Presentation:
Federal Income Taxation
Chapter 3 Compensation for Losses
Professors Wells
August 26, 2015
Clark v. Commissioner
p.90
Facts: Clark paid $19,941.10 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?
2 Recoveries for Personal
and Business Injuries
p.92
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?).
3 Windfall Gains
Glenshaw Glass
p.96
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.
4 Home Run Ball and Treasure Trove
p.101
Supp. pp. 28-30
Treas. Reg. §1.61-14: “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. cash found in a piano. Included in gross income upon discovery
because this was income from whatever source derived, citing Treas. Reg.
§1.61-14(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?
5 Damages for Personal Injury
“Prior Law”
p.104-106
Solicitor’s Opinion 132:
• “[G]ross income does not include everything that comes in”
• The statutory exclusion for personal injury damages, first enacted in 1918,
may have merely codified the result reached under prior law, which had been
based on the conclusion that damages for personal injury are not “income”
under the early tax acts.
• Emotional distress type damages, such as for alienation of affection, were
apparently not thought to constitute damages for personal injury under the
original understanding of the statutory exclusion (page 104);
• Damages for slander or libel affecting business or professional reputation or
property rights was apparently understood early on to constitute income (see
limiting interpretation of Sol. Mem. 957, page 104); and
• Most importantly, receipt of damages for invasion of nontransferrable personal
rights (“not assignable and not susceptible of any appraisal in relation to
market values”)— although a money that comes in—involves no derivation of
gain or profit, and so is not within the general definition of income.
Rev. Rul. 74-77: amounts received for alienation of familial rights is not gross
income to the recipient.
6 Damages for Personal Injury
Attn: Tort Lawyers
p.108
Code §104(a)(2) – exclusion for damages received for personal
physical injuries. The “physical injury requirement” cuts back the
holdings of cases that involved discrimination claims, loss of familial
rights (Rev. Rul. 74-77), and scope of Solicitor Opinion 132.
The omitted Murphy case upheld the constitutionality of taxing
nonphysical injury personal awards.
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. See p. 128
7 Structured Settlements
p.108
Supp. p. 31
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?
8 Medical Expense Recoveries
p.129
Tax Treatment of Insurance for Medical Care
Funding Method
Premiums
Proceeds
Employer Provided
Coverage
Excluded, §106
Individually
Purchased Insurance
Limited Deduction, §213(d)(1)(D) Excluded, §104(a)(3)
Self-Insurance
N/A
Excluded, §105(b)
Limited Deduction, §213(a)
1.  §105(b): Health insurance payments made by an employer provided health
plan do not represent income to the employee.
2.  §104(a)(3) excludes insurance proceeds received under employee
purchased health plan.
3.  Premiums paid by employees for their health insurance are nondeductible
except in limited long-term care situations (see §213(d)(1)(D) and (d)(6)), but
the premiums paid by the employer are deductible for the employer (§162(a))
and not income to employee (see §106).
9 4.  Tax Expenditure Impact in 2015: 207.2 billion (p.536).
Disability Insurance
p.146
Gross income if disability payments are made by employer provided
health insurance as §105(b) only excludes amounts received to pay
“medical care” and not to supplement wages. But, employer is
entitled to deduction for these amounts (see §162(a)).
Gross income excludes disability insurance payments for payments
on individually purchased insurance under §104(a)(3) as §104(a)does
not require amounts be paid for “medical care.” But, the employee
is generally not entitled to a deduction for premium payments for
disability policies (see §213(d)(1)(D)). 10 Life Insurance - Code §101 GI Exclusion
p.147
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”?
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., “windfall” because of 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
11 Life Insurance, cont.
p.148
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
12 Life Insurance, cont.
Defining Life Insurance
p.148
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.
13 Employer Paid Life Insurance
p.150
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)
14 Problems
Life Insurance
1.
2.
3.
4.
p.150
A purchased a $100,000 life endowment insurance policy. At age 65, after A had paid
total premiums of $80,000, the policy matured and the insurance company began to
make payments to A under the policy. A will be paid $10,000 a year for as long as she
lives; if she dies before age 75, any excess of $100,000 over what has previously been
paid to her will be paid to her estate or designated beneficiary. How are periodic
payments under this policy taxed? How much, if any, of the lump-sum payment will be
taxed if A dies before age 75?
B owned a life insurance policy on his own life. In order to remove it from his estate for
federal estate tax purposes, B transferred the policy to his daughter in exchange for
securities worth $45,000. Shortly thereafter, B died and the policy was paid off at the
face amount of $100,000. Is any part of the proceeds taxable as income?
C purchased a $100,000 paid-up life insurance policy for $60,000. With the remaining
$40,000 she purchased a life annuity, which will pay $5,000 a year. C then transferred
the life insurance policy as a gift to her daughter. How will payments under the annuity
contract and the life insurance policy be taxed?
National Bank lent D $100,000 and required D to purchase credit life insurance in that
amount, payable to the bank. D defaulted, and Bank deducted $100,000 as a bad debt
loss. Subsequently D died, and Bank collected $100,000 from the insurer. Is that
recovery taxable to Bank? McCamant v. Commissioner, 32 T.C. 824
15 (1959).
Sanctity of Annual Accounting Period
p.151
Burnet v. Sanford & Brooks
For the period 1913-1916 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 1920.
16 Tax Benefit Rule Limitations:
Dobson v. Commissioner
p.156
Facts: Taxpayer purchased 300 shares of stock and found the stock was
not registered correctly and recovered $45,150.63
•  $23,296.45 allocable to 100 shares taxpayer had sold in 1930
(prior tax deductible loss of $41,600.80)
•  $6,454.18 allocable to 100 shares sold in 1931 (prior tax
deductible loss of $28,163.78)
•  $15,400 related to 100 retained shares.
IRS treated $15,400 received for the 100 retained shares as a return
of capital but treated the amounts received for sold shares as income.
Issue: Must the proceeds of settlement attributable to shares sold in
1930 and 1931 be included in gross income?
Held: The recoveries allocable to the shares sold were taxable only to
the extent that the earlier year losses produced a tax
17 benefit—i.e., a reduction in taxes in the earlier years.
The Inconsistent Events Rule
(Supp. pp. 32-37)
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
18 Alice Phelan Sullivan
(Supp. pp. 38-39)
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
19 Modifications – The Tax Benefit Rule
p.165
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.
20