Presentation:
Federal Income Taxation
Chapter 7 Receipt Subject to Offsetting
Liability
Professors Wells
September 21, 2015
Transactions with Borrowed Funds
p.437
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.
2 Debt Cancellation
p. 437
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
3 Debt Cancellation: Relief Provisions
p.439
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? Note 1 (p.441):
a)  A promises to make a gift to her son. Her son releases her from the promise.
b)  B promises to make a $1,000 contribution to a church. Subsequently the
church agrees to accept $500 in full satisfaction of the pledge.
c)  C Corporation issues bonds in payment of a dividend. It subsequently buys
back the bonds for 90 cents on the dollar.
d)  D receives a bill from his lawyer for $1,000. In the following year, D complains
about the bill and the lawyer agrees to accept $600 instead of $1,000.
e)  H had borrowed $100,000 from a bank. In order to improve H’s credit
standing, the bank surrendered H’s note in exchange for a $100,000 note
executed by H’s wife, W. Later the bank sold W’s note to H’s brother, X, for
$50,000. X obtained the funds for the purchase from H and W
4 and tore up the note immediately after buying it.
Code §108
Insolvency / Bankruptcy Exceptions
p.439
§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 §1017.
Question: Do you see for symmetry reasons we must have
attribute and/or basis reduction if an exception is given for COD
Income?
5 Code §108
Purchase Price Reduction
p.442
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).
6 Student Loan Forgiveness
p.442
§108(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. 2008-34 regarding law school loan forgiveness
programs.
7 Zarin case
Gambling Debt Compromised
p.442
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.
8 Claim of Right Doctrine
p.453
North American Oil Consolidated v. Burnet
FACTS: In 1916, $171,979.22 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?
9 Claim of Right Doctrine
United States v. Lewis
p.455
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. 455)
10 Claim of Right Doctrine
Alcoa v. United States
p.458
FACTS: Alcoa produced waste from 1940-1987. Federal law required
environmental clean-up, and Alcoa expended considerable amounts to
clean up these sites.
Taxpayer Position: claimed that Alcoa was entitled to rely on §1341 to
claim the greater of a tax deduction or the higher amount allowed under
§1341.
IRS: claimed that Alcoa could not satisfy the first or second requirement
for eligibility under the provision, i.e., (1) inclusion of an item in gross
income under claim of right, and (2) later determination that the taxpayer
did not have an unrestricted right to that item (restoration of that item).
Court Holding: §1341 was not applicable because Alcoa was not
required to restore funds held under claim of right.
11 Embezzled Funds
James v. United States
p.468
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 (S. Ct. case) (p.468):
unlawful gains are gross
income.
Note: Only if §501(c)(3)
Organization
12 Embezzled Funds
McKinney v. United States
p.476
Plaintiff embezzled $91,702.06 in 1966, culminating a plan
originated in 1956, and he reported that amount as miscellaneous income
on his 1966 tax return and paid the tax due on it. Plaintiff was convicted
in state court for the crime, and he repaid the embezzled money to his
employer in 1969.
Issue: Tax treatment in year of repayment.
Court said repayment is not part of trade or business. Also, §1341 did
not apply because must have a colorable claim of right.
Why did government allow a loss deduction under §165(c)(2)?
13 Debt and Property Purchases
p.479
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).
14 Effect of Debt on Basis and Amount Realized
p. 479
Identifying types of debt:
1) Recourse – personal liability
2) Nonrecourse – debt secured only by the pledged asset.
Crane case – p. 483 – 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.
15 Crane v. Commissioner
p. 479
Facts: 1932:
Property worth $262,042.50 inherited subject to
non-recourse debt of $262,042.50
1932-1938: Property depreciated by $28,000 (25,500).
1938:
Property sold subject to mortgage ($255,000) +
$2,500 cash
Taxpayer Position: Amount Realized of $2,500 less Zero Basis.
IRS Position: A/R of $257,500 – Basis $233,997.40 = Gain $23,502.60
($178,997.40 + $55,000)
Court Holding: Taxpayer gain is $23,502.60. Relief of mortgage is
as real a benefit as the receipt of cash.
How do you read Footnote 37?
16 Parker v. Delaney
p. 486
How would Justice Magruder have Decided Crane?
Facts: 1932:
Property worth $262,000 inherited subject to
non-recourse debt of $262,000
1932-1938: Property depreciated by $28,000.
1938:
Property sold subject to mortgage ($255,000) +
$2,500 cash
Original&Cost&(§1012)
Addition&to&Basis
Depreciation&Allowed
Adjusted&Basis
Amount&Realized
Gain&Recognized&
Crane&Rule
$273,000
$0
C$45,000
$228,000
$259,000
$31,000
Magruder
$0
$14,000
C$45,000
C$31,000
$0
$31,000
17 Tufts case
Debt Exceeds Property FMV
p.491
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?
18 Tufts choices for decision
One or Two Transactions?
Integrated transaction
Two transactions
1.850 debt
1.450 basis
400 gain
1)
(capital gain?) OR
2)
1.850 debt relief
1.400 value
450 COD income.
1.450 basis
1.400 value
50 capital loss. 19 Treasury Regulations &
Nonrecourse Debt
p.496
Reg. §1.1001-2(a)(1) - the amount realized includes the
amount of liabilities from which the transferor is discharged.
Reg. §1.1001-2(a)(4)(i) - the sale of property that secures a
nonrecourse liability discharges the transferor from the
liability.
Reg. §1.1001-2(b) - the fair market value of the security is not
relevant for determining the amount of liabilities being
discharged.
20 Rev. Rul. 91-31
Debt Reduction - No Transfer
p.501
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?
21 Revenue Ruling 90-16
Bifurcation
(Supp. pp. 56-57)
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.
22 Disposition Hypotheticals
Example 1: FMV=$100; R. Debt=$90; Cash=$10; Basis=$50
See Reg. §1.1001-2(a)(1)
Example 2: FMV=$100; Non-R. Debt=$90; Cash=$10; Basis=$50
See Reg. §1.1001-2(a)(1)
Example 3: FMV=$100; Non-R. Debt=$120; Basis=$50
See Tufts.
Example 4: FMV=$100; R. Debt=$120; Basis=$50
See Rev. Rul. 90-16.
23 Woodsam Associates
p. 504
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.
24 Estate of Franklin
p.921
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.
25 Pleasant Summit Land
p. 926
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?
26 Summary
Non-Recourse
Recourse
1.  Acquisition
NR Debt < FMV of Property: NR Debt gives basis
(Crane)
1.  Acquisition
R. 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.
p.507
2.  Post-Acquisition Pledge: No Basis
increased in pledged property
(Woodsam)
3.  Disposal
Bifurcated Approach
RR 90-16, Reg.§1.1001-2(c) Example (8)
2.  Post-Acquisition Pledge: No Basis increase
Amt. Realized =
FMV of Property
in pledged property (Woodsam)
COD Income =
Debt discharge
above FMV
3.  Disposal
Integrated Approach (Tufts result)
4.  Forgiveness of portion of R. Debt: CODI
Amt. Realized = NR Debt + Other (Tufts)
or does a §108 exception apply?
4. Forgiveness of portion of NR Debt: CODI or
does a §108 exception apply? Rev. Rul. 91-31.
Gifts of Encumbered Property p.507
Estate of Levine v. Commissioner
Gift (FMV= $925,000; B= $485,429.55)
Encumbrances: $910,481.34
IRS Position: Gain= $910,481.92 - $485,429.55 = $425,051.79
Taxpayer Position: Crane inapplicable because gift, not sale.
28 Gifts of Encumbered Property
Diedrich v. Commissioner
p.514
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 3rd party.
Does the donor have (capital gain) income to the extent the
gift tax amount paid exceeds tax basis for the transferred
property?
29 Question re
“Net Gift” Transaction
p.517
Gift to Non-Charity Basis=$15x; fmv=$100x. Reg. §1.1001-1(e).
•  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. §1.1015-4.
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).
30 Review Questions
1.
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.
2.  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.
3.  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.
4.  Same as #3 except that C must pay P’s $10,000 debt to the United States
Treasury for income taxes.
5.  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?
31