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CAPITAL GAINS AND LOSSES
DEFINITIONAL SECTIONS
1. § 1221 defines capital asset as:
a. Property held by taxpayer
b. Whether or not used in his trade or business
c. EXCEPT:
1.
Stock in trade, other property which would be included in inventory of the
taxpayer, or property held primarily for sale in the ordinary course of his trade
or business
a. Some things fit in all three (ex: whiskey); some things don’t qualify as
inventory b/c special to make, but selling in OC (ex: special made
cabinets)
2.
Property, used in T or B, subject to allowance for depreciation, or real property
used in T or B
i. Picked back up in §1231
3.
Copyright, literary, musicial or artistic composition, a letter or memo, held by
a. A taxpayer who created such property
b. Or, in case of letter or memo, a TP for whom such property was
prepared or produced, or
c. A TP in whose hands the basis of such property is determined in whole
or in part by reference to the basis of the property in the hands of a
taxpaper described in above 2 sections
4.
Accounts or notes receivable acquired in OCB for services rendered or from sale
of property described in (1)
5.
Publication of the US Government given to politicians/gov’t employees
6.
Any commodities derivative financial instrument held by a dealer
a. Cases: Arkansas Best, Corn Products
7.
Any hedging transaction which is clearly identified as such before the end of the
day on which it was acquired or originated
8.
Supplies of a type regularly used or consumed by the TP in ordinary course of T
or B
a. Jet Fuel example: You stockpile jet fuel; prices fall, and it becomes
worth less. You sell it. Absent this provision, it would generate a capital
loss, b/c not in the T or B of selling jet fuel. TP capital loss deduction is
limited. TP would rather it be ordinary.
b. Example 2: What if she bought options to purchase jet fuel, and they
became worthless? If she had exercised the options, the deduction
would be ordinary, so the option to exercise those options would also
be ordinary. (this applies to the hedging transaction provision, above)
2. Bynum factors for determining what constitutes inventory or Property Held Primarily for Sale
to Customers in the Ordinary Course of the T/B vs. capital asset: Balance factors:
a. Frequency and substantiality of sales
b. Proportionality of income from selling this vs. whatever you claim as real T/B
c. Improvements made to the land
d. TP’s solicitation and advertising efforts
e. Utilization of real estate brokers and agents
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3. Distinctions between long term and short term, gains and losses, and other terms
a. See § 1222
4. Holding period of property
a. See §1223
5. Maximum Capital Gain rates
a. § 1(h)(1)(C) Generic 15% rate
i. Catchall- a NCG that weren’t taxed at the 28% or 25% rates
b. § 1(h)(1)(D): 25% category - Unrecaptured § 1250 gain
i. § 1250 gain- generally defined as the LTCG attributable to depreciation allowed
with respect to real estate held for more than one year
c. S 1(h)(1)(E): 28% category - collectibles and § 1202 gain
i. § 1202 gains: gains on investment in start-up or small corps
1. § 1202 excludes a specific percentage of the gains from these type of
investments
2. Currently, this percentage is 100% exclusion
ii. Collectibles gain - defined in 1(h)(5)
6. PROBLEM: Definition of Capital Asset - Problem 1
7. Computing Net Capital Gain
a. Must first determine amount of each gain and loss realized, and characterize as LT or ST
b. Preferential rates of 1(h) only apply when TP has Net CG (§1211(11))
i. Net CG: Excess of Net LTCG over Net STCL
ii. Net LTCG = LTCG – LTCL
iii. Net STCL = STCG – STCL
c. Computing the tax under 1(h)(1)(A):
i. Tax shall not exceed:
1. The greater of:
a. Taxable income reduced by NCG, OR
b. Lesser of
i. TI taxed at less than 25%, or
ii. TI reduced by ANCG
1. § 1(h)(3): ANCG= NCG - 28% gain - 1250 recap
gains + qualified dividend income
d. Adjusted Net Capital Gain
i. Defined in 1(h)(3)
ii. Subject to a maximum tax rate of 15%
1. But is afforded preferential treatment even if TP is in 15% bracket
a. In that case, ANCG taxed at 0% - see § 1(h)(1)(B) for calc.
i. Where ANCG does not exceed [taxable income @ less
than 25% - (TI reduced by ANCG)], taxed at 0%
ii. IF ANCG exceeds this calculation, none gets this rate
2. Includes qualified dividend income (defined in § 1(h)(11)
e. Attribution of Capital Losses Included in NCG Computation
i. FIRST NOTE: If capital losses exceed gains, you don’t have any net gains, so
forget about 1(h). You look to 1211 & 1212.
1. Problem 7
ii. Because STCL are offset first against STCG, it is only the excess STCL which must
be attributed to one of the categories of LTCG
iii. LTCL & NSTCL attribution rules among multiple categories of LTCG:
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1. Short term capital losses
a. STCL first reduce STCG
b. Any NSTCL then reduces any net gain in 28% category
c. Then reduces an unrecaptured 1250 gain
d. Then reduces any adjusted net capital gain
2. Long term capital losses
a. LTCL are first applied against LTCG in same category
b. Any net loss in the 28% category is applied to reduce any
unrecap. 1250 gain, and then reduces any adjusted net capital
gain
c. Any net loss in the 15% category first reduces gain in 28%
category and then the unrecaptured 1250 gain
f. PROBLEMS 2-6: Rate preference for LTCG and Limits on CL deductions- Steps shown
8. Application of § 1211(b) limitations on Deduction of Capital Losses
a. Capital losses may be deducted to the extent of:
i. Capital gains PLUS
ii. $3,000
b. The loss must be deductible under some other provision of the code, first, though.
i. Ex: loss on sale of stock deductible under § 165(c)(2)
c. Qualified dividends are not part of the 1211(b) calculation
d. NETTING PROCESS:
i. STCL net against STCG & LTCL net against LTCG
ii. If STCL > STCG, the excess STCL netted against excess NLTCG
iii. If LTCL > LTCG, the excess LTCL netted against excess STCG
iv. STCL are deemed to have been deducted first in the $3,000 portion of 1211(b)
e. Problem 7 illustrates net capital loss problem
9. Hedging & Options: Capital or not?
a. An option is a K to buy or sell something at a stated price for a certain period of time
i. STRIKE PRICE - the price the product will eventually be bought for under the
option
ii. SPOT PRICE - the market price
b. Divided into 2 categories:
i. Call option: right to call property to you; right to force someone to sell you the
goods from that option at that stated price
ii. Put option: right to force someone to purchase whatever goods are in the
option at the stated price
c. HEDGING is using the option to hedge against fluctuations in price
d. § 1221(a)(7) provides ordinary treatment (and not capital) for any hedging transaction
which is clearly identified before the close of day on which acquired, originated or
entered into (Regs. give more than one day)
i. § 1221(b)(2) defines hedging: any transaction entered into in the normal course
of the TP’s T/B primarily:
1. To manage risk of price changes w/r/t ordinary property held by TP
2. To manage risk of interest rate or price changes w/r/t borrowings made
or to be made by TP
3. To manage other risks as defined by Treas. Regs.
e. If actual item would be an ordinary asset to the TP, then hedging the risk of that asset is
going to be ordinary.
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f.
Treas. reg. say you CANNOT use stock as a hedging instrument, based on Arkansas Best
i. Arkansas Best: Buying stock in companies is buying a capital asset, so its a
capital loss
10. Ordinary Income Substitutes
a. Under Hort & Davis, even if §1221 literal language it would be capital, if the asset is a
mere substitute for ordinary income, it will still be ord. inc.
i. Lease buyout, where disputed amount was essentially a substitute for rental
payments which are GI; must be regarded as OI.
ii. Sale of right to lottery payments OI not CG
b. Kenan: Using appreciated property to satisfy any other amount owed will be treated as
a sale or disposition under § 1001= realization event
i. So where securities were used to satisfy the debt owed to the heir, it was a
realization event
1. It was a general bequest. The heir bore no risk, b/c she got her $5 mil. in
either cash or securities. If it was to be cash, the securities would have
to have been sold by the estate, realizing a gain.
ii. And to determine whether it was capital or not, looking at §1222 which says
“sale or exchange,” the Court said that b/c treated as a disposition of the asset
used to satisfy a debt owed, here it will also be treated as S or E b/c satisfied
debt owed to heir (just as if you’d sold stock & then used cash to satisfy
bequest) => sale or exchange
iii. NOTE: there will be times when you haave a sale or disposition under § 1001
but don’t have a sale/exchange under § 1222
1. Ex: involuntary disposition b/c of a fire does equal a disposition but
doesn’t equal a sale/exchange
2. For an involuntary conversion to be treated as capital, must have
statutory granting provision.
3. § 165(h): Casualty losses - doesn’t say S or E  losses will be ordinary
a. But see (h)(2)(B): Where casualty gains exceed losses, it is
treated as all capital G/L
QUASI-CAPITAL ASSETS: SECTION 1231
1. § 1231 is not a deduction-granting provision
a. Deductions are granted under §§165, 167 and 179
b. Deductions disallowed under §267
i. Ex: no loss allowed on sale of home, so doesn’t enter into § 1231 analysis
2. § 1231 gains and losses are generated by two categories of transactions:
a. Sale or exchange of property used in the trade or business
i. Must be depreciable or real property
ii. Must have been held for more than one year
iii. Must not be excluded under § 1221(1), (3), (5)
b. Involuntary or compulsory conversion of 2 types of property:
i. Property used in the trade or business
ii. Capital assets held for more than 1 year in connection with a trade or business
or a transaction entered into for profit
3. § 1231 looks at assets as a pool:
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5.
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a. If G > L  everything treated as capital
b. If L>G  everything treated as ordinary
c. For certain involuntary conversions (fire, shipwreck, theft, casualty):
i. If L>G  all ordinary, before you even get to the primary netting
Hotchpot analysis
a. Preliminary Hotchpot Analysis
i. Determine whether the gains and losses are described in § 1231(a)(3)
ii. Determine whether they arise from transactions listed in §1231(a)(4)(C)
1. This includes involuntary conversions from fire, storm, shipwreck, or
other casualty, or from theft, of any property used in the T/B or any
capital asset held for more than 1 year & held in connection with T/B or
transaction entered into for profit
2. It does NOT include condemnations.
iii. Net those arising from transactions listed in § 1231(a)(4)(C)
iv. If losses exceed gains, these amounts do NOT enter into primary hotchpot.
1. They will not be characterized by §1231.
2. They will be individually deducted/reported
v. If gains exceed losses, these gains and losses enter into the Principal hotchpot.
vi. If gains equal losses, they enter into the principal hotchpot.
b. Primary/Principal Hotchpot Analysis
i. Determine what gains and losses enter into principal hotchpot
1. § 1231(a)(3) defines § 1231 gains and losses
ii. Compare the § 1231 gains to § 1231 losses.
iii. If §1231 gains exceed losses, the gains and losses ARE to be treated as LTCG/L
iv. If § 1231 losses exceed gains, the gains and losses ARE NOT treated as capital
but are ORDINARY.
Applying § 1222
a. After doing preliminary & principal hotchpot analyses, then you go to §1222 netting
process to determine NCG, which is then taken to 1(h) to determine applicable rates
Recapture of Net Ordinary Losses: §1231(c)
a. Taxpayers could potentially arrange timing of sales of these §1231 assets so as to
generate these G/L in different years, maximizing the benefits of s 1231.
b. § 1231(c) says that, if you generate any 1231 gains in the next 5 years, to the extent
you’ve taken a 1231 loss, it will be 1231 recapture (it will be taxed at ordinary income
rates)
c. This carryover hangs around for five years, unless completely used up before then
d. Where you have a portion of net § 1231 gain in a year being recharacterized as OI under
§ 1231(c), the gain recharacterized consists:
i. First, of any net §1231 gain that is 28% rate gain,
ii. Then any any net §1231 gain that is unrecaptured §1250 gain
iii. Finally, any net §1231 gain that is adjusted net capital gain
e. Problem 3
Recharacterization of § 1239
a. Assume A has a piece of equipment which has been used in his T/B, took depreciation
ded. as offset against OI, and the equipment has appreciated in value. Assume paid 100k
(§ 1012 cost), depreciation deductions have been 80k, & AB now = 20. Assume FMV =
200. Total Gain = 180
b. If we just sold the property to an unrelated third party:
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i. Will have 1245 recapture: If you sell certain assets on which previously took
depreciation, to extent G is generated by depreciation, it will be taxed as OI.
ii. So, here, 80k of gain will be OI under § 1245. Remaining 100 will be § 1231 gain
& will be capital, assuming no §1231 losses.
c. If A sells it to his wholly owned corporation:
i. In absence of any special rule, would still have 80k OI/ 100 Capital & corporation
would take a basis of 200. Corp. can then depreciate the asset, offsetting OI.
Thus, recycling assets.
ii. BUT, § 1239 says any gain recognized to transferor is to be treated as ordinary
income if the property is in the hands of a transferee subject to § 167
depreciation.
1. So, entire 180 k will be taxed at OI if you sell it to the related entity.
Corp. still gets deductions, but they are deferred & taken over time, so
you have to wait for them. This is not so fun anymore to the TP! Thus,
the anti-abuse purpose is achieved.
Depreciation Recapture
1. § 1245
a. Deals with PERSONAL PROPERTY (tangible & intangible)
b. §1245 says that recapture income is characterized as ordinary income.
i. Gain on disposition of personal property which is attributable to depreciation
deductions, rather than appreciation in FMV, is NOT eligible for capital gain
treatment
1. Disposition includes sale, exchange, involuntary conversion, or other
c. If you sell an asset at a loss, you don’t have to worry about §1245 recapture.
d. Recomputed Basis: depreciation you’ve taken that gets you back up to your original
basis:
i. Any of this depreciation back up to your original basis will be ordinary income
e. Assets which were subject to accelerated depreciation also goes to § 1245
2. § 1250
a. Deals with REAL PROPERTY
b. §1250 says that when sold, treated as 25% gain instead of at OI rates
c. § 1250 Essentially DEAD LETTER LAW
i. When § 1250 property is disposed of at a gain, § 1250 says you only include in
OI the amount of depreciation taken on a §1250 asset that was more than
straight line
ii. So, only applies if you have property that was placed in service prior to 1986.
1. Because SL has applied since 1986
iii. BUT, if §1250 property Is not held more than a year, all depreciation taken is
additional depreciation.
3. If a portion of the gain does not fall under § 1245 or § 1250, then it is characterized under §
1231 & § 1221(2)
4. Unrecaptured § 1250 gain
a. § 1(h)(6) defines unrecaptured § 1250 gain as the LTCG from § 1250 attributable to
depreciation deductions allowed the TP and not otherwise recaptured as ord. inc.
5. § 179 Election
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6.
7.
8.
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a. The current § 179 election to expense certain depreciable business assets is $125,000
(phase-out beginning at $500,000)
b. Certain type of real property may no longer be expensed under § 179
c. § 179 has recapture provisions, and kicks in anytime when there is a sale or the property
is no longer used predominately for T/B purposes.
d. § 179(d)(1) says that the benefit of § 179 will be recaptured
i. The benefit is the excess of the § 179 election taken over the additional
depreciation the TP would have been entitled to if they had not made the 179
election
§ 1245 Taint
a. § 1245 taint is preserved for recapture when the property takes a carryover basis
i. Under § 1245, it doesn’t matter who took the depreciation deductions, it’s still
1245 property & it carries over to any donee recipient to be considered when they ultimately dispose of it.
b. The taint DOES NOT carry over with transfers at death, b/c the recipient takes a FMV AB
§ 1245(b): exceptions to when it will apply
Sales to related parties
a. § 1239: if sell it to a related party, and will also be depreciable property in the hands of
that related party, then it will all be ordinary income upon disposition
b. Related parties are defined by the following sections: 1239(b)  1239(c)(2)267(c)(2)
& (4)
i. And NOTE: per § 267(c)(5), can’t have two 267(c)(2) attributions in a row
Problems 11-15
NONRECOURSE DEBT
1. Recourse v. Nonrecourse Debt
a. Difference is in the remedies available to the lender
b. Recourse:
i. Can either be secured or unsecured
ii. If unsecured, lender has available to it the right to collect the full debt from all
of the assets of the borrower, except those that are otherwise protected (ex:
bankruptcy laws, state statutes)
1. Ex: credit card debt
iii. If secured, a particular piece of property stands as security for the loan, and thus
the lender can grab that piece of property first & with lesser procedural rules; if
the property is insufficient to pay the entire debt, the lender can then go after
the other assets of the borrower, b/c the borrower still liable on the note
1. Ex: home mortgage
iv. Considering it in terms of the risk of loss:
1. Ex: You purchase a piece of property, borrowing 500 on recourse. If the
property loses value, the owner of the property suffers the loss, b/c the
owner must pay the $500 no matter what.
c. Nonrecourse debt:
i. Always secured
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ii. The property standing as security for the debt will always satisfy the entire debt;
i.e., even if value of property falls, lenders only recourse is the value of that
property
iii. Nonrecourse debt shifts the risk of loss (or at least part of it) to the lender
iv. Example: Borrow $ 500 to buy property worth $500 on a nonrecourse basis.
When the property drops to a FMV of $400, the debtor can default on the note
and avoid paying the full $500.
v. Example 2: Borrow $400 & put in $100 of your own cash for property with FMV
of $500. The borrower bears the risk of loss for the first $100. The risk of loss
shifts to the lender when the value drops below $400. At that point, the debtor
has every incentive to let the property go back to the lender when the FMV
drops below the debt amount.
2. Debt & Basis & AR
a. If you borrow $500 on recourse debt, you are going to have to make the investment
eventually, so there is no question as to whether you include recourse debt in basis
b. Nonrecourse debt is more of a conditional obligation to pay.
i. Do we still include nonrecourse in basis and amount realized?
ii. Crane v. Comm’r: As long as the value at least equals or exceeds the debt:
1. Liabilities, whether recourse or nonrecourse, assumed, taken subject to,
or otherwise incurred in the acquisition of property are included in TPs
basis.
2. Liabilities of a seller, whether recourse or nonrecourse, assumed or
taken subject to by a purchaser, are included in the seller’s AR
a. Debt is treated as cash received
3. Why?
a. Economic benefit: that’s how the borrower will treat it. If the
value is > debt, the borrower doesn’t care the type of debt; they
are going to pay it to keep the property
4. Crane Holding (Woodliff): Seller must include in AR any nonrecourse
liability taken subject to by a buyer, a mortgagor, not personally liable
on a debt who sell the property subject to the mortgage and for
additional consideration realizes a benefit in the amount of the
mortgage
iii. What about when the FMV is less than the debt (debt owed > value)?
1. Tufts: In Nonrecourse debt, IF FMV < Debt => AR includes debt assumed
+ FMV of other property; Debt is treated as Cash
2. Azaiwa: In Recourse debt, IF FMV < Debt => AR includes FMV of
property received
3. NOTICE: §108 does NOT apply here, only applies to relief of
indebtedness not disposition of property
4. Estate of Franklin: if FMV < debt from beginning, there is no investment
in the property by the purchaser & there isn’t going to be, and since you
only get basis in the property for the investment, AB doesn’t include
debt
a. But, this tends to be situation when amount of debt is a good
amount greater than FMV property.
b. Sometimes debt can be included in basis when the FMV < debt
but by a de minimis amount
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c. § 1.1001-2(a)(1) & (3): If you did not include debt in basis, then
you do not include debt in amount realized
i. Prevents taxpayer from recognizing big gains, even
though no appreciation, simply b/c wasn’t allowed to
include debt in AB but would have been required to
include in AR
5. Problem 16
iv. Putting it together:
1. If value < debt & debt is recourse: AR ,≠ debt; AR=amt. of debt satisfied
+ any cash
2. If value < debt & debt is nonrecourse: AR = amount of debt
v. A reduction in the principal amount of NR debt gives rise to cancellation of debt
income, rather than a reduction in basis
1. There was no sale or disposition, thus § 1001 not triggered
2. § 108 applies, unless some of the exclusions apply
3. Problem 17, 18
vi. The AR on the disposition of property subject to NR debt may include both the
principal balance and accrued interest (Allen)
1. Thus, if a bank pays the back property taxes and adds it to the
mortgage, it’s as if the bank loaned her the money & TP paid them
herself. She gets deduction for them. They are added to basis &
includable in AR.
a. The tax benefit does not apply (doesn’t have to be OI).
2. Problem 19
c. Nonrecourse Borrowing & the § 108 Insolvency Exclusion
i. The amount by which a NONRECOURSE debt exceeds FMV of the property
securing the debt is taken into account in determining whether, and to what
extent, a TP is insolvent within § 108(d)(3), but only to the extent that the excess
NR debt is discharged.
LIMITATIONS ON TAX SHELTERS
1. Two ways of sheltering income:
a. Timing & “conversation of rates”:
i. Benefit from the time value of money: take depreciation deductions up front,
even though you have to recognize the gain later (0% loan from G). Even better
if you can convert OI into capital gain (gave you the time value benefit, &
allowed you to pay back at lower rate than deducted)
b. Funneling income to tax exempt related party:
i. tax exempt from U.S. taxes
ii. Ex: Set up a partnership w/a foreign Co. Corp & a US Corp, set up so that you
have income in earlier years, offsetting deductions in later years, with an
ultimate 0-sum gain at p’ship level. You make the Foreign co. corp a 99% partner
fro income years, then buy them out & make US corp 99% partner for deduction
years.
2. § 465 attacks the timing aspect:
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a. Don’t get to take the depreciation ded. until you have some of your own property
invested/at risk. Thus, you get them when you generate some income from the property
or you put yourself at risk to actually suffer the loss.
b. § 465 allows you to take your deductions up to:
i. The income from that activity AND
1. As long as generating income, not taking deductions & sheltering other
activity
ii. Your amount at risk
1. Includes the amount the TP has invested in the activity, any property
dedicated to the activity, and any property pledged for debt used in the
activity
2. You can still use qualified nonrecourse dollars as part of amt. at risk, but
must be:
a. Borrowed from Government
b. Guaranteed by the Government
c. Borrowed from someone in the T/B of lending money
3. You can NOT use nonqualified nonrecourse dollars
4. You can also include recourse debt
c. Mechanics of §465
i. First, determine beginning amount at risk:
1. Cash put in
2. Basis of any property contributed to the activity
3. Any recourse debt
4. NR debt up to extent you have pledged other property to pay the debt
5. Qualified NR debt
ii. Make yearly adjustments
1. Primary adjustments are any additional amounts put at risk (i.e., put in
more of any of those categories just above); generations of taxable
income is treated as $ contributed to activity
2. Decreased by any carryover losses used up in a given year & any
withdrawals from the activity
iii. Limits
1. Losses from the activity (deductions from activity exceed income from
it) are disallowed unless you have an amount at risk
2. Deductions are held in suspense, and carryover to the next year (and
thus devalued by TV of money)
a. Note: This does NOT change basis computation
i. So if you get a §168 deduction, basis must be reduced,
even if it is held in suspense under § 465
iv. Keep a running track of:
1. Any losses
2. Amount at risk for each year
3. Suspended losses
4. Basis adjustments
v. See example, pgs 31-32 of notes
d. After § 465, you can still shelter income, as long as you are at risk.
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i. Leaves you with plenty of basis based on someone else’s money, as long as that
debt is recourse, using depreciation deductions to offset other income, or if its
real estate, can be nonrecourse debt, so long as qualified lender.
3. § 469 is a sheltering rule (as opposed to a timing rule)
a. It considers offsetting income from one activity with deductions from another
b. Requires TPs to classify income, losses, and credits as either PASSIVE or NON-PASSIVE
c. Non-passive Activities
i. Activities in which you materially participate (T/B) & portfolio inc.
ii. To be material, participation must be regular, continuous, and substantial
d. Passive Activities
i. Activities in which you don’t materially participate, limited partnership interests,
rental activity (with exceptions)
1. Rental activities: generally passive, unless significant services are
rendered in connection with the rental of the property
ii. Passive Activity deductions can only be used to offset income from passive
activities (every PAL needs a PIG: passive activity loss needs passive income
generator)
iii. Tax credits related to passive activities may only offset tax liability of passive
activities
iv. Unused passive losses will be carried forward to the next year in a suspense
account (§ 469(b))
1. Can’t use until you generate more passive income
v. Suspended losses are allowed in full when the activity is disposed of
4. Activity, Defined
a. Case-by-case basis
b. Facts & Circumstance test found in Reg. § 1.469-4
i. Provides great flexibility
ii. But NOTE: Once you define it, you cannot change it!
c. Factors given the greatest weight include:
i. Similarities & differences in types of business
ii. The extent of common control
iii. Geographical location
iv. Interdependence between activities
d. Ex: You have a restaurant & a bakery. Restaurant is losing money; bakery showing
positive income.
i. You’d want to materially participate in the restaurant, so it wouldn’t be passive.
ii. If you can’t show that you materially participated in the restaurant, you might
want to try to show the rest. & bakery as one activity, thus making it all one
activity.
iii. If you didn’t materially participate between the two of them, then you might
want to keep them separate activities. If you then sell the restaurant, all losses
come out of suspense & offset non-passive income.
iv. If you’d defined it as one activity & then sold the rest., you haven’t disposed of
an entire activity & thus your losses do NOT come out of suspense.
5. Basic disallowance of § 469(a)
a. § 469(a)(2): Must be a TP caught by passive activity rules
b. Passive activity loss= passive income - passive deductions
i. So only the excess deductions will be disallowed
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c. § 469(a)(2): Persons caught by § 469 are:
i. Any individual, estate, or trust,
ii. Any closely held C-Corp, and
iii. Any personal service corporation
d. This leaves room for sheltering by some C-corps
6. Rental Activities as Passive Activity
a. § 469(c)(2): Passive activity includes rental activity, except under (7): pg 426 of Code
i. (7) provides that for certain TP, it will not be per se passive- they will have
opportunity to show material participation
1. Real Property trade or business defined in § 469(c)(7()(C)
ii. Regs: Do not include where there is a substantial provision of services
iii. Reg. § 1.469-5T, pg 1515: test for determining whether materially participated
b. Exception for small investors in real estate: see § 469(i)
i. Can deduct up to $25,000 against non-passive income
ii. Must be at least 10% owner
iii. Must actively participate
1. Lower threshold than material participation
2. Means you make the management decisions
iv. Phased out for taxpayers with income over $100,000
7. Interplay of § 465 & § 479
a. § 465 applies first; only deductions which make it through §465 get taken into account
with §469; see what deductions survive §469, and that’s what’s allowable in any given
year
i. Thus, must have been at risk under § 465 b/c otherwise, it wouldn’t have carried
over to the §469 analysis
b. Example
i. Purchased a piece of depreciable property with a § 1012 cost basis of $1.2 mil.
Assume amount at risk is $30,000. Depreciation for the year was $40,000 and is
only deduction (artificial assumption). Assume it is passive.
ii. Assume Yr 1:
1. Passive Income from activity = $20,000
2. Deductions = $40,000
iii. In absence of 465/469, could deduct all of it (20 offsetting the passive income,
20 offsetting other income)
iv. We know we will be able to deduct the $20,000 - amount which is up to the
amount of income.
v. What about other $20,000?
1. § 465: can deduct up to amount at risk - here, at risk $30,000 - § 465
doesn’t limit deduction in Yr 1
a. At risk remaining= 10,000
2. § 469 limits?
a. Allows $20,000 of deduction (up to amount of income) and
disallows 20k (excess of income)- yes it limits
vi. Thus at end of Year 1:
1. At risk = 10
2. Deductions in § 465 suspense = 0
3. Deductions in § 469 suspense= 20,000
vii. Assume Yr 2:
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viii.
ix.
x.
xi.
xii.
xiii.
xiv.
xv.
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Tax II - Professor Davis
1. Passive Income from activity = $7,000
2. Deductions = $40,000
Excess of deductions over income = $33,000
How much of this $33,000 is allowed as a deduction this year?
1. We were allowed 17 (income + amount at risk)
2. § 465 limits?
a. $10,000 at risk- so 17,000 is allowed; other 23,000 is disallowed
by §465
3. § 469 limits?
a. Only talking about deductions which made it through §465- had
income of 7 & deductions of 17,000
b. So under §469, can deduct 7 (up to amount of income); other
$10,000 is disallowed
Thus at end of Year 2:
1. At risk = 0 (used up the 10 that was there at end of year 1)
2. Deductions in § 465 suspense = 23,000
a. Deductions in § 469 suspense=30,000 (20 + 20)
Assume Yr 3:
1. Investment of $100,000 of cash
2. Passive Income from activity = $50,000
3. Deductions = $40,000
At risk= 100,000
§465 limits?
1. Allowed to deduct full amount plus the full amount of the suspense
account
a. Total= 63,000 (40 +23)
§469 limits?
1. Income 50
2. Dep
40
3. Susp 23
a. Note: once it comes out of §465 suspense, that’s when we take
into account of 469
4. Current deductions of 63 - only 50 of it will be allowed.
a. Other 13 is added to 469 suspense
Thus at end of Year 3:
1. At risk = 100,000
2. Deductions in § 465 suspense = 0
3. Deductions in § 469 suspense= 43,000
Assume Yr 4:
1. Sell property at gain of $100,000
a. Passive income then = 100
b. No other deductions
2. Amount in suspense account (43,000) is fully deductible & is deducted
in year of disposition
a. Note: If we’d had $143 in suspense, all of it would still be fully
deductible. The excess over the 100 would offset other income
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Alternative Minimum Tax
1. AMT Defintions
a. AMT: the excess of the tentative minimum tax over the regular tax for the year
i. Tentative minimum tax, individuals= 26% of the first $175,000 in “taxable
excess” plus 28% thereafter
1. Taxable excess: excess of alternative minimum taxable income over
exemption amount
a. Alternative Minimum Taxable Income: see § 55(a)(2)
i. supposed to measure something closer to economic
income & then is to impose a lower rate of tax than
regular rate, but on a larger base
1. Lower rate, bigger base
b. Exemption Amount: Statutorily provided in §55(d)
i. For 2010, would be $47,450
ii. Subject to phase-out provision of 55(d)(3)
1. See problem for explanation
2. Code provisions
a. § 55: basic definitions
b. §56 & 58: adjustments (up or down)
c. § 57: add-back provisions (all up)
3. The AMT as currently designed is an add on tax: pay regular tax liability plus AMT
a. Example:
i. Regular tax of $15,000.
ii. TI +/- adjustments = AMTI - exemptions = taxable excess
iii. Apply AMT rates to get a tentative minimum tax
iv. Assume tentative minimum tax is 20k
v. You’ll pay 15k of regular tax + the amount of the AMT is the excess of the
tentative min. tax over the regular (AMT=5,000)
vi. Total tax liability is 20k
vii. It is separated out this way (as in 91.vi.) because taxpayers will be subject to
regular tax or AMT over the years, resulting in paying more tax over the years
that they flipped in and out of AMT & reg. Separated out b/c there might be a
credit available to offset AMT, so need to know how much paid in additional
AMT to know how much you can offset w/those credits.
viii. Ex: AMTI depreciation is slower than regular depreciation.
ix. In early years, TI depreciation is higher, so AMT will go up (upward AMT
adjustment). In later years, you are entitled to more depreciation for AMT
purposes than regular purposes, so that will be a downward AMT adjustment. If
in the later year, when you were entitled to a downward adjustment, you don’t
have to pay AMT, and just pay regular tax, this will generate an ability to take a
credit later.
4. AMT problem: See problem 21 & printout
5. Depreciation & AMT
a. The same recovery period is used for both regular tax & min. tax purposes
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7.
8.
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b. Except for § 1250 property (gen. real property) and property otherwise depreciated
under the straight line method, depreciation for AMT purposes MUST be calculated
using the 150% declining balance method.
i. Will most likely see the difference w/r/t 3-yr, 5-yr, 7-yr, & 10-yr tangible
personal property
Limitation on Itemized Deductions, Standard Deductions, and Personal Exemptions
a. Misc. itemized deductions under § 67(b) are not allowed for AMTI
b. State and local taxes which were deductible BTL for regular taxes are not allowed for
AMTI
c. Medical expenses are allowed under AMTI only to extent the exceed 10% of AGI
d. Interest deduction limitations of § 163(d) and (h) are modified
e. The standard deduction & personal exemptions are NOT allowed in computing AMTI
f. Overall limitation on itemized deductions under § 68 does not apply in computing AMTI
Tax-Exempt Interest
a. Private Activity bond interest which was otherwise exempt must be included in AMTI
interest
Qualified Small Business Stock
a. Seven percent of the amount excluded under § 1202 must be added back under §
57(a)(7)
Determining tax liability on taxable excess
a. If there is net capital gain included in the taxable excess, the special lower maximum
rates of § 55(b)(3) must be applied.
b. The remainder (or the total, if no net capital gain), is taxed under § 55(b)(1)(A)(i)
SALE OF BUSINESS & SALE-LEASEBACKS
1. Sales of Businesses
a. Per Williams v. McGowan, you are selling several separate assets & you must allocate a
portion of the purchase price to each asset & then determine the gain or loss recognized
on each of those assets.
2. Order of valuation- Residual Method
a. § 1060 & Reg. § 1.1060-1(c)(2) requires the purchaser & seller to allocate the sales price
among seven classes of assets:
i. Cash & general Deposits
ii. Actively traded personal property, CDs, foreign currency
iii. Mark-to-market assets & certain debt instruments
iv. Requires a recognition of a gain on certain assets before a realization vent; G(L)
recognized each year; only for certain TP, in certain industries, for certain types
of assets
v. Inventory & property held primarily for sale to customers
vi. All assets not otherwise included in this list (1-4,6-7)
vii. This will often be bulk of assets- land, equipment, vehicles, etc.
viii. All § 197 intangibles except goodwill & going concern
ix. Goodwill & going concern
1. If any residual purchase price after allocating to 1-6, allocate here
b. Allocates to the easiest valued assets first, descending
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c. This applies not only to sales of business, but also mergers
d. § 1060 binds the parties to any written allocation of consideration or written agreement
regarding FMV of any asset, UNLESS the treasury determines the allocation or value is
inappropriate.
i. Parties are NOT REQUIRED to make allocations in the purchase agreement
3. § 197 Intangibles
a. § 197 provides a list of certain intangibles, some of which have no identifiable life, or
very short useful lives, for which Congress provides you can amortize, but must be over
15 years.
b. Notice: Some assets are only within 197 within context of a purchase or acquisition of
an entire trade or business, and if not within § 197, you are in §167 & must write-off
over useful life.
i. Gooodwill
ii. Going Concern value
iii. Workforce in place
iv. Business books & records
v. Patent, etc.
vi. Customer-based intangible
vii. And any other similar item
c. To the extent amounts are allocated to those items, § 197 allows buyers to benefit from
the amortization; sellers, meanwhile, are content with their continued right to claim
capital gain treatment for the amounts allocated to those items
d. § 197(e) specifically excludes some intangibles from the 15-year amortization rule.
i. See pg 1013 of textbook
e. Sale of an intangible at a loss
i. § 197(f)(1) denies loss recognition of the TP sells an intangible at a loss but still
retains other amortizable § 197 intangibles.
ii. Instead, the loss will be allocated among the remaining intangibles, increasing
their basis.
f. See Problem 22
4. Sale-Leaseback
a. Fulfill a variety of functions:
i. Sometimes just a sale-leaseback
ii. Sometimes part of shelter activity
1. Run into § 465/§ 469 analyses, unless rent of intangible property
2. In early 80s, almost all equipment co. was done this way (doctors
owned equipment; construction co. leased)
iii. Sometimes part of a financing arrangement
1. Recall Estate of Star: Gov’t saw a disguised sale instead of a lease. If
sprinkler system was part of the building, it would be depreciable over a
long time. If it was part of the rental payments, currently deductible
when paid. Customer was essentially trying to accelerate the write-offs.
If treated as an actual purchase, paid over 5 years, customer of sprinkle
co. would be entitled to depreciation deductions over the useful life of
building (assume 15 yrs). If we paid exactly same amount but called it
rent, write off over 5 years (terms of rental agreement).
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1. What suggests a purchase as opposed to a rental arrangement? “Smell
test”: Does it smell more like a rental or a purchase?
b. Must consider in determining whether it’s a lease or a purchase & financing:
i. The likelihood of continued ownership at end of rental agreement
ii. Option to buy (if FMV, suggest lease; if minimal, suggest purchase)
iii. Whether rental payments were FMV of rent or whether they equaled purchase
price + interest
iv. Who holds title of the property? Holding title generally suggests that person is
the true owner (although not definitive)
v. Amount accepted by “seller”: If truly a sale, you’d demand FMV. If not, you
would accept less
vi. who has risk of loss, who insured the property
1. In lending arrangements, it is split b/t the lender & the true owner, but
rests primarily with the owner.
c. Reasons you might want to disguise a financing arrangement as an ownership
arrangement:
i. Tax benefits (depreciation)
1. If maxed out on depreciation deductions, construction co. might lease
from a high-income PS. This allows the PS to get the benefit of the
deductions & the construction company to deduct the rental exp. If PS
sets rental payments at less than depreciation, then they get big
benefit.
a. If you ask if the rental payments equal purchase price + interest
i. If so, construction co. will want an option to purchase at
end of lease
b. Then must ask whether the option was minimal, or whether it
approximates FMV at end of lease.
i. If minimal, Const. Co. actually controlled disposition & it
was more of a purchase than a lease. Construction co.
held upside benefit; the downside risk is split between
the equipment dealer (b/c risk of nonpayment) & the
partnership (b/c of risk of construction co. stopping to
pay rent, leaving them on hook for debt) & the
construction co. ( b/c risk of loss of value of property).
ii. Thus, downside risk doesn’t tell you much about who
actually owns the property, b/c it is often shared
iii. Must ask WHAT KIND OF RISK
iv. Dealer & PS bear risk of nonpayment. Construction co.
bears equity loss (fmv in relation to the amount of debt)
c. If it’s really a lending arrangement, tax consequences should be
the same as if you’d actually borrowed the money & purchased
the asset. The lease payments should be treated as principal +
interest payments, and b/c only interest is deductible, can’t
deduct all payments. Then, partnership doesn’t get the
depreciation on the equipment; they are getting interest &
principal payments. The construction co. gets depreciation
deductions, which might not be useful to them.
d. See Frank Lyon discussion of notes
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i. Sale-leaseBack Characterized as Financing arrangement
1. When TP sells the property to lender and then leases it back from
lender with option to purchase…Service may call this a Financing
Arrangement if they disregard the sale-leaseback, it’s a mortgage
2. BUT SEE Frank Lyon – not disregarded and TP got depreciation and
interest deductions
e. Problem 23
LIKE-KIND EXCHANGES
1. § 1031 Requirements for a like-kind exchange:
a. Must be an exchange
i. As opposed to a sale/disposition
ii. Swapping property for property
iii. No cash comes into hands of seller
1. If cash touches seller’s hands, destroys exchange & destroys 1031 status
2. I.e., seller can’t sell for cash first & then turn around & reinvest
iv. Escapes taxation b/c of (1) issues over valuation of FMV of property & (2)
illiquidity: b/c no cash to pay tax & (3) investment solution- still invested in
something; BUT
1. Valuation issue undercut when cash is exchanged too (when FMV of
properties isn’t =), b/c parties have to be valuing property to know the
difference needed to be made up in cash/debt
2. Liquidity: sometimes no less illiquid when the nature of the two assets
are different but both still illiquid
3. Investment solution: properties don’t really have to be that alike
b. Property given up & received must be T/B or investment
i. Given up= relinquished prop.
ii. Received= replacement prop.
c. Exchanged solely for property of like kind
i. Intent at time of exchange must be to hold the property for T/B or investment
ii. Regs help determine what is like kind
1. All real estate is of like-kind, including leasehold interests for 30 years or
more
2. Leaseholds in minerals, water, etc. which convey unlimited rights tend
to qualify, while the limited leaseholds don’t
iii. Don’t really mean solely- can have some cash changing hands.
iv. Cash triggers gain recognition on that portion, but still deferral of the rest
2. § 1031 is applied on a taxpayer-by-taxpayer basis
a. So if X & Y exchange, and Y doesn’t qualify, that doesn’t disqualify X
3. What cannot be considered “like-kind”:
a.
b.
c.
d.
e.
f.
stock in trade (inventory) or other property held primarily for sale,
stocks, bonds, or notes,
other securities or evidences of indebtedness or interest,
interests in a partnership,
certificates of trust or beneficial interests, or
Choses in action
4. Note: The exclusion of the gain or loss is a deferral, not a permanent exclusion
5. Deferral is worked out through basis rules
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a. § 1031(d) basis calculation= the basis of all property transferred -- cash received + gain
recognized -- loss recognized= total basis in all property received
i. Note: no loss recognized on the like-kind property in a 1031 exchange; but
maybe on non-like-kind
ii. IMPORTANT: When boot is transferred, don’t forget to include it in that first #!!
iii. IMPORTANT: When debt is taken on, that is included in first #!! (?)
b. If you get more than one piece of property, the total basis in all property received must
be divvied up pursuant to § 1031(d), allocating FMV to the non-like kind property &
everything else to the like-kind property.
i. Basis ought to go to the NLK property first, b/c that is the property which
generated the gain. It also preserves the gain in the LK property
c. Example 1:
i. Taxpayer 1: FMV 400 - AB 100 (property 1)
ii. Taxpayer 2: FMV 400 - AB 300 (property 2)
iii. Gain:
1. TP 1: Realized 300; recognized 0
2. TP 2: Realized 100; recognized 0
3. *exchange was solely like-kind
iv. Basis
1. TP 1: Basis of property given up + inc - boot rec’d -loss= 100 +0-0-0=100
AB in property 2
2. TP 2: Basis of property given up + inc - boot rec’d -loss= 300 + 0 - 0 - 0 =
300 AB in Property 1
d. Example 2:
i. Taxpayer 1: FMV 400 - AB 100 (property 1); Cash 100
ii. Taxpayer 2: FMV 500 - AB 300 (property 2)
iii. Gain:
1. TP 1: Realized 300; recognized 0
2. TP 2: Realized 200; recognized 100 (b/c got back cash of 100, which is
nonqualifying & is boot rec’d)
a. He essentially cashed out of that 100 of the investment
iv. Basis
1. TP 1: Basis of property given up (100 + 100) + inc - boot rec’d -loss= 200
+0 - 0 -0= 200 AB in property 2 (new to him)
a. holding property with FMV = 500; preserves gain of 300
2. TP 2: Basis of property given up + inc - boot rec’d -loss= 300 + 100 - 100
- 0 = 300 AB in Property 1
a. Preserves gain of 300, which is correct amount, b/c equal to
original gain amount in property 2 when he held it + amount of
income he already had to recognize
6. Exchanging less than full interest in a property
a. Even if one TP only gives up part of his or her interest, it can still qualify to be like kind.
i. Regs. & Rev. Rul. 73-476 tell us that a TIC will be treated same way as fee simple
interest.
7. § 1031 & Related Parties
a. Where you have a conflict between § 267(a)(1) & § 1031, § 1031 controls.
i. In 1031 the loss is preserved. In 267, the loss is not necessarily preserved.
ii. See Problem 24, part j.
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b. 1031(f) imposes a 2-year holding period on exchanges between related persons
c. If either person sells the property within 2 years of the exchange, it triggers the gain
recognition in that year as if 1031 hadn’t applied.
i. This holding period requirement applies to both the property received and the
property transferred.
8. Treatment of Liabilities
a. If one person’s property is subject to debt, it is going to be treated as cash changing
hands and will be cash received for the person who is relieved of the debt.
b. If there is debt on both sides, the debt amounts are netted, and whoever has the excess
of debt relieved will be treated as getting cash to the extent of the excess.
c. If you received cash & had debt changing hands:
i. To the extent you are receiving cash, it will be treated as boot, regardless of
how much debt you take on/give up.
ii. If you are giving up cash & being treated as getting cash from debt relief, you
can net the two.
iii. Thus, an asymmetrical rule
d. Problem 24, part l., m., n.
9. Three-Corner Exchanges
1. Rev. Rul 77-297:
B wants A’s property. A wants a § 1031 like kind exchange. B doesn’t have any property, so A
wants C’s property.
a. A & B agreed that FMV of ranch was $1000. B was to put into escrow $100 & was to
pay 200 at closing, giving a 540 note and assuming 160 liability= 1000
i. A has a gain realized of the AR over his basis
1. Could defer some recognition b/c of note, but might recognize some if
not § 1031
2. Critical for 1031: A doesn’t get any cash & can’t get any, so its critical
that he can’t touch that money in escrow for a certain time period
ii. A convinces B to go buy C’s property  this deal in (a.) never happens
b. C agreed to sell B his ranch, agreeing FMV was 2000 & B put 40 in escrow, agreed to
pay an additional 800 at closing, assumed a debt of 400, and signed a note for 760=
2000.
c. B actually bought C’s ranch. Then A & B exchanged properties.
i. A had this ranch with FMV= 1000 but it was subject to debt of 160, making net
value of deal= 840. (get the 160 from knowing that B was going to assume such
debt if sale went through)
ii. B had the the ranch with FMV= 2000 but it was subject to debt of 400 & 760,
making net value of deal= 840.
iii. They swapped, assuming each other’s debt.
d. A has a good §1031 exchange, b/c he didn’t get & couldn’t get any cash before the
exchange, and got no cash on the exchange.
i. But its as if A gave up his property + $1,000 (b/c gave up debt of 160 & assumed
1160). Basis will be $1,000 + $1,000= 2,000
e. B failed the §1031 requirements b/c he never held for T/B or investment, but B
doesn’t care, as there is no gain involved in the purchase (they bought for 2k, sold for
2k). B is indifferent.
f. Note: This deal is asking a lot of B. B just wants the ranch.
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g. Note: C would title it directly to A. You want as few people as possible in your chain of
title, to protect against B’s lien holders from slapping a lien on the property while B
held it.
10. Starker & deferred exchanges
a. Starker: Transferor identified property for the buyer to buy & give to transferor, instead
of the buyer paying the transferor cash. This doesn’t come to fruition until 5 years after
the agreement was entered into. Starker argued the exchange was good under § 1031.
Court said nothing in § 1031 which said when you had to do it, i.e., didn’t require
simultaneous exchanges. Just said had to have an exchange.
b. Congress responded to Starker with § 1031(a)(3): To be good, it must be identified
within 45 days & must be received within 180 days or due date of your tax return (due
date + extensions) (thus, if you start the exchange in Dec., you would appear to have
only 3 months to get it done, but you can get extension to August
i. Thus, these Starker deals are still allowed, but the time to accomplish is short
ii. Clock starts ticking upon the transfer of the relinquished property
c. Regs authorize use of a qualified intermediary in a simultaneous exchange
i. Reg. 1.1031(k)-1: Treatment of Deferred Exchanges
1. You can still do a 1031 exchange even though you have someone ready
to pay cash.
2. 1.1031(k)-1(g)(4)(v): can transfer to the qualified intermediary as long as
you did not and will not get any cash before the transfer to the qualified
intermediary. You must also give notice to all parties to the agreement
in writing on or before the date of the relevant transfer. (pg 1775-76)
ii. Who can be a qualified intermediary?
1. Anyone who is not a disqualified person under Reg. 1.1031(k)-1(k)
a. Reg. 1.1031(k)-1(k) lists as a disqualified person anyone who has
acted as the taxpayer’s:
i. Employee
ii. Attorney
iii. Accountant
iv. Investment banker or broker
v. Or real estate agent or broker
b. Within the 2-year period ending on the date of the transfer of
the first of the relinquished properties
iii. The QI does not have to take legal title, although they can (not advisable)
iv. Advisable to set up a trust or escrow account, if possible, to prevent QI from
having full access to your funds once the transfer to them happens. You can use
a trust or escrow account in addition to a QI.
1. Reg. 1.1031(k)-1(g)(3): Qualified escrow arrangements
a. (g)(6) requires the terms of the escrow agreement to be such
that you cannot get the cash unless there is no property
identified within the 45 day period or if there is no replacement
property acquired within the 180 days
i. You cannot have option to get money under other
circumstances; otherwise, treated as receiving cash & §
1031 treatment FAILS.
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v. If property is transferred to QI or is held in escrow account, you can require that
any appreciation will accrue to your benefit, but it can’t be taken out until after
the transaction is complete.
vi. You can loan money to the QI in order to purchase the replacement property.
vii. QI can also borrow cash, borrow against relinquished property, and borrow
against replacement property- basically are acting as your agent w/out being
agent
11. Identification of Replacement Property in a Starker exchange
a. Reg. 1.1031(k)-1(c): proper identification for purposes of identifying the replacement
property before the end of the identification period
i. Code pg 1769
ii. Actually receiving the property within the 45 days is sufficient for identification
iii. It must be described in a way which unambiguously identifies the property
iv. Reg. 1.1031(k)-1(c)(2) says it must be in writing, must be signed, and must be
hand delivered, mailed, telecopied, or otherwise sent b4 end of identification
period & must be sent to either:
1. The person obligated to transfer the replacement property to the
taxpayer
2. Any other person involved other than yourself
a. So can send to qualified intermediary
b. Reg. § 1.1031(k)-1(c)(4) (pg 1769): Identification of multiple replacement properties
i. 3 property rule
1. Identify three properties, w/o regard to the FMV
ii. 200 % of value rule
1. Identify any # of properties up to 200% of value of property you are
transferring
iii. 95% receipt rule
1. Oops rule: If you have identified more properties as replacement
properties than permitted by the first 2 rules, this one gets you 1031
treatment if you acquire 95% of property identified
a. But this may make you acquire more property than you want
12. Reverse Starker exchanges
a. A “reverse Starker” is an exchange where the replacement property is acquired before
the relinquished property is transferred.
b. Rev. Proc. 2000-37 provides a safe-harbor for these transfers to qualify under § 1031
i. Text Pg 955: Property will be held in a qualified exchange accommodation
arrangement (and therefore fall under the safe harbor) if all of the following
requirements are met:
1. Qualified indicia of ownership of the property is held by the titleholder
who must be a taxpayer who is subject to federal income tax or, if a Ps
or S corp, more than 90% of stock is held by such persons
2. At the time the ownership of the property is transferred to the
exchange accommodation titleholder, the TP intend that property to be
either replacement or relinquished property in an exchange intended to
qualify under § 1031
3. The TP & exchange accommodation titleholder must enter into a
written agreement no later than five business days after the property is
transferred to the exchange accommodation titleholder
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4. No later than 45 days after the transfer of the replacement property to
the exchange accommodation titleholder, the relinquished property
must be properly identified.
5. The property must be transferred to the TP as replacement property no
later than 180 days after transfer of ownership to the exchange
accommodation titleholder; AND
6. The combined time period that the relinquished property & the
replacement property are held in such an arrangement cannot exceed
180 days.
ii. This Rev. Proc. pulls the time requirements back into the mix, applying the same
time requirements to the holding of the replacement property that 1031 applies
to the timing when you give up relinquished property first.
1. Have 45 days to identify the relinquished property (already know
replacement property) & 180 days for the transfer of relinquished &
replacement properties to take effect
2. The clock begins to run on both time frames from the transfer of the
replacement property (b/c that’s the property shifting hands first)
iii. Problem 26
iv. The titleholder will be treated as owner, and not the taxpayer, so long as
operating within the Rev. Proc. safe harbors.
1. If you operate outside the safe harbor terms, it takes away protection of
titleholder being respected as owner, and usual rules regarding
ownership of property apply.
v. The titleholder cannot be the taxpayer or a disqualified person under Reg. §
1.1031(k)-1(k)
vi. Permissible agreements, text pg 956:
1. The taxpayer may personally guarantee some/all of obligations of the
titleholder
2. The taxpayer may lend or advance funds to the title holder
3. The titleholder may lease the property to the taxpayer
4. Etc.
vii. Protecting against value fluctuation
1. Rev. Proc. 2000-37(4)(7) Have an agreement protecting the titleholder
against loss
2. (6) use puts and calls at fixed prices, effective for a 185 day period,
which protects title holder among other things from deal falling through
viii. Identifying “alternative & multiple properties”
1. Same three methods as allowed in starker exchanges (1.1031(k)-1(c)(4)
13. Exchanges Qualifying for both § 121 & § 1031 treatment
a. Service has said it makes sense to allow you to use both 121 & 1031 if you qualify for
both. Rev. proc. 2005-14
b. Rev. Proc. 2005-14 gives mechanics of how to put the two together:
i. § 121 must be applied to gain realized before applying § 1031
1. Remember, must have used as primary residence for 2/5 last yrs.
ii. Under s 121(d)(6), the § 121 exclusion does not apply to gain attributable to
depreciation deductions claimed w/r/t the business portion of residence
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iii. In applying § 1031, cash or other NLK property received in exchange for the
property is taken into account ONLY TO EXTENT that such boot EXCEEDS gain
excluded under § 121
iv. In determining the § 1031(d) basis of property received in the exchange, any
gain excluded under § 121 is treated as gain recognized by the taxpayer
c. Primary difference in 121 is 1031 is that 121 is perm. exclusion but 1031 is a deferral.
INVOLUNTARY CONVERSIONS
1. Coverage of § 1033
a. Includes involuntary conversions of personal property as well as T/B property
b. Requires an involuntary conversion event
i. Defined in § 1033 as “destruction in whole or in part, theft, seizure, or
requisition or condemnation or threat or imminence thereof”
1. Destruction as a result of fire, storm, or shipwreck falls within § 1033
2. Destruction need not be sudden- can be gradual
ii. Rev. Rul. 89-2: Contamination can fit within the definition of destruction.
Destruction can be anything rendering property unfit for its intended use.
c. Allows conversion to qualified property directly, OR allows conversion to cash &
subsequent reinvestment
d. Have 2 years after end of tax year in which IC happens to get it done (much longer than
under 1031)
e. Property which is qualified is property which is similar or related in use
i. Narrower standard than “like kind”
ii. Two tests for similar or related in use:
1. End user test- pretty narrow; lots of Rev. Rul. & cases
2. Lessor test- less restrictive test than end user; considers obligations,
duties, and services provided by lessor
iii. BUT With condemnation conversion (a government taking of property) of real
property, you get “like kind” standard under § 1033(g)
f. Gains not recognized are preserved for later recognition
g. Gains are recognized to the extent you cash out of investment
2. Problem 28
3. Time for replacement
a. § 1033(a)(2)(B): Converted property must be replaced within a 2 year period following
conversion of the property
b. § 1033(a)(2)(A) requires the replacement property be purchased for the purpose of
replacing the converted property
4. Partial recognition of gain under §1033
a. Realized gain will be recognized under s 1033(a)(2) to the extent that the amount
received upon the conversion exceeds the cost of the replacement property
i. But remember: recognition is limited by amount of gain actually realized
5. Splitting proceeds(Willamette Industries)
a. Tax Court has allowed a taxpayer who mitigated damages, making them only partial, to
split the FMV proceeds and defer a gain on the proceeds received when they had to cut,
process, & sell their timber before they normally would as a result of damage to it.
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6.
7.
8.
9.
10.
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i. When they sol the wood, they were being paid for the wood itself & for the
processing services. TP argued that they were only claiming as proceeds from
involuntary conversion the FMV of the damaged trees before the processing
began (splitting the sales price). TC agreed.
Basis calculation
a. § 1033(b)(1): Conversion of property to property
i. Basis= property converted - proceeds not reinvested + gain recog. - loss recog.
b. § 1033(b)(2): Conversion of property to money to property
i. Basis= Cost of replacement property - gain realized but not recognized
Holding period of replacement property
a. Tacking is allowed if the converted property was capital under § 1221 or a § 1231 asset
Involuntary Conversion of Principal residence
a. § 121 provides that an involuntary conversion will be treated as a sale for § 121
purposes
b. So, a TP can take advantage of § 121 to exclude some/all of realized gain, and any
realized gain not excluded under § 121 could be deferred under § 1033 if req. met.
c. For the purposes of applyint § 1033, § 121(d)(5)(B) says that Amount Realized=
proceeds of the involuntary conversion - gain excluded under § 121
1. Effectively requires § 121 be applied before § 1033
ii. And then Gain recognized= Proceeds - reinvestment
d. See examples, pg 968- 69
e. Problem 29
f. You are permitted to elect out of § 121 and have only § 1033 apply
i. Why would you do this? Maybe have another property which would qualify
under 121 & thus still get the full § 121 exclusion & defer gain on this property.
If you did it opposite, then you might not get to exclude any gain on the other
property & would have to recognize a gain.
§ 1033(i) restricts related party transactions
a. See statutory provision & § 267
Condemnation Proceedings
a. Condemnation: process by which private property is taken for public use without the
owner’s consent, but upon the award and payment of just compensation
i. Contrast to a seizure: no compensation
b. In the instance of condemnation, don’t have to wait until condemnation act & you get
condemnation proceeds. You can sell the property under threat of condemnation, those
are involuntary proceeds, & you can take those involuntary proceeds & reinvest under
1033
c. Threat of condemnation: As long as gov’t had taken the position that it would seize the
land, when the TP sells it to a gov’t authority, that is a threat of condemnation which
allows it to come within the statute, as long as the payments weren’t compensation for
damages (any damages portion may be deemed “destruction”)
d. Two step process:
i. Property must have been destroyed for its intended use
ii. If the property is sold to a gov. authority after the passage of an ordinance
authorizing eminent domain proceedings, then the sale is one under threat of
condemnation, to extent TP can establish the proceeds represent compensation
for the taking by the gov.
Lessors/Investors & § 1033
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a. Test: similar/related in use
i. Look at the use by the landlord, not by the tenants
ii. Liant: Consider:
1. The extent and type of lessor’s management activity
2. Amount and kind of services rendered by him to the tenants
3. The nature of his business risks connected with the properties
b. Rev. Rul. 64-237 restricts this test
i. In considering whether replacement property acquired by an owner/lessor is
similar/related to converted property, attention is given primarily tot eh
similarity in the relationship of the services or uses that the original and
replacement properties have to the owner/lessor
ii. Says that if the taxpayer changes his end use so that he has changed the nature
of his relationship to the property, he will be outside § 1033
INSTALLMENT SALES
1. § 453 installment sale rules
a. When property is sold at a gain on a deferred payment or installment basis, with all/part
of sales price to be paid following year of sale, the gain on the sale, and the tax liability it
generates, can be spread over the period during which payments are received
i. Based on liquidity- no ability to pay tax if payment isn’t yet made to you
b. §453 spreads tax liability over time of payment, collecting from each payment some
portion of the taxable income & some portion will be allocated to basis
c. § 453 does not apply to an installment sale at a loss
i. Problem 31
d. § 453 does not apply to revolving credit plans or payments on installment obligations
arising out of sale of stock or securities (453(k)) and such payments are treated as
received in the year of disposition.
i. Goes back to liquidity idea- if you have a share of stock to sell, you don’t have
liquidity problems, b/c you could sell it to a willing buyer on the market
e. Installment reporting is generally not allowed for dealer dispositions or dispositions of
personal property includable in inventory
i. Dealer disposition: disposition of personal property by a person who regularly
sells or otherwise disposes of personal property of thee same time on the
installment plan, or any disposition of real property held by TP for sale to
customers on ordinary course of business.
2. Installment ratio of § 453(c)
a. Payment received x (gross profit/total K price)= income portion of each payment
i. Ordinarily, gross profit= gain = AR- & total K price
ii. This ratio is called the “gross profit ratio”
iii. This ratio tells you how much gain is to be included each year
iv. Character of gain is determined by that of underlying property
b. Problem 30
c. Note: interest payments are included in income for person receiving & deductible for
person paying
3. Cash v. Accrual method
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a. Doesn’t make any difference under §453, unless Tp elects out of the § 453 provision.
i. Might elect out if you have a large capital loss & the gain was going to be
capital, thus allowing you to use up your deduction more quickly
4. Payments & Liabilities
a. Qualifying debt
i. Liability relief is generally not treated as a payment for §453(c), assuming it is
qualifying indebtedness
1. Qualifying indebtedness assumed, or taken subject to, by the buyer
ordinarily is not a payment.
2. Obvious qualified debt: acquisition debt, or debt taken on for
maintenance/running of property as it was used in a business,
substantial rehab. debt, or some debt related to the improvement or
use of the property (non-tax avoidance)
ii. All of the mortgage relief is effectively treated as a tax-free return of basis.
iii. How does this affect the Gross Profit ratio?
1. Gross profit remains same
2. Total contract (K) price is reduced by the qualified indebtedness
a. Qualifying indebtedness offsets selling price only to extent of
basis
3. This allows the total recognized gain to be properly reflected
iv. When qualified indebtedness exceeds basis, the excess will be a payment in the
first year
1. Problem 33
2. Everytime you have excess debt, inclusion ratio should be 100%
v. What if the buyer issues a promissory note to the seller in the amount of the
unpaid purchase price?
1. These notes themselves generally do NOT constitute payment, even if
the debt is guaranteed by a third party.
b. Non-qualified debt
i. Example of non-qualified debt: after acquired debt done in contemplation of
the sale
1. Assume that the longer the debt has been outstanding the less likely it is
to be disqualified. To extent related to use of property, less likely to be
DQ. And vice versa (recently acquired, debt acquired for personal
reasons more likely to be DQ)
ii. If not qualified debt, its treated as a payment in the first year. Ratio is not
adjusted. Inclusion ratio is unchanged by the debt
1. I.e., non-qualified debt does NOT reduce contract price
c. Problem 32
5. Contingent Payment Sales
a. Situation arises when you have future payments based on rents or profits: the aggregate
sales price therefore CANNOT be determined in year of sale, thus can’t do GP ratio
b. Open transaction doctrine: no gain arises and no tax liability imposed until the taxpayer
first fully recovers basis in the property. Once basis has been recovered, remaining
payments would constitute gain (Burnett v. Logan case)
c. Regs give default rules:
i. First preference: If K has a max. price, then use that as selling price
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1. Problem: If you end up not collecting max price, you make adjustment
in last year of K to take into account
ii. Second preference: If you don’t have a max. price but a set maximum # of years,
divvy basis up among # of years
1. If amt. collected < basis allocation, unrecovered basis amt. carries
forward
iii. Third preference: Divvy basis up among 15 years
1. Gives TP incentive to come up with max. K term or max. K price
iv. Problem 38, 39
d. If taxpayer elects out of § 453, §453(d) says recognize all gain in first year
i. Gain= Amount of notes - basis
ii. UNLESS you can get open transaction doctrine treatment
1. Rare
2. FMV of notes must not be less than FMV of property you’ve disposed of
a. Even if can’t ascertain value of these contingent payments, you
can ascertain FMV of property disposed of
i. Thus giving you FMV of notes
ii. Therefore, recognize all gain in year of disposition
b. So, most situations, you are not going to be able to argue open
transaction doctrine.
iii. Problem 40
6. Depreciable Property & Recapture Income
a. § 453(i) requires recognition in the year of sale of any recapture income
i. § 1245 says you must recognize your recapture income immediately, in year of
disposition. No exception in 1245 for 453.
b. Since recapture income is recognized regardless of payments received, the recaptured
amount must be added to seller’s AB to avoid over-reporting income
c. Problem 34
7. Disposition of Installment Obligations
a. When a taxpayer disposes of an installment obligation, the § 453 deferral ENDS.
b. § 453B says a disposition of the note is a realization event
c. To determine the gain:
i. Depending on the type of disposition, the basis of the obligation is subtracted
from:
1. Amount realized on disposition OR
a. Used when the taxpayer sells or exchanges the note, or it is
satisfied at other than face value
2. Fair market value of the obligation
a. Used when the note is otherwise disposed of, such as by gift or
cancellation
i. Problem 36
ii. This prevents transfer of the gain to someone else
ii. Basis of obligation= difference in face value & amount that would constitute
income were the obligation satisfied in full (applying GP ratio)
1. See example, pg 995
2. Backs into basis
a. Multiply the GP ratio times the total which would have been
collected- this is what would have been included in GI
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b. Subtract that from the total which would have been collected
c. That’s your basis
3. See problem 35
d. Character of the recognized gain or loss depends on the character of the underlying
property
e. Transfer of an installment obligation between spouses incident to divorce
i. Per §453B(g), § 453B(a) does not apply if §1041 otherwise would have applied
1. § 1041: transfers b/t spouses will not trigger gain recognition
a. § 1041 applies, even if spouse paid for it.
ii. Transferee steps into shoes of transferor for reporting gain on receipt of
payments on the installment obligation
1. Transferor will not recognize gain
iii. Problem 37, 41, 42
8. Second Dispositions by Related persons
a. In general, § 453 doesn’t prevent related parties from utilizing it on a first disposition.
b. BUT § 453(e) puts limitations on second dispositions by related persons
i. AR upon resale by the related party installment purchaser triggers recognition
of gain by initial seller, based o nhis GP ratio, only to the extent the AR from the
second disposition exceeds actual payments made under the installment sale.
1. If this results in recognized gain to the intiail seller, subsequent
payments actually rec’d by the seller are recovered tax-free until they
have equaled amount realized from the resale which resulted in the
accelerated recognition of the gain.
c. § 453(e)(2): the rule applies only w/r/t second dispositions occurring within 2 years of
the initial installment sale.
d. § 453(e)(3): If the second disposition occurs, the initial seller will be treated as receiving
the EXCESS OF
i. the lower of:
1. 2nd seller’s AR on the 2nd disposition, or
2. 1st seller’s sale price
ii. OVER
1. Aggregate payments received w/r/t first disposition before the close of
that year, plus
2. Aggregate payments treated as received
e. After determining the amount deemed received, apply inclusion ratio
f. Problem 43, 44
9. Disposing of property to a related party in return for a note
a. In general, the installment method is unavailable in the case of installment sales of
depreciable property between related persons.
i. Related persons defined in § 1239(b)
1. Controlled entity & taxpayer are related parties
a. § 1239(c): Controlled entity= a corp more than 50% owned
directly or indirectly by such person
i. Constructive ownership rules of § 267(c) (except (3))
apply
b. 453(g) says that all payments to be received shall be treated as payment in year of
disposition.
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i. This rule prevents deferring the gain & recycling the depreciation. It otherwise
creates a mismatch of income & deductions (gain & depreciation deduction)
c. Problem 45
10. Special Rules for Non-dealers
a. § 453A(d): Pledging notes as security for the loan
i. If you’d actually disposed of notes, you’d recognize gain.
ii. § 453A says that pledging is the same sort of “turning notes into liquid cash” & it
is therefore an appropriate time to impose tax liability in certain circumstances
1. § 453A(d) says treat it as a payment at the time the indebtedness
becomes secured indebtedness or the time the proceeds of the
indebtedness are received by the taxpayer
b. § 453A(b): If installment obligation $150k or less, §453A doesn’t apply.
i. If installment note is over $150k, if you pledge it as security for a loan it will
trigger inclusion & it will be treated as a payment received under § 453A(d)(1)
c. When you collect later payments, the amount coming in as actual payments will not be
taxed, up to the amount previously taxed.
i. After that, you go back to the regular GP ratio
d. In limited circumstances, the taxpayer must pay interest on the deferred tax liability
attributable to the § 453A installment obligation.
i. § 453A(b)(2) requires interest payments on obligations exceeding 5 mil.
ii. § 453A(c)(2)(B) tells you what interest rate to use
iii. § 453A(c)(3) tells you what tax rate to use
1. Notice difference for capital gains
iv. § 453 is like getting a 0% interest loan on the tax liability owed on those gains.
v. § 453A is essentially a partial taking away of that deferral benefit. It is no longer
a 0% loan. It is now a loan with interest.
vi. §453A(c)(3) & (4) gives you the benefit of having a $5,000,000 bar before you
are subject to the interest charge.
e. Example Problem
i. Sell your piece of property for a gain of $20 million with a zero basis. Year 1,
disposition, there is no payment. Year 2, payment of 10 million, and Year 4,
payment of 10 million received.
ii. Assuming nothing kicks you out of 453 , what happens when you receive the
first 10 million?
1. GP ratio is 100% (20/20)
2. You include the 10 million in year 1 and the other 10 million in year 4.
3. Assuming a 30% rate of tax, you’ve deferred tax of 3 million from each
payment.
iii. In the absence of 453, in year 1, you’d have tax liability of $6 million.
iv. Assuming § 453A imposes 10% tax:
1. In year 1, you’d have 600k of interest (6 mil. * .10)
2. In year 2, you are still deferring 3 million worth of tax, b/c have received
only one of the payments, so you pay interest of 300,000 in year 2
3. Same in year 3
4. At end of year 4, you’ve paid all tax liability, so you pay no interest.
f. Problem 46
11. Installment Obligations & Like Kind Exchanges
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a. In a like kind exchange in which an installment obligation is part of the boot received, §
453(f)(6) provides that:
i. The like kind property is not treated as a payment
ii. The gross profit ratio is specially determined:
1. Total K price is reduced by the amount of LK property received
2. Total GP reduced by the amount of gain not recognized under § 1031
b. Problem 47
Original Issue Discount
1. Original Issue Discount Code provisions impute an interest equivalent- called OID- to debt
instruments that do not bear an adequate rate of interest, and require this interest equivalent
be included in income on a current basis
a. The difference in face & purchase price is interest and can’t be treated as anything else
b. Takes the cash method taxpayer & puts them on an accrual method w/r/t that interest
c. This means that the TP, even though they don’t receive actual interest payments, will
have to take into account that interest component over time.
d. The interest is to accrue economically (compounded regularly at stated intervals & at a
constant interest rate)
2. Interest rates
a. If the market sets the rates, such as with bonds, its easy to determine the interest rate
b. But with things like sale of property for a note receivable without stated interest, it is
more difficult to tell what portion of the selling price is interest, b/c there is no market
rate.
i. In those instances, the statute says we are to use a certain interest rate.
ii. Once you know the interest rate, term, & the end price, you can discount it to
PV, which will be the sales price of the property
3. Mechanics of § 1272 & 1273
a. 1273 tells us how much interest there is
b. Then go back to 1272: tells how to include it
4. § 1273: Determination of OID
a. OID= the excess of redemption price at maturity over the issue price
i. Redemption price at maturity: all payments you are going to receive at maturity
1. Ex: sell a 10 mil bond for 4 mil., 10 years. Redemption price is 10 mil.
2. Ex 2: bond could also include some stated interest to be paid at
maturity. That stated interest to be received is also included in the
redemption price
3. Redemption price does NOT include stated interest which is paid at
least annually.
ii. Issue price: defined in various ways under § 1273(b)
1. Publicly offered debt instruments not issued for property: issue price
will be the initial offering price to public
2. Debt which is unique between lender & borrower: issue price is
whatever the price of the bond is
3. Debt issued for publicly traded property: issue price is FMV
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5.
6.
7.
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4. NOTICE: This excludes debt which is issued for property not publicly
traded
b. § 1273(a)(3)De minimis rule: OID is treated as ZERO if OID is less than ¼% of the stated
redemption price at maturity, multiplied by # of years to maturity
§ 1272: Current inclusion in Income of OID
a. § 1272(a)(1): The holder of any debt instrument having OID must currently include the
earned portion in income as OI
i. Debt instrument includes bond, debenture, note, certificate, etc.
ii. Once included, increases AB of bond
b. Current inclusion is calculated using a constant interest rate, compounded semiannually, for the period to maturity
c. Tells us that every year, interest is to be included by ultimate recipient, even though
don’t get currently; and payor gets current interest deduction
d. Exceptions to the inclusion requirement:
i. See § 1272(a)(2)
ii. § 1272(c)(1): Does not apply when debt instrument is purchased at a premium
(for an amount in excess of principal)
Qualified Stated Interest
a. If the interest is regularly paid, at least annually, it is not included in the redemption
price. § 1273 (a)(2)
i. Davis says it doesn’t have to be a fixed rate: could be prime + 2, etc., so long as
you refer to some externally stated interest rate
Problem 48
§ 1274: determination of issue price in the case of debt instruments issued for property
a. Issue price of where debt instrument is issued for property logically should be FMV.
i. But where it’s not publicly traded property, it’s often hard to determine FMV
b. 1274 defines issue price
i. Once we know issue price, you can know your OID (redemption price - issue
price)
ii. And once you have OID, you go to 1272.
1. Include interest as it accrues economically over time
c. It’s Congress saying they don’t trust parties to determine FMV & they don’t want to
administratively have to determine FMV.
i. So, they set a min. interest % which should be charged, allowing you to discount
the sales price to present value to determine issue price
ii. IR will be lower than rate used by TP, issue price will be higher and OID less
d. Determining appropriate interest rate
i. § 1274(d): Provided by the Government in AFRs - look for applicable rate
1. Reg. § 1.1274-4(a)(1): Use the lowest applicable Federal rate during
either:
a. The 3-mo. period ending with the month the sale or exchange
occurs, or
b. The three month period ending with the month in which there
is a binding contract for the sale or exchange
e. § 1274(a): If there is adequately stated interest, the issue price = principal amount
i. If not adequately stated interest: issue price= imputed principal amount
1. Imputed principal amount= sum of present value of all payments due
f. Debt Instruments to which §1274 applies:
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9.
10.
11.
12.
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i. Applies to any debt instrument given in consideration for sale/exchange of
property IF stated redemption price at maturity exceeds:
1. Stated principal amount, where there is adequately stated interest, OR
a. There is adequately stated interest if the stated principal
amount is less than or equal to the imputed principal amount
2. Imputed principal amount, in any other case
3. AND where some or all of the payments are due more than 6 mo. after
date of sale/exchange
4. * Stated < or = imputed  issue price= stated b/c adequately stated int.
5. * Imputed < stated  issue price = present value
ii. If you don’t have adequately stated interest paid currently, then §1274 will
apply.
g. Problem 49
h. When adequate interest is charged & paid currently there is no OID
i. Exception to 1274
i. Sales of principal residence & certain farm sale not subject to 1274
ii. Nor sales involving Any debt instrument arising from the sale or exchange of
property if the sum of the following amounts does not exceed $250,000
Special Rules: Cash Method Election of § 1274A- the 2M rule
a. (c) Election to use cash method where state principal < $2M- Requirements:
i. Qualified debt instrument
ii. Cannot be new §38 property (not tangible personal property)
iii. Stated principal cannot exceed $2M
iv. Seller must not use accrual method
v. Property sold must not be dealer property
vi. 1274 must otherwise be applicable
vii. Seller and purchaser must jointly elect to use cash method
b. Seller takes unstated interest computed under 483 as income as payments are made;
buyer gets deductions as interest is paid
Interest Rate Limitation on Qualifying Sales of $2.8M or Less
a. §1274A(a): In the case of any qualified debt instrument, discount rate under 1274 or
483 is limited to 9% compounded semiannually (so if test rate= 10%, use 9%)
i. Qualifying Debt Instrument: Stated Principal Amount is less than $2.8M and
property is not new §38 property
b. If the stated principal amount were 2m or less, not only could the 9% limitation apply,
but the cash method election of § 1274A(c) could also apply.
Interest Rate Limitation on Certain Land Transfers Between Related Parties
a. In determining unstated interest on a sale of land between family members, the max
discount rate is 6%, semiannually
b. Does not apply if qualifying sales between individuals sales in calendar year > $500k
Personal Property
a. 1274 and 483 do not apply to obligor on a deferred-payment sale of personal use
property
i. Property not used in T/B or for income producing purposes
ii. Deduct OID when it is paid, not as it accrues
Unstated Interest: §483, when sales less than $250k
a. When the total payments do not exceed $25,000, § 1274 does NOT apply.
i. But if no interest is being charged, it must still be “imputed”
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b. Imputed Interest under § 483 is called unstated interest
c. Unlike OID, interest included in income based on TP’s regular method of accounting, &
cash method TP includes upon receipt or constructive receipt.
d. Determine if there is unstated interest: 483(c)(1)
i. 1. Is there a deferred payment?
1. 483 may apply to any payment on account of sale/exchange due > 6mos
later, where at least 1 payment due > 1 yr after sale
ii. 2. Is there total unstated interest under this contract?
1. Unstated interest = Total deferred payments due under the K – Present
values of such payments and any interest payments due
a. Present value determined using test rate
iii. 3. Unstated interest earned same as OID by using test rate, but not included as
income by cash method taxpayer until payment is made
e. 483 does NOT apply to cash-for-debt instrument deals
Tax Consequences of Divorce
1. Three different kinds of payments we are concerned with upon divorce:
a. Alimony: Spousal support
b. Child support
c. Property Settlements: division of property b/t economic owners
2. § 1041: transfers b/t spouses or incident to divorce are not appropriate times to impose tax
consequences
3. Child Support
a. In an intact family, you only get the dependency exemption. No deduction for
supporting your own children.
b. Upon divorce, the same basic tax results follow. Still no deduction for supporting your
own children.
i. Except for § 152 exemption- custodial parent gets this deduction, unless
specifically agreed otherwise
c. Under §152, even though we have default rule, the parties can agree to shift the
deduction to noncustodial parent (might agree to this if the noncustodial parent was in
the higher tax bracket, making the deduction more valuable to that parent)
i. To shift this dependency exemption, written agreement must be attached to the
return.
ii. Custodial parent might seek a little more child support in return for giving up
that deduction
4. Alimony
a. If alimony payments are being made, the couple is still effectively sharing their income
b. If you didn’t allow the deduction, you’d be taxing the person who earned it while the
benefit of those dollars actually went to the payee spouse
c. Now, payor spouse gets to deduct alimony payments & payee includes it in income.
i. This is still ‘splitting income.’ It is an advantage because recipient spouse is
probably in a lower tax bracket & because you get to stack that income in 2
separate brackets, instead of all in one single person bracket.
d. You can elect out of these default rules.
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i. Thus, no deduction by payor, no inclusion by payee
e. Problems arising with alimony
i. Taxpayers are tempted to manipulate these rules & try to disguise all of it as
alimony (deductible) as opposed to child support & property settlement (nondeductible)
1. Nontax risks of this to payor?
a. If state-mandated amount of child support, they could come
back & claim they weren’t getting any. You’d have unclean
hands & couldn’t really claim you were already paying it, but it
was just really disguised to defraud gov’t.
b. If child wants to change custody, then payor would also want to
lower it but would be faced with same dilemma.
2. Nontax risks to payee?
a. If payee gets a higher paying job, payor will want to reduce
ii. Alimony must end on death of payee spouse. If you convert a property
settlement to a periodic alimony payment, and that payee spouse dies before
collecting all of these payments, then the estate will be barred from getting the
remainder
f. § 71 Requirements of alimony:
i. Payment in cash
ii. Received by or on behalf of spouse
iii. Under divorce or separation instrument
iv. Which doesn’t designate it as not includible in GI and not allowable as
deduction
v. If spouses are legally separated under divorce or separate maintenance, may
not be members of same household; AND
1. But notice, if you don’t meet the statutory requirements under this
element, then you can still live in the same household.
vi. The payor spouse must have no obligation to make payments for any period
after payee’s death.
g. § 71(b)(2) Divorce or separation instrument:
i. A decree of divorce or separate maintenance or a written instrument incident to
such a decree;
ii. A written separation agreement; or
iii. A decree (not included in (A) requiring a spouse to make payments for the
support/maint. of other spouse
iv. *MUST have an agreement, and it MUST be in writing
h. Child support under § 71
i. § 71(c): Subsection (a) doesn’t apply to child support
ii. (c)(2): if it’s a contingency related to the child but it is called alimony, although
it’s not called child support, it will be treated as child support
iii. Problem 51
i. § 71(f): Front loading
i. When there are larger payments in early years which drop off sharply, it looks
more like a property settlement.
ii. Code says that unless payments are relatively equal, it won’t really be treated as
alimony
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iii. Payments characterized as excess alimony payments, having been included by
the payee & deducted by the payor in a prior year, are “recaptured” in the
subsequent year & the tax treatment previously afforded is reversed
1. The payor is forced to give back the excess deduction in the year the
determination of excess is made.
2. The payee gets a later-year deduction on account of the prior year
excess included in income.
iv. Recapture of excess alimony payments are recaptured ONLY in the third postseparation year
1. Post separation year
a. First post-sep. year is the first calendar year in which the payor
spouse paid the payee spouse alimonly or maintenance
payments to which § 71 applies.
b. The 2nd and third post-sep. years are the 1st and 2nd
succeeding years.
2. I.e., based on the alimony paid in these 3 years, it may be determined in
year 3 that excess alimony was paid in years 1 and 2. If so, excess is
recaptured in year 3.
v. To determine excess:
1. Per § 71(f)(4), you can reduce your payments about 15,000 per year and
not get into trouble
2. § 71(f)(3) and(f)(4) provide calculation of excess payment for years 1 & 2
vi. Problem 50
Problem 52, 53
KIDDIE TAX
1. Basic idea behind the “kiddie tax”
a. Basically says that any unearned income (with small exceptions) will be taxed at parents
rates
i. Note: earned income will be taxed to the child @ child’s rate
b. This prevents adults in the economic unit to shift income to children for lower rate
2. Coverage of the “kiddie tax” under § 1(g)(2)
a. A child that is not 18 years old
b. A child that is over 18 but under 24 who (1) is in school & (2) doesn’t provide over ½ of
their own support
3. Mechanics
a. § 1(g)(1) makes sure that, if the child’s income is higher than parents, child will pay at
child’s own rates
b. Child’s share of allocable parental tax: if you have multiple kids, then you figure out the
all of kids income taxed at parents rate, calculate allocable parental tax, & divvy among
the kids
c. What is taxed at the parent’s rate? The NET UNEARNED INCOME
i. § 1(g)(4): Net unearned income= EXCESS of
1. The AGI for the tax year which is not attributable to earned income
OVER SUM OF
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a. The standard deduction under § 63(c)(5)(A) plus
b. The greater of
i. The standard deduction or
ii. Child’s itemized deductions
ii. Earned income= compensation for personal services
d. § 151(d)(2) provides that, if the parent claims the child as a dependent, the child is only
allowed a limited deduction under§ 63(c)(5)(A)
i. The child’s standard deduction may not exceed the greater of:
1. For 2010, it’s $850 OR
2. $250 plus the individual’s earned income
ii. So basically the unearned income taxed at the parent’s level is that which
exceeds $1,700 (assuming you used the two $850 shares under 63(c)(5)(A))
e. Determine parent’s tax on their income normally, then their tax on their income plus
kids unearned income, and the difference in those two tax amounts is what is divvied up
between the kids.
i. If income all falls w/in one tax bracket, you take kids net unearned income x
marginal bracket, & that’s the tax liability related to child.
4. Problem 54 explains well
MOVING EXPENSES
1. § 217 provides a deduction for moving expenses
a. § 217 requirements
i. You must move a certain distance away: at least 50 miles further from former
residence than was his former principal place of work, or if no former principal
place of wokr, at least 50 miles from former residence
1. This makes sure there is some business motive from the move, and not
just because you want to move to another neighborhood
2. Boils down current commute + 50 miles
3. And if no current commute, 50 miles from residence
ii. Must meet a timing requirement
1. Must work a certain # of weeks over next 1 year or 2 years (depending
on whether employee or self-employed)
2. Exceptions for death, disability, involuntary termination
b. Current list of what is deductible:
i. Moving of taxpayer, household members, and household goods & effects, from
former to new residence
ii. Traveling, including lodging, from former to new residence
iii. What doesn’t qualify:
1. Meal costs
2. Travel to look for housing
c. § 217 deductions are above the line deductions
Child Care Expenses
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1. § 21 allows for a limited child care credit
a. It contemplates 2 portions: portion which allow parents to work & also portion which
parent would have expended in caring for child anyway
b. To calculate actual credit, must first determine how much you have in qualified
expenses & what the % portion you receive is, based off of your AGI.
c. Progressive credit: More benefit for lower income people, less benefit for higher inc.
2. § 21 applies only if there are “employment related expenses” and one or more “qualifying
individuals”
a. Employment related expenses: expenses for household services & for the care of a
qualifying individual, incurred to enable the TP to be gainfully employed
b. Qualifying individual: will be either:
i. a dependent of the TP under 13 for whom the TP is eligible to claim a
dependency exemption,
ii. a dependent of the TP who is physically or mentally handicapped & resides with
TP, or
iii. the spouse of the TP, if the spouse physically or mentally handicapped & resides
with TP
c. §152(c) defines a qualifying child as any individual who:
i. is a child, grandchild, brother, sister, step-sibling, or descendant of such sibling
or step-sibling,
ii. who has same principal place of abode as TP for more than ½ of taxable year
iii. Who has not attained age of 19 or is a student under 24
iv. Who has not provided over ½ of their own support for the calendar year in
which taxable year for TP begins
v. Who has not filed a joint return with a spouse
d. §152(d) defines a qualifying relative as:
i. See code §
ii. If you have an elderly parent living with one child but who is supported by all
the kids, § 152(d)(3) says that IF you have a multiple support agreement, choose
who gets dependency deduction
e. Dependent care centers defined in (b)(2)(C) & (D)
3. § 21 is a nonrefundable credit
a. Nonrefundable: reduces tax liability dollar-for-dollar down to zero, but no refund for
extra amount of credit that you might have
b. Refundable: Refund for excess credit, above tax liability
4. Dollar limitations under § 21(c)
a. $3,000 for one child/ $6,000 for 2+
b. Phase out at upper income levels
c. Limited by the lesser of certain incomes (see statute
5. Calculation of credit
a. Calculate applicable percentage:
i. 35% reduced (but not below 20%) by 1 percentage point for each $2,000 or
fraction thereof by which the TP’s AGI exceeds 15,000
1. Always round up with increments of 2,000
b. Multiple dollar amount available x applicable percentage
6. Employer paid child care expenses
a. § 129 excludes from GI of an employee amounts paid or incurred by an employer
pursuant to a dependent care assistance program.
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i. The exclusion is limited to $5,000
b. 129 exclusion may be better for those in higher income tax brackets, especially if credit
is less than marginal rate. Exclusion would be worth whatever marginal rate is.
7. Problem 56
LEGAL EXPENSES
1. Standard: look at origin of claim
a. Does it lie in something which is a personal expense?
b. Does it originate from a business or profit-seeking transaction?
2. Problem 57
3. Example
a. Oxford attorney driving to see a Tupelo client who gets into an accident on the way b/c
of attorney’s negligence: T/B related. Although negligence can be somewhat personal, it
doesn’t overcome the fact that the origin of the claim is T/B related.
b. Question: Is this something common in life of T/B and therefore makes it T/B related?
SCHOLARSHIPS & PRIZES
1. Prizes & Awards
a. § 74 generally includes all prizes & awards, with narrow exceptions
b. Exclusions
i. Certain awards are excludable under 74 if given away to a governmental unit or
charitable institution
ii. § 74 allows an exclusion for “employee achievement awards”
c. Argument is usually over how much to include, not whether it is included
i. You include FAIR MARKET VALUE (willing buyer, willing seller, etc….) at the time
of receipt
ii. But what is FMV?
1. Generally, look at retail, not wholesale or cost.
iii. Problem 58
d. Donating prizes to qualified governmental unit or charity
i. If you can designate & exclude, you avoid limits of §170 (which prevents whole
inclusion & only partial charitable contrib.. deduction (b/c of reductions in 170))
e. Certain “employee achievement awards” are not excluded
i. See 74(c) & 274(j): deduction limit is $400 if not a qualified plan & $1,600 if
qualified plan.
ii. If employer is limited by one of these deduction limits, that will be the
maximum exclusion for employee-recipient.
1. Thus, any excess will be reported as income
iii. Problem 59
2. Scholarships
a. § 117(a): Gross income does not include qualified scholarships received by an individual
who is a candidate for a degree at an educational organization.
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b. § 117(b): Excludable as scholarship is tuition and fees, other fees (ex: lab), books,
supplies, and equipment required for courses
i. Leaves out room & board
ii. If you get a general scholarship, there is no tracing requirement, as long as you
can specifically show you spent that scholarship on the qualified & related
expenses
c. 117(c) says that (a) does not apply to payments for teaching, research, or other services
the student it required to perform as a condition for receiving the scholarship
d. Also, S.Ct. said you are not a student if you are a resident (ex: medical resident)
e. Problem 60, 62
f. Athletic Scholarships
i. Rev. Rul. 77-263 is what universities rely on that these athletic scholarships are
not for services & thus not included in GI.
ii. RR 77-263 says they really have to be student athletes & must not be required
to perform, BUT looks at it on a yearly basis, only
iii. Problem 61
EDUCATION EXPENSES
1. Deductibility of Educational Expenses under § 162
a. An individual may deduct educational expenses that either:
i. Maintain or improve skills required in employment or T/B, or
ii. Meet express requirements by his employer or required by law necessary to
retain his established employment relationship, status, or compensation.
b. An expense is NOT deductible under § 162 if it either:
i. Meets the minimum educational requirements for qualification in the TP’s
employment or trade or business, or
ii. Qualifies the TP for a new T/B.
c. Note: even if you fail § 162, you can still look at other places like 222 (limited
deductibility), 25A(a) & (c) (limited credit ability) & 221 (interest on loan deductible,
limited availability based on AGI)
d. Problem 62
2. Skills/Maintenance or Employer-Requirement Test of Reg. § 1.162-5(a)
Skills/Maintenance
a. Refresher courses or continuing education courses, as well as academic or vocational
courses, fall within this category of expenses
b. The taxpayer must be established in carrying on a trade or business at the time the
educational expense in question is incurred in order for it to be deductible
i. Wassenaar: TP who hadn’t practiced as an attorney couldn’t deduct cost of LLM
ii. Raseen : 1 year’s employment after college was not enough to sufficiently
establish TP in T/B of engineering
1. Want to know the min. requirements, including informal requirements
iii. Ruehmann: maybe even a short period of practice will establish you in T/B
1. (Ruehmann: less than 1 year of practice, but already had license in hand
c. Temporary abandonment/withdrawal from the T/B when educational expenses are
incurred will not disqualify you from being in the T/B
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3.
4.
5.
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i. Rev. Rul. 68-591: a suspension of employment for a year or less will be temp.
ii. BUT Tax Court: There is no magic one year limit; facts & circumstances test
iii. Furner: 18 months was temporary
Employer-Requirement
d. This test only applies with respect to “express requirements” which are imposed for a
bona fide business purpose
e. Only the minimum education necessary for job, status, or pay retention qualifies
i. But excess may satisfy skills/maintenance test
The Minimum-Educational-Requirements & New-Trade-or-Business tests of Reg. § 1.162-5(b)
a. A TP may not deduct educational expenses required to meet min. educational
requirements for qualification in his employment or T/B
i. But once these requirements are met, the expense incurred to satisfy a
subsequent change in the requirements WILL be deductible.
b. A TP may not deduct educational expenses part of a program of study which will qualify
him for a new trade or business
i. OBJECTIVE TEST- don’t care that it wasn’t TP’s intent to qualify for new T/B
ii. A mere change of duties is not equivalent to a new trade or business if the new
duties involve “the same general type of work” as the present employment
1. Compare tasks & activities the TP is qualified to perform before the
acquisition of a particular title or degree, and those after
a. IF significantly different, no educational expense deduction
iii. Courts consistently say BA is min. req. for any host of T/B, so getting a BA
qualifies you for a new TB & therefore not deductible, and it’s also personal
iv. Sharon: Mere expansion” of an existing T/B v. entering into new T/B
1. Sitting for the bar in another state qualifies as a NEW trade or business
2. Limited to attorneys
3. Can’t deduct bar costs, but can capitalize over life expectancy
v. Mallick: TP required by employer to get BA, & court still denied deduction. Even
though current employer required it to get same position she had, it still also
qualified her for other TB
vi. Glasgow case: A minister took all sorts of courses, & all were linked to his skills
of being a pastor, b/c the court said skills required of a pastor were many &
varied
vii. Problem 64
Travel Expenses
a. § 274(m)(2) disallows any deduction for travel as a form of education.
b. BUT travel expenses and meals & lodging are deductible where an individual travels
away from home “primarily” to obtain education & those education expenses are
deductible (Reg. § 1.162-5(e)(1))
Hope Scholarship Credit
a. §25A: Tax credit of up to $1,500 per student for a max. of 2 years for the qualified
tuition and related expenses of higher education
i. Eligible students: those enrolled at least half-time in one of the first 2 years of
post-secondary education in a program leading to a degree, certificate, or other
recognized educational credential.
ii. Credit is phased out for taxpayers with certain modified AGI levels
Lifetime Learning Credit
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7.
8.
9.
10.
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a. §25A(c): Tax credit of up to 2,000 per taxpayer for qualified tuition and related expenses
of higher education
i. Phaseout rules & AGI limits of Hope Credit apply
b. Not limited to a max. # of years or to the first 2 years of higher education
i. Graduate level education may qualify
c.
The lifetime Learning Credit and the Hope Scholarship Credit CANNOT be taken in the same
year.
Coverdell Education Savings Accounts (§ 530)
a. Trust accounts which may be created for any child under 18 for the purpose of paying
the child’s qualified higher education expenses or qualified elementary and secondary
education expenses
b. Per beneficiary, a maximum amount of $2,000 per year may be contributed
i. Must be CASH contributions
c. Any fund balance must be distributed to the beneficiary within 30 days of 30th birthday
d. Qualified higher education expenses include tuition, fees, academic tutoring, special
needs services, books, supplies, computers & equipment, and room, board, uniforms,
and transportion
i. f they are taken out for non-educational expenses, you are taxed on a portion of
the earnings (but not on own contributions, b/c already taxed) & pay a penalty
e. ANY individual can contribute to a child’s ESA, up to the $2,000 max.
i. EXCEPT: Modified AGI phase out: no contribution allowed if AGI over 110/220
f. Contributions to a Coverdell ESA are not deductible
i. But grow tax-free and are withdrawn tax-free, so long as it does not exceed the
child’s qualified higher ed. expenses in the year of withdrawal
g. Unused portions of a Coverdell may be rolled over to other ESAs for other children
Deduction for Qualified Higher Education Expenses
a. § 62(a)(18) & § 222 provides for an ATL deduction for qualified higher education
expenses
b. See discussion in book, pg 443
Interest Deductions for Interest on Qualified Education Loans
a. § 221(a): ATL deduction for interest paid by a taxpayer on any qualified education loan
(§ 62(a)(17)), up ton $2,500.
i. Phased out for certain AGI levels
Section 529 Qualified Tuition Plans
a. § 529 provides for deferral on income earned on amounts placed in qualified stateauthorized pre-paid tuition plans or college savings accounts to cover higher ed. exp.
i. Notice: doesn’t cover pre-college education, like Coverdell did
b. Two types:
i. State pre-payment plans: restricts where child can go to school
ii. Qualified tuition plans: more like Coverdell, without same limits
c. There is no limit imposed for higher AGIs
d. Qualified higher education expenses include expenses for tuition, fees, books, supplies,
equipment, and certain room & board expenses.
e. Overall limit on contributions which cannot be more than qualified education expense
to provide for beneficiary.
i. But can make contributions in varying amounts in different years.
f. Contributions are not deductible, but
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i. Earnings earned tax free.
ii. Withdrawals come out tax free, as long as being used to pay for qualified
education expenses.
1. If you take out too much from this plan (more than education
expenses), the excess will be divvied between basis/contribution &
earnings, and the earnings portion will be taxed & plus you’ll pay a 10%
penalty.
2. They can be rolled over for another beneficiary (family members,
defined very broadly).
g. Taxpayers may claim a Hope Credit or Lifetime Learning Credit at the same time they
claim a § 529 exclusion, both on the same student, as long as the distributions from the
two are not used for the same expenses
12. Educational Assistance Programs
a. §127: Employer payments for educational assistance to an employee are excluded from
employee’s GI, up to a max of $5,250 per year
DEFERRED COMPENSATION: NONQUALIFIED PLANS
1. § 404(a) governs an employer’s deduction under any form of nonqualified deferred
compensation plan.
2. The employer receives a deduction only when the employee recognizes income from the
arrangement
3. Unfunded Plans
a. Agreement is merely a contractual obligation on the corporation’s behalf to make the
payments to the employee when due, and the amounts in the reserve are not held in
trust for the taxpayer
b. Unfunded plans, if truly unfunded, are essentially a promise to pay in the future
i. Under normal accounting rules, these are non-events & thus would not be
taxed. You’ve not had anything qualifying as receiving gross income.
c. Employee has a risk of non-payment, albeit low, if employer is stable.
d. Employer doesn’t get deduction until employee actually realizes the income
i. Matching of expenses & deductions
e. If truly no money has been set aside, but employer promises to pay a set amount
whenever employee requests it, the employee will be taxed on receipt or constructive
receipt (cr: not being able to turn back on income available to you).
i. If you could demand payout of an amount of money, you are just ‘turning your
back on it’ over and over and it will be constructive receipt
ii. Ex: employer promises to pay 10% of income of execs and payout will not
happen until X, but employee can get funds at anytime if they pay a 10% penalty
1. This essentially makes the funds available, except for substantial risk of
forfeiture.
2. Usually a substantial risk of forfeiture means there hasn’t been a
transfer.
3. But 409A stepped in & said that it was essentially so available to
employee that it would be taxed as current income
4. Funded Plans
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a. Employer sets aside a set amount of $ in a trust, protected from claims of e’er’s
creditors, and all contributions + earnings will be paid to employee on retirement
b. Employee will be taxed on that when it is set aside on their behalf, even though no
actual receipt of funds by TP.
i. It will be either deemed constructive receipt or the economic benefit is there,
which is treated the same as actual receipt
c. Employer gets deduction in same year in which it is set aside, on the economic benefit
theory
i. But no deduction is allowed unless separate accounts are maintained for each
employee.
5. Rabbi Trusts
a. Defined: an irrevocable trust that allows its assets to be used solely to provide deferred
compensation, EXCEPT the assets remain subject to the claims of the employer’s
creditors in the event of the employer’s bankruptcy or insolvency
i. This exception makes the trust “unfunded” for tax purposes
1. Thus avoiding constructive receipt & economic benefit doctrine
2. But also made the trust risky for employees
a. 4th cir. held the employees were unsecured creditors
ii. TP took position the fact that it was subject to claims of creditors was a
substantial risk of forfeiture, and didn’t include. Gets back to how substantial is
that risk? Large v. small employers & likelihood of them going bankrupt
b. Aggressive techniques cropped up to protect the rabbi trust assets from creditors,
despite the express trust terms
i. Offshore trusts- still subject to creditors claims, but difficult and expensive for
the creditors to reach
ii. Funding triggers based on financial health of employer- ex: if employer
exhibited increased risk of nonpayment, an unfunded plan would provide for
transfer of funds into a Rabbi trust, or if already in a Rabbi, creditors rights
would be eliminated
c. § 409A responded to these two techniques in § 409A(b):
i. Assets set aside in an offshore trust to provide NQ deferred comp. and any
amount which has a trigger based on employer’s financial health will be treated
as property transferred, whether or not the assets are available to satisfy claims
of general creditors.
1. Refers to§ 83, which essentially says that if you get comp. for services
by a transfer of property, it will be included by employee or indep.
contractor at time of transfer of property unless there is a substantial
risk of forfeiture.
a. 409A(b) essentially says that this is not a risk of forfeiture.
What you’ve been doing is not really a risk of forfeiture. We are
going to tell you what a real risk of forfeiture is, and that’s in
409A. You really have to be at risk for general creditors
ii. There is also a 20% penalty + interest charge
6. § 409A
a. §409A requirements place restrictions on the design and operation of nonqualified
deferred compensation plans.
b. 409A(a)(1) sanctions
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i. If a plan fails to comply in form or in operation with § 409A, all compensation
deferred under the plan, past and present, is includible in GI to the extent not
subject to a substantial risk of forfeiture & not previously included in GI
1. “in operation:” if you have a NQP which meets all 409A requirements
but you let a few people get money early, that’s not in operation
ii. Substantial risk of forfeiture: Compensation is subject to SRF if entitlement to
the amount is conditioned on the performance of substantial future services by
any person or the occurrence of a condition related to a purpose of the
compensation & the possibility of forfeiture is substantial.
c. Requirements under 409A(a)(2)-(4)
i. (2) Distribution requirements
1. The compensation may not be distributed earlier than
a. Separation from service
b. Disability
c. Death
d. Specified time under the plan at date of deferral
e. Change in ownership of corp.
f. Unforeseeable emergency (narrowly defiend)
2. This separation from service requirement is qualified; for specified
employees the distribution may not be made before 6 months after the
date of separation from service
a. Specified employees - § 469
b. Average employees don’t have to wait 6 months under this rule
ii. (3) Acceleration of benefits
1. Plan cannot permit acceleration of the time or schedule of any
payment, unless provided by the Service
iii. (4) Deferral Elections
1. An election to defer compensation for services performed during a TY
must be made before the year begins, or within 30 days after the
participant becomes eligible to participate
2. Plan participants can elect to extend the time of payment, but it cannot
take effect until at least 12 months after the election was made
3. In the case of a payment to be made based on separation from service
or scheduled at a specified time, the election must defer the first
scheduled payment for at least five years
7. Inclusion & Deductibility: timing
a. Funded arrangements: If there is a transfer of property for services, employee has to
include in GI when that transfer of property occurs, unless there is a substantial risk of
forfeiture
i. If/when substantial risk of forfeiture lapses, taxed.
ii. Easy to see when employer agrees to give stock shares in exchange for
employee’s service for 5 years.
1. That would be included in 5 years- when that substantial risk of
forfeiture lapses.
2. Doesn’t matter if employee has to pay some portion of price of stock.
Difference in share price & what they pay just determines how much
they include in GI
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Tax II - Professor Davis
b. “Unfunded” plans: money available, but available to general creditors; not taxable to
employee until receipt or constructive receipt
i. 409(a) says unless plan meets its requirements, even if unfunded, there will be
CURRENT inclusion; i.e., unless it meets those requirements, it looks very
available to TP & thus constructive receipt
c. Under § 404(a)(5), “other plans” (anything which is not qualified) are not deductible by
employee includes in income
d. So, 83 & 409(a) tells when employee includes & 404(a) tells you when employer deducts
8. Transfer of Stock Options instead of Stock, itself
a. Example: Instead of getting share of stock in for 5 years service, employer gives
employee option to purchase stock, period. This is completely without substantial risk
of forfeiture.
b. Issue: When do you include that in GI?
i. When has there been a transfer of property?
1. If stock publicly traded: Option is easily valued. For options with a
‘readily ascertainable value’, they work just like stock
a. When option is exercised, you are just completing your
purchase of the stock, and it is not generally a realization event.
2. Most options don’t have a readily ascertainable value (ex: for small
corps or non-public companies).
a. In that case, the transfer of property does NOT happen until the
option is exercised. The granting of the option is NOT the
transfer of the property; it is when the stock actually transfers
that it is the transfer of property.
c. How much do you include? Difference in FMV & exercise price
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