a
significant increase in market interest rates.
Seller did not want to record losses on its
“books”, i.e. for regulatory and financial
accounting (i.e., shareholder) purposes. Cont.
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9
Cottage Savings
Association,
cont.
Issue: Did a tax disposition event occur? Were
the properties “materially different”?
Holding: This exchange does cause losses to be
realized for federal income tax purposes (even
though not for regulatory purposes). Cf.,
Memo R-49. An exchange occurred of
“materially different” properties.
Cf., inclusion in gross income when based
merely on property appreciation in value, i.e.,
an economic accretion to wealth.
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10
Cottage Savings
Association,
cont.
Consider the IRS litigating position in Cottage
Savings. What was achieved by IRS losing this
case? Should the Cottage Savings tax litigation
result have been controlled by the reporting for
financial accounting purposes (particularly
when accounting is dictated by another
government agency)?
Consider that this transaction was done “solely”
for a tax avoidance purpose (i.e. no business
purpose – except to survive with reduced tax
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liability).
11
Debt Modification as a
“Disposition”
p.224
Is the modification of a debt a realization event?
Reg. §1.1001-3 states that a “significant
modification” of a debt instrument is an
“exchange” for FIT purposes.
Consider a change in (1) length of term, (2)
interest rate, (3) another element (e.g., priority).
Exception from realization treatment for a
“unilateral option” or a change in an “index
rate” where a variable rate obligation.
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12
Nonrecognition Treatment
p.227
Code §1001(c) provides that “except as
otherwise provided in this subtitle” gain or loss
shall be recognized.
How retain the future potential for recognition
of that gain? Answer: Preservation of the
unrecognized gain (or loss) in determining tax
basis for replacement property. See §1031(d).
Why provide for nonrecognition in certain
situations? A concern about illiquidity and/or
valuation? Mitigation of a “lock-in effect”?
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13
Like-Kind Exchanges
p.228
Code §1031 provides that no gain or loss shall
be recognized on the exchange of property held
for productive use in a trade or business or for
investment if exchanged solely for property of a
like kind.
But, gain recognition treatment required if
“boot” is received (gain is limited to extent of
boot). §1031(b).
Basis is shifted to the replacement property,
except a FMV basis for the boot. §1031(d).
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14
PLR 200203033
p.229
Private letter ruling request re §1031 tax free
exchange eligibility for a swap of a conservation
easement in Property A for a fee interest in real
estate (also subject to a conservation easement).
Treated as “like kind” real estate – assuming
held for productive use in business or for
investment.
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15
Identifying “Like Kind”
Property
P.232
Is like-kind treatment permitted for:
1) Different types of real estate? Cf., TICs; saleleasebacks (how long a lease?); oil and gas
properties?
2) Auto/truck trade-ins? Low tax basis when
prior tax depreciation; not for personal auto.
3) Professional athlete contract swaps?
4) Partnership interest swaps?
See limits in §1031(a)(2). Liquid securities and
inventory are not eligible. Coins?
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16
How is the Gain Potential
Kept for Tax Purposes?
Tax basis for the replacement property is:
1) Same as the tax basis for the property
transferred;
2) Decreased by the boot received;
3) Increased by the gain recognized on the
exchange.
See §1031(d) providing the rules for a
transferred tax basis for the replacement
property.
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17
Like Kind Exchange with
No “Boot” Received
Example 1: Client owns property A. Exchange
of Property A worth 10x, basis 4x, for like-kind
property B, also fmv 10x.
Taxable inclusion of 6x gain is postponed.
Tax basis for the replacement property is 4x (to
preserve the income tax potential on the 6x
deferred gain). §1031(d).
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18
Like Kind Exchange with
“Boot” Received
Example 2: Client transfers Property A worth
10x (basis 4x, accrued gain 6x) for like-kind
property B, fmv 8x, plus 2x cash received
(“boot”) by transferor.
§1031(b) - 6x gain is realized. Gain to be
recognized to the extent of the 2x “boot.”
Tax basis for the replacement Property B (fmv
8x) is 4x (to preserve the 4x deferred gain).
Tax basis for 2x cash received is (obviously) 2x.
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19
Like Kind Exchange with
“Boot” Received
Example 3: Client transfers Property A worth
10x (basis 4x, accrued gain 6x) for like-kind
property B, fmv 3x, plus 7x cash received
(“boot”) by transferor.
§1031(b) - 6x gain (not 7x cash amount) is
realized and recognized.
Tax basis for the replacement Property B is 3x
(fmv).
Tax basis for 7x cash received is (obviously) 7x.
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20
Loss - Like Kind Exchange
Provision is Not Elective
Example 4: Client transfers Property A worth
10x (basis 12x, accrued loss 2x) for like-kind
property B, fmv 10x (same fmv).
No loss can be recognized. §1031(a) .
Tax basis for the replacement Property B is 12x
(the 2x potential loss is retained in the
replacement property for possible future loss
recognition, unless subsequent appreciation
occurs).
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21
Loss - Like Kind Exchange
Provision is Not Elective
Example 5 (boot received): Transfer of
Property A worth 10x (basis 12x, accrued loss
2x) for (1) like-kind property B, fmv 8x and (2)
2x cash boot received by the “seller.”
No loss can be recognized. §1031(a) .
Tax basis for the replacement Property B is 10x
(the basis of the transferred property, as
reduced by the 2x cash); 2x potential loss is
retained in replacement property (8x fmv);
2x basis for the cash received.
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22
Like Kind Exchange with
“Boot” Received in Kind
Example 6: Client transfers Property A worth
10x (basis 4x, accrued gain 6x) for (1) like-kind
property B, fmv 8x, plus (2) other property (e.g.,
listed stock) worth 2x.
§1031(b) - 6x gain is realized; recognition only
to the extent of the boot.
Tax basis for the replacement Property B is 4x
(& remaining 4x gain potential). Tax basis for
the other property is 2x.
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23
Like Kind Exchange &
Taxpayer Adds Cash Boot
Example 7: Client transfers (1) Property A
worth 10x (basis 4x, accrued gain 6x) and (2) 5x
cash for replacement property B with a 15x fmv.
§1031(a) - 6x gain is realized; no gain
recognition is required.
Tax basis for the replacement Property B (fmv
15x) is 9x (4x old basis plus 5x new cash paid to
other party).
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24
Multiparty Transactions
p.234
How arrange a tax-free swap when only one
party wants a tax-free swap?
Consider a three-party (or more) transaction.
Consider the potential applicability of the
federal income tax doctrine of “substance over
form.”
What other possibilities exist for intermediaries
(e.g., exchange agents)?
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25
Like-Kind Exchange
Deferred Property Receipt
“Starker” exchange – p. 237.
Delayed receipt of the exchange property – by
relying on the creditworthiness of the other
exchanging party. Does this qualify as a §1031
exchange (when initially receiving a promise)?
See §1031(c) specifying 45 day (identification)
and 180 day (completion) limitations.
What if an interest charge equivalent is credited
to the replacement property purchase?
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26
Involuntary Conversion
Gains & &1033 Deferral
P.232. Postponement of realized gain occurs if:
1) A gain is derived from an involuntary
conversion, e.g., theft, casualty, seizure, or
eminent domain (or a taking “threat”?).
Consider: proceeds received from insurance.
2) An acquisition occurs within the required
time period (before the close of the 2nd taxable
year of gain) of a replacement property “similar
or related in service or use.” Cf., the more
expansive §1031 “like kind” property concept.
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27
§1033 Example: Business
Property Destroyed
Building destroyed by fire is business property.
Taxpayer receives 350x insurance proceeds;
200x tax basis for the old property and 325x
reinvestment in the replacement property.
Under §1033(a)(2)(A) the 150x of realized gain
is included in GI only to the extent of 25x (350x
insurance proceeds less the 325x reinvestment).
The 125x of unrecognized gain reduces the tax
basis for the replacement property to 200x.
Unrecognized gain is preserved for the future
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with this tax basis adjustment.
28
Corporate Transaction
Nonrecog. Rules
p.238
Note §1001(c). Consider the formation of a
corporation (a separate taxable entity):
1) Transfer occurs of appreciated assets into
corporation in exchange for stock of corp.
Gain recognition required? §351.
2) §1032 – corporation does not recognize gain
on exchange of shares for shareholder’s assets.
3) What about multiple individuals
contributing various assets (e.g., traded shares)
to a corporate investment fund?
Cont.
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29
Corporate Transaction
Nonrecog. Rules
cont.
4) What tax basis to the shareholder for stock
received? See §358 re substituted basis.
5) What tax basis to the corporation for the
assets received from the shareholder? §362(a) .
Consider the effect of two levels of gain now.
6) Property subject to debt is transferred to
corporation in §351 transaction. See §357(c) for
gain recognized when liabilities exceed tax basis.
7) What if services are rendered to the corp. in
exchange for shares? Percentage limit?
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30
Tax-free Reorganizations
p.240
1) Change place of corp. organization from
California to Delaware. Why? How? Taxable?
Nonrecognition occurs and substituted tax basis
applies for the replacement shares.
2) What if a merger occurs of A corp into B
corp and the A shareholders receive shares of B
Corp.? Is gain recognition required to A
shareholders? Not if a tax-free reorganization.
See §§354 and 368.
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31
Deemed Realization –
Constructive Sales P.241
How to (1) raise cash, (2) protect against
downside, and (3) postpone tax realization?
E.g., “sale against the box” – sell borrowed
shares (possible?) - assuming the loan of the
borrowed shares can be subsequently closed
(e.g., when appreciation has disappeared with a
§1014 tax basis step-up at death).
§1259 – gain is to be recognized on a
constructive sale of an “appreciated financial
position.” Similar- futures or forward contracts.
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32
Original Issue Discount
P.245
Debt instrument does not provide for (1) any
current interest or (2) adequate (i.e., market)
interest. Then, interest income must be accrued
– whether for a cash basis or an accrual basis
taxpayer, i.e., treated as “original issue
discount” (or “OID”, the unstated interest).
OID is the difference between the (1) issue price
and (2) the redemption price. §1273.
Tax policy objective: To avoid interest income
postponement while enabling a current interest
expense deduction (c)
(for
an accrual basis obligor).
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33
Debt Obligation Issued for
Property
p.246
No a readily determinable issue price.
Therefore, apply a discount (interest) rate to the
anticipated payments.
What is the appropriate interest rate for this
purpose? – the “applicable federal rate” (AFR).
What is the present value of the imputed
principal amount – based on the current AFR?
Any difference will be OID – to be reported on a
current basis (though not actually received).
See Table, p. 247. (c) William P. Streng
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34
Maturity of the OID
Obligation
What is the tax treatment on the receipt of
proceeds of the OID obligation at the time of its
maturity? Capital gain?
However, all OID has previously been included
in gross income, and this inclusion enables an
addition to the tax basis of the debt instrument.
At maturity the basis and the proceeds are the
same – producing no realized gain. Before the
OID rules: treat all this gain as capital gain
when the obligation matures and is then paid.
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35
Market Discount
p.248
Borrower issues debt at a 5% market rate (e.g.,
receives 100x par value at time of issuance).
Interest rate in the market then increases (e.g.,
to 8%) and 100x obligation declines to 70x fmv.
Purchaser then acquires this discounted
obligation for 70x and receives (1) the 5%
interest (current income) and (2) 30x profit
when the debt instrument matures. How treat
the 30x? §§1276 and 1278 specify this gain is
ordinary income – but not until the debt
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proceeds are actually
received.
36
Exceptions to the OID
Rules
P.248.
Sale for deferred payment(s) of a principal
residence or farm for less than $1 million (e.g.,
for a principal amount without any interest).
See §483 – providing for the treatment of the
discount portion (1) as interest income (and not
as capital gain), but (2) only when the payment
is received, i.e., a recharacterization rule, but
not a timing acceleration rule for the cash basis
seller.
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37
Open Transactions
Burnet v. Logan
p.249
Transfer of corporate shares in exchange for
(1) cash and (2) a promise of future payments
(iron ore royalties). Was the contract to be
currently valued (discounted cash flow) and
treated as received currently by the owner?
IRS claims a “closed transaction,” with tax basis
to be recovered in the future.
Held: Open (not closed) transaction treatment;
no current value for the promise of future
payments. Entitled to return of all capital first.
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38
Open Transactions, cont.
p.251
Possible approaches to the timing of gain
recognition when a promise/contract (not a
promissory note) is received:
1) Open transaction – all payments are tax
basis components until full basis recovery.
2) Value the stream of expected payments as of
date of sale. Compare this amount with basis.
3) Open transaction, but allocate basis to each
expected payment (i.e., an installment method).
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39
Open Transaction
Treatment
p.252
Is available only in “rare and extraordinary
circumstances.” Reg. §1.1001-1(a).
See Warren Jones case, p. 252: Limited cash
and a 133x contract received (fmv 77x). Fair
market value is treated as GI when received.
Why wanting “open transaction” treatment?
1) Postpone inclusion in gross income.
2) All proceeds treated as capital (gains) while
the transaction is “open.” No receipts are
considered as being interest income.
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40
Installment Method
§§453, 453A, 453B p.254
Objective: coordinate income tax reporting
with the taxpayer’s actual receipt of cash.
Assuming no OID or unstated interest (§483):
What is the ratio of (1) gain to (2) the total
expected payments? Apply that ratio to each
payment to determine the amount of gain
embedded in each payment. §453(c).
Alternative: Elect out of §453 treatment for
closed transaction treatment, unless (unlikely)
possible open transaction treatment is available.
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41
Second Disposition by
Related Person
p.255
§453(e) provides if (1) 1st disposition of
property is to a “related person,” and (2) 2nd
disposition is by the related person to another
before all installments are paid on disposition
One, then the 1st disposition is treated as closed
when the related person sells.
E.g., 1st sale on installment basis to related
person and 2nd sale for cash, related person can
not hold cash pending installment payments
with deferral to 1st seller.
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42
Planning Around §453(e)
p.255
How avoid this “second disposition by related
person” rule of §453(e)? Transfer to a person
other than a “related person”?
Who is a related person? See §453(f) re crossreference to §318(a) or §267(b) related party
definitions. Does not include (1) a nephew or
niece, or (2) same-sex relationship person
(whether marriage or otherwise). See DOMA
which precludes latter as a defined relationship.
Then, a form over substance argument by IRS?
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43
Limitations on Installment
Sales Eligibility
See §§453(b)(2) and (k). Installment sales
provision is not available for (1) inventory sales
or (2) sales of publicly traded securities.
See §453A – interest charge is applicable if
aggregate obligations from $150,000 plus sales
exceed $5 million.
§453A(d) – a loan is treated as payment if the
obligation is pledged for a bank loan.
§453(i) – no deferral for installment obligation
when “recapture of depreciation” income arises.
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44
Additional Limitations on
§453 Eligibility
p.256
No §453 eligibility where payment in the sale is
made by buyer with (1) demand notes or (2)
publicly traded debt obligations.
But, no limitation applies where (1) the debt is
guaranteed, §453(f)(3), or (2) a bank guarantee
with a “standby letter of credit” is provided by
the buyer to seller. Reg. §15a.453-1(b)(3)(iii)
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45
Sales with Contingent
Payments
p.256
What if the amount of the payments is actually
contingent? Note Burnet v. Logan.
Apply §453 in this order:
1) Allocate basis over the maximum to be paid.
2) Allocate tax basis over the maximum
payment period.
3) Allocate tax basis in equal annual amounts
over a 15 year period.
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46
Constructive Receipt
Doctrine
p.256
Cash taxpayers include an item in income when
actually or constructively received. See Reg.
§1.451-2(a) re constructive receipt, i.e., when
set aside or otherwise made available.
See Amend case, p. 257. Cash basis taxpayer.
Deal to deliver grain under an agreement to get
payment in the subsequent year.
No constructive receipt. A bona fide deal.
No right to currently demand the funds & no GI
inclusion currently.(c) William P. Streng
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47
Pulsifer v. Commr.
P.262
Minors win Irish Sweepstakes but not entitled
to current funds until (1) becoming of majority
or (3) court approval for funds release.
Held: Winnings are to be included in GI for the
year of the award, and not for the subsequent
year when actually retrieved.
The funds were irrevocably assigned for benefit
of minors and only need apply for the funds.
“Economic benefit” occurred in the earlier year.
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48
Non-Qualified Deferred
Compensation
p.263
See Rev. Rul. 60-31 identifying “non-qualified”
compensation whose income is deferred for tax
recognition in a future year.
Cf., a “qualified” deferred compensation plan.
No monetary limit on the deferrable amount.
Must have a “cash method” taxpayer who
receives a mere “promise to pay.”
Immediate income recognition if the funds are
paid into an escrow account for the employee
(i.e., funds are not controlled by the employer).
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49
Minor v. U.S.
p.264
Contributions made to a deferred compensation
plan held not currently includible in GI.
Supplemental agreement with employer that
compensation for future services paid to a trust
& retirement annuity policies to be purchased.
Does “economic benefit” rule require inclusion?
- “Constructive receipt” doctrine not applicable.
- Economic benefit? Not here; assets remain
subject to the employer’s creditors; & risk of
forfeiture arises with non-compete requirement.
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50
Deferred Compensation
Tax Issues
p.268
- When can an employer deduct future payment
to be made? Only in the future when paid, even
though an accrual basis taxpayer. §404(a)(5).
- §457 – dollar limitations on plans of state
agencies; payor is not subject to tax.
- §403(b) – Tax-exempt charities and public
educational agencies have limitations.
- §409A – taxpayer employer; no employee
deferral if election exists to accelerate benefitseven though based on an external condition.
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51
Qualified Pension/Profit
Sharing Plans
p.270
Personnel objectives: Enable employee loyalty
and employee incentives (including investing in
the employer’s stock; cf., Enron Corp.).
Defined benefit (DB) plan: employer agrees to
pay fixed retirement benefits based, e.g., on
(1) years of service and (2) final pay amount.
Defined contribution (DC) plan: amount
contributed based on formula (e.g., 5% of
current compensation) and the amount paid on
retirement is based on investment returns.
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continued
52
Qualified Pension/Profit
Sharing Plans
p.270
Qualified plan income tax results:
1) Employer deduction for plan contributions.
2) No current GI to the employee-participant;
GI inclusion upon later distribution to retiree.
3) No GI for investment returns received by the
intermediary holding entity (e.g., trust).
4) Non-tax benefit – funds are protected from
employer’s financial risks (although possible
actuarial underfunding for DB plans). Cont.
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53
Qualified Pension/Profit
Sharing Plans
p.273
Limitations on qualified plan structuring:
1) Non-discrimination rules – can not favor
highly-paid employees (but social security
integration).
2) Vesting – benefit becomes nonforfeitable;
cf., effect of termination before retirement.
3) Funding – infusion of contributions into a
separate trust enables security of funds.
4) Limits on contributions made by employer.
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54
Special Retirement Plan
Structures
p.273-4
- Self-employed persons – use a Keogh plan
when only one (or several) employees.
- But, other mechanisms for corporate plans?
- IRAs – individual retirement accounts – e.g.,
when employer not providing benefits. §408.
- Roth IRA –nondeductible contributions, but
non-inclusion for accruals and distributions.
Note: (1) Penalties for early withdrawals, &
(2) Required minimum distributions (70 ½).
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-
55
Stock Options &
Restricted Property P.275
What is a stock option? Right to buy stock
(employer’s common stock?) at a specified price
during a defined period of time.
Compensation –as additional work inducement.
Should the issuance of an option to purchase
employer’s stock (or other property) constitute
employment income when issued to an
employee? Yes, benefit derived for rendered
services. See LoBue, p. 276.
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56
Options – Timing &
Characterization Issues
Option One:
1) Employee includes value of option in GI in
the year of grant of the option.
2) Employer deducts that amount as
compensation in year of grant.
3) Later, employee increases tax basis for shares
when exercising option at option price.
4) Employee has capital gain when subsequently
selling shares at price above tax basis.
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Options – Timing &
Characterization Issues
Option Two:
1) Employee includes nothing in GI in the year
of grant of the option. Possible forfeiture?
2) Employer deducts nothing as compensation
in year of grant but later when exercise.
3) Later employee exercises & compensation
income for FMV of stock less option price.
4) Employee has capital gain when subsequently
selling shares at price above tax basis.
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Options – Timing &
Characterization Issues
Option Three:
1) Employee includes nothing in GI in the year
of grant of the option. Possible forfeiture?
2) Employer deducts nothing as compensation
in year of grant but later when exercise.
3) Employee exercises but no compensation
income (for FMV of stock less option price).
4) Employee has capital gain when subsequently
selling shares at price above tax basis (and no
compensation income).
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Incentive Stock Option
(ISO) Rules §422
P.278
Statutory structure permitting GI inclusion
limited to capital gain upon sale of stock.
What is ISO stock? See §422 rules:
1) Stock retention requirements.
2) Option price at FMV when granted.
3) Granted under an option plan.
4) $100,000 limit on option stock amount.
5) No employer deduction for compensation.
Net benefit if employer loses immediate
deduction but deferral
ofP. Cap.
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Streng Gain for EE?
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Nonstatutory Stock
Options
p.280
Stock is available to employee but is subject to
restrictions on transferability and a risk of
forfeiture. No inclusion since a valuation issue?
Note §83(a) – inclusion in GI when stock option
is issued if a “readily ascertainable” FMV.
No current inclusion when option is
“nontransferable” and a “substantial risk of
forfeiture” – inclusion when conditions lapse.
GI inclusion when exercise for the difference
between exercise price and stock value.
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Election to Accelerate
Inclusion re NSO
p.281
§83(b) – employee can elect current inclusion
(even if forfeiture risk) to extent of FMV.
GI inclusion based on value of stock without
restrictions.
No tax deduction by employee who made a
§83(b) election if forfeiture of the option
subsequently occurs.
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Cramer
p.283
Options provided to acquire non-publicly
traded stock. Vesting and transfer restrictions
applied to induce continued employment.
§83(b) elections filed to include value at grant as
ordinary income & to enable future capital
gains. Elections reported fmv at grant as zero.
Reported option gain as LTCG & high basis.
But, upholding Reg. §1.83-7(b)(2) (& no
ascertainable FMV & therefore ordinary
income). Plus, serious penalties are applicable.
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Transfers Incident to
Marriage & Divorce p.290
1) Should transfers of property (including cash)
from one divorced spouse to another cause
realized ordinary income to the transferee?
2) Should such a transfer enable a tax deduction
to the transferor (particularly if sourced from
transferor’s current income stream)?
3) Should a transfer of appreciated property
from one spouse to another be treated as (a) a
sale of property and (b) the transfer of proceeds
to the other spouse (with a §1012 tax basis)?
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Davis
p.291
Transfers in Divorce
The property transfer to an ex-spouse of
appreciated property in the divorce context (in
exchange for a release) is a gain recognition
event to the property transferor – since a “sale
or exchange.” How value the transaction? Are
rights given up equal to property transferred?
What is the income tax treatment to the other
party who is acquiring the property? What tax
basis for that property to transferee?
What did that person transfer in the exchange?
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Code §1041
p.295
§1041 provides for (1) no recognition to the
transferor on a property transfer in divorce;
and (2) a transferred tax basis for the property
when held by the recipient.
Further, no deduction is available for the
property transfer to the other (ex)spouse.
Limits on §1041 – see Rev. Rul. 87-112 re no
tax-free transfer of accrued interest income.
Does the Davis case survive the enactment of
§1041?
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Property Transfers –
Example
H and W together own investment property:
1) W receives Property One – 90x tax basis and
100x fair market value.
2) H receives Property Two – 110x tax basis and
100x fair market value (depreciated).
Equal property division on a pre-tax basis (but
not on an after-tax basis).
What happens when they sell these properties?
Consider the impact of §1041.
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Farid es Sultaneh
p.296
He transferred appreciated shares to her in
contemplation of marriage. An antenuptial
agreement concluded for gift (after the stock
transfer) where she released (any) dower rights.
What tax basis when she sells (for $19) shares
transferred to her? 15 cents or $10 per share?
Held: She took the shares as a purchaser.
What did she sell? Gain to her?
What did he sell? Gain to him?
Dissent: He was married to another when gift.
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Alimony & Child Support
p.300
Certain payments (alimony) after divorce:
- Income to recipient (§71(a)), and,
-Deduction to payor spouse (§215), “above the
line” (§62(a)(10)).
A federal definition of alimony applies to
determine whether the payment constitutes
gross income.
No deduction to payor parent for child support
payments made to the other ex-spouse.
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Alimony Requirements
§71(b)
p.300
1) Cash payments (not property transfers).
2) Termination of this obligation occurs at the
death of the payee spouse. §71(b)(1)(D).
3) No excessive front-loading. §71(f). P.301.
4) No disguised child support. §71(c). Note
“deadbeat dad” treatment. §71(c)(3).
5) Parties are not living in the same household.
§71(b)(1)(c).
Under §71(b)(1)(B) parties can opt out of
alimony tax status (c)
(and
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Indirect Alimony
Payments
H pays (in cash):
(1) her mortgage payments on her residence
(paid directly to the lender bank); and
(2) Premiums on a life insurance policy on his
life (paid to the insurer) & she owns the policy.
Result: Taxable alimony to her if she owns (1)
the house and/or (2) the life insurance policy,
even though she does not receive the funds.
Remember the Old Colony Trust Co. case.
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Child Support Obligations
P.304
Child support is (1) not deductible by the payor
and (2) not gross income to payee (custodian?).
Diez-Arguelles v. Commr., p.304.
Failure to pay child support and here custodial
parent deducts amount as nonbusiness bad debt
Held: No tax basis for the bad debt (§166(b))
and no tax deduction to the payor.
But, was an indirect loan made to the obligor
parent when the custodian pays child expenses
and a bad debt occurs when no reimbursement?
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Consumption Tax
p.308
Should a “consumption tax” be implemented as
an alternative to the current income tax?
What is a consumption tax? I.e., taxation only
on consumption but a deduction is permitted for
income from savings. The income tax is
between a wealth tax and a consumption tax.
How determine the consumption tax base?
Income plus borrowings less savings (zero basis)
equals the consumed amount tax base times the
applicable tax rate.
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Value Added Tax
p.310
A transactions tax similar to a retail sales tax,
but imposed on the national level (in all OECD
countries except U.S.).
Cf., wealth tax
VAT applies at each stage of production, with
an immediate credit for the VAT taxes
previously paid in the chain of supply as
attributable to the manufacturing of that
specific item.
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Accrual Method
Taxpayers
p.312
Fundamentals of the accrual method of
accounting:
1) Income inclusion for amounts earned (even
though not received); and,
2) Deduction for obligations incurred, even
though not paid.
However, federal income tax exceptions:
(1) not permitting deferral of prepaid income or
(2) no accrual of estimated future expenses.
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Delay in the Receipt of
Cash
p.313
Georgia School Book Depository case – p. 313.
Accrual basis taxpayer: Should school book
royalties be accrued when books are sold?
Is expectation reasonable that claims would be
paid? Here, current fund insufficient to pay bill.
But, all duties were performed for the accrual of
income. And, payment would eventually occur
from the collection of the beer excise tax.
No serious doubt as to ultimate collection and
the sales commission
should have been accrued.
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Hallmark Cards case
p. 316 (note)
Hallmark cards – shipped Valentine cards to
retailers in December, but retailers did not want
ownership on 12-31 for personal property tax
purposes.
Then, Hallmark retained title until January 1.
Hallmark’s income was permitted to be accrued
in the subsequent year when tile passed to the
retailer and all events occurred when title
passed.
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Prepaid Income
p.316
American Automobile Association – p. 317
One year membership fee paid in advance.
When earned by AAA? Ratable allocation to
each month (& partial deferral to next year).
IRS says immediate accrual to gross income.
Ratable reporting was not permitted.
What if proof of delivery of services is provided?
What if the method is consistent with GAAP?
What effect of repeal of §452 and §462? & §455?
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Streng
Cf., dissent: What(c)about
78
Subsequent Prepaid
Income Cases
p.321
Schlude (Sup. Ct., p.321): prepaid dance
lessons; inclusion at time of receipt of payment.
Artnell (7th Cir.) – deferral until games played.
Boise Cascade (Ct. Cl.) – consistently reporting
income when services rendered (not requiring
any earlier reporting if advance receipt).
Rev. Proc. 2004-34 (services) – reporting in the
current or subsequent year, if consistent with
financial accounting; Regs. §1.451-5 (sales of
goods) & similar treatment as services.
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Deposits v. Advance
Payments
p.323
Indianapolis Power & Light, p. 323
Advance deposits to enable establishing electric
service received. Interest paid on the deposit
amount. Eventually credited against customer’s
account. No separate escrow or segregation of
funds.
Held: Equivalent to loans by customers, rather
than advance payments. Loan repayment was
possible and not a prepaid amount received.
Same treatment for lease deposit amounts?
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Westpac Pacific Food
p.324
Is an “advance trade discount” paid (for volume
purchase commitment) to retailer gross income?
Taxpayer treated up-front cash as a liability.
Then applied the discount pro-rata to full
purchase price as paid.
This method was consistent with GAAP.
Tax Court says advance payment was income.
Reversed, as advance trade discounts not
constituting GI. Not an “accession to wealth.”
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Current Deduction of
Future Expenses
P.329
Can an income tax deduction be available
before the liability is actually paid?
Deductions are subject to the “all events” test
for accrual basis taxpayer.
Question: Is the fact of liability firmly
established and the amount determined with
reasonable accuracy.
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General Dynamics Corp.
Sup.Ct.
P.329
Deduction was claimed for medical expenses
reimbursable to employees
1) when the expense was incurred, but
2) no current claim to the employer had been
made as of the end of the tax year.
Amount claimed based on estimates of past
experience. Sup. Ct.: “All events” test was not
satisfied; some employees might not file a claim
for reimbursement.
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The “Economic
Performance” Test P.330
§461(h)(1) enacts the “all events” test.
This provision also specifies that the “all events”
test is not treated as met any earlier than when
economic performance for that item occurs.
A fixed obligation to pay an amount next year
can not be deducted currently.
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