chapter 2 p.45 characteristics of income · an accretion to wealth: 1) accrued but unrealized...

Chapter 2 p.45

Characteristics of Income

How is the concept of “income” defined?

Consider the Haig-Simons definition:

“Accession to wealth” consists of

1) Consumption (occurring during the

measurement period), and

2) Increase (if any) of the value of

property rights (during the

measurement period).

10/24/2013 (c) William P. Streng 1

Basic Code Structure &

Tax Code Definition

a) Code §1 – the tax imposing provision (for

individuals) & Code §11 (for corporations).

b) §61 - statutory definition of “gross income” –

all income “from whatever source derived.”

§61(a)(1) compensation

§61(a)(2) business income

§61(a)(3) property gains

§61(a)(4) interest, etc.

c) §63(a) – defining “taxable income”10/24/2013 (c) William P. Streng 2

Income Definitional

Considerations p.46-47

Is gross income limited to income from “labor”

or “capital”?

What about “windfalls”? This does increase

one’s liquidity. See Glenshaw Glass (later, p. 78)

in GI inclusion of windfalls.

How far should the income tax base be

broadened? Any need to consider IRS

implementation and administrative

considerations?


Income Definitional

Considerations, continued

Consider whether the following might constitute

an accretion to wealth:

1) Accrued but unrealized appreciation

2) Value of an “underpriced & subsidized”

education at college/law school.

3) Value of one’s leisure – since could have been

earning income if not at leisure.


Noncash Benefits p.48

Reg. § 1.61-1(a) – gross income includes income

realized in any form, whether money, property

or services. Income may be realized in the form

of services, meals, accommodations, corporate

stock, a partnership interest or other property.

What about barter transactions?

What are the administrative problems?

But, consider importance of “economic

substance,” rather than mere “form.”


Meals & Lodging Provided

to Employees p.49

Example 1: Employer pays rent directly to the

apartment owner for occupancy of apartment by

the employee.

Can this rent be excluded from GI since not

received in cash by the employee? Should this

device enable her federal income tax savings?

Should the employer’s deduction be impacted?

What about other direct, substitute payments

for compensation? E.g., an auto or stock?

See Old Colony Trust case, next slide10/24/2013 (c) William P. Streng 6

Old Colony Trust Co.

p.50

Employer pays the employee’s tax liability, i.e.,

employer pays all the employee’s “debt” to IRS.

What happens to the employee’s “net worth”?

Held: Discharge of this debt of the employee

was gross income to the employee.

Really a three party transaction (also IRS)?

Note: Does the corporate resolution (and the

payment obligation) present a “pyramiding”

problem? What is that?

What is the “bracket stacking” problem?10/24/2013 (c) William P. Streng 7

Payment for a Deferred

Annuity Contract p.50

Example 2: Employer pays $10,000 to insurance

company which issues obligation to pay

employee $50,000 when reaching age 70.

Her rights are fully vested (i.e., she gets money

even if she is subsequently fired).

She lives to age 70 and receives the payment.

Does she have (any) gross income? When? At

issuance? Accrual each year? When cash paid?

What does the employee receive to be included

in gross income? See Drescher case, Ch. 3.10/24/2013 (c) William P. Streng 8

Employer Owned Lodging

Used by Employee p.51

Example 3: Employer provides to an employee

the free use of an employer owned apartment

(which has a rental value of $1,000 per month).

How determine this fair market value at $1,000

per month? Is this value (in the form of

apartment availability) includible in the

employee’s gross income?

Does the employer have both a wage expense

deduction and gross income (as property

owner)?10/24/2013 (c) William P. Streng 9

Benaglia v. Commr.

“Tax Common Law”? P.52

Taxpayer hired as manager of a hotel & lived

(with spouse) in the hotel. Meals were provided

without charge. Gross income to manager for

the FMV of these items (& to wife)?

Held: These items were primarily “for the

convenience of the employer” and, therefore, no

GI inclusion. Cf., person who must pay for food

– a violation of concepts of “horizontal equity”?

If inclusion: (1) retail fair market value; (2) cost

to employer; (3) subjective value to taxpayer? 10/24/2013 (c) William P. Streng 10

Benaglia v. Commr.

P.52 - Dissent

Dissent notes the employment contract letter:

He says one of the terms is to include

availability of living quarters & meals.

Should this be “deal point” be conclusive on

gross income inclusion?

How much? A valuation issue: but, he states

his cost to live elsewhere would be $3,600. Is

this an appropriate valuation?

What about the benefit to the wife?


Code §119 Meals &

Lodging p.56

Tax provision for a statutory exclusion.

Requirements for a Code §119 exclusion:

1) For the convenience of employer; &

2) On the business premises. What are the

employer’s business premises?

Tax planning by the employment attorney:

How negotiate the employee’s employment

contract (considering the §119 potential

application)?


Kowalski case,

US Sup. Ct. p.57

Meal cash allowance – not furnished “in kind.”

Therefore, not fitting within Code §119.

But, is a tax “common law” exclusion available

in this situation?

What are the “business premises” for this

purpose for the state troopers?

How structure (if at all) arrangements for the

state troopers to fit within §119?


“Employee” Status

Required for §119 p.56

This treatment is not available to a self-

employed person.

What about §119 for the sole employee of a

corporation entirely owned by the employee?

How then “required” to live in the premises?

Then a “double benefit” for U.S. income tax:

(1) no inclusion in gross income of employee,

but (2) a tax depreciation deduction to the

corporation for the building.


GI Exclusion for Fringe

Benefits - §132 p.59

Statutory exclusion for certain items:

1) No additional cost services - §132(b).

- See §132(h) re others treated as employees,

including parents when air transportation.

- See §132(j) re affiliates of airlines.

- See §132(i) re reciprocal agreements.

2) Employee discounts - §132(c).

- Discount by “gross profit percentage”

- Discount for services @ 20 percent. 10/24/2013 (c) William P. Streng 15

GI Exclusion for Fringe

Benefits - §132, cont.

3) Working condition fringes - §132(d).

- If employee paid, would be a business

expense deduction. Use of company

automobile; security protection;

4) De minimis fringes - §132(e). E.g., use of

employer photocopy machine; periodic meals.

5) Other items, e.g., parking, moving expense

reimbursement, on premises gyms.

§132(j)(1) - Nondiscrimination rules apply for

§132(a)(1)&(2).10/24/2013 (c) William P. Streng 16

“Cafeteria Plans”

§125 p.62

Employee may chose among a variety of

noncash benefits or cash; this rule negates

applicability of the “constructive receipt”

doctrine re receipt of income.

But, no option permitted to take cash.

“Use it or lose it” rule applies at the end of the

year - §125(d)(2)(A), except when a change in

family circumstances.

A non-discrimination rule applies. §125(b ).

Not applicable to deferred compensation plans.10/24/2013 (c) William P. Streng 17

Frequent Flyer Credits

Gross Income? p.63

Frequent flyer credits can be traded for (1)

other airline tickets, (2) flight upgrades, or (3)

other (non-airline) merchandise.

Are these reductions of the cash price of future

flight costs when these credits are earned?

What if (1) the initial travel is for business, paid

by the employer, but (2) employee gets the

mileage credit? Part compensation?

Gross income when other than airline benefits?

Issuance of IRS Form 1099 to account holder?10/24/2013 (c) William P. Streng 18

Haverly case p.65

Benefits from 3rd Party

School official receives unsolicited sample books

for review and possible adoption by the school

and purchase by students. Not items for his

personal consumption.

Inclusion in his gross income? If inclusion, is a

business expense deduction available?

If given to charity (e.g., school’s library) can a

charitable deduction be claimed? Even if no

earlier/contemporaneous inclusion of FMV of

books in GI? See Rev. Rul. 70-498, p. 65.10/24/2013 (c) William P. Streng 19

Health Insurance

p.66

Employers can deduct the cost of medical

insurance provided for employees. §162.

Benefits received by employees are excluded

from their gross income. §106.

This exclusion extends to medical insurance.

Self-employed can the deduct costs of medical

care, including health insurance. §162(l).

See the Tax Expenditure List re cost to USG re

health care benefit exclusions, etc.


Turner v. Commr.

Valuation issue p.67

Taxpayer wins steamship tickets to Argentina.

Tickets are nonrefundable and nontransferable.

But, tickets actually exchanged for other tickets.

What was the value for the tickets received?

The retail price of original tickets was $2,200.

But, tax value was settled for $1,400.

What is the argument supporting a lesser

valuation? Tickets no an essential item to

them?10/24/2013 (c) William P. Streng 21

Other Inclusion/Valuation

Issues p.70

1) Winning the automobile: what GI inclusion

amount?

2) Catching the record-setting baseball:

what inclusion if the baseball is returned?

3) Treasure trove (including sunken ship

treasure – when realized)? Reg. §1.61-14.


Imputed Income

p.71

Consider the imputed rental value received

from occupying one’s own residence (and the

benefit from mortgage interest deduction).

Cf., what income tax result from investing an

equivalent amount in U.S. Treasury bonds?

Same ability to pay for each investment?

But, possible lower rents to the non-home owner

when living in a depreciable apt. building?

Cf., other personal investments: vacation

homes, yachts, paintings10/24/2013 (c) William P. Streng 23

Imputed Income from

Services p.74

Imputed income is derived from one’s services

on a person’s own behalf. Is this GI?

Services for one’s self: lawyer prepares own last

will; individual paints one’s house; or,

tends one’s garden (& harvests vegetables and

flowers).

What about the services provided at home by the

“stay at home spouse”?

Allow a special deduction where spouses both

are working and incurring additional costs?10/24/2013 (c) William P. Streng 24

Barter Transactions

Rev. Rul. 79-24 p.76

1) Swap of lawyer’s services for house

painting. Members of a “barter club.”

2) Receipt of a painting in exchange for free

rent for an apartment.

In each situation the exchanged items are

includible in gross income under §61, as valued

at FMV. Reg. §1.61-2(d)(1).

See §6045 re barter exchanges and required

information reporting.

3) Free checking for a bank account? P.78.10/24/2013 (c) William P. Streng 25

Windfalls & Gifts

Punitive Damages p.78

Glenshaw Glass: Damages recovered for lost

profits plus punitive damages for violations of

anti-trust laws. Were the punitive/exemplary

damages includible in GI? Yes.

Windfalls are within the scope of §61.

Within “income from whatever source derived.”

“Undeniable accessions to wealth.” p.80.

Punishment factor is not relevant.

Cesarini (p.81): cash found in the piano as a

windfall and gross income. Reg. §1.61-14.10/24/2013 (c) William P. Streng 26

Defining the Concept of a

Gift (for income tax) p.82

§102 provides for a GI exclusion for “gifts.”

Even though an accession to wealth? Yes.

But, no deduction to donor for wealth transfer.

Issue: Was the transfer a gift for FIT purposes?

Duberstein, p. 83: Received a Cadillac from a

business associate (Berman) who was thankful

for business tips. Berman deducted the car cost

as a business expense. Tax Court: GI inclusion.

Stanton case, p. 84: Dist. Ct. says gift. Cont.


Duberstein, cont.

U.S. Sup. Ct. p.88

Gift must be made from “detached and

disinterested generosity.”

Deciding this case is to be on tribunal’s

experience with mainsprings of human conduct to

totality of facts of each case. P.88.

Lower Ct. decision to be reversed when “clearly

erroneous” - FRCP 52(a).

Duberstein case was not “clearly erroneous” – it

was based on a compensation event.

Stanton: remand for further proceedings. Cont.10/24/2013 (c) William P. Streng 28

Duberstein, cont.

U.S. Sup. Ct. p.88

Stanton, continued – was trial court’s

determination too sparse? See FRCP Rule 52(a)

re finding facts.

Frankfurter opinion – p. 89: apply a

presumptive rule putting the burden on the

taxpayer to prove the payment has no

relationship with employment.

Therefore, include Stanton’s payment in gross

income?

See Douglas dissent – p. 89.10/24/2013 (c) William P. Streng 29

Business Gift Tax

Analysis Options

Dealing with Duberstein situations:

1) Analyze the facts in each situation.

2) Rebuttable presumption that not a gift, but

that income is derived in a business situation.

3) Non-rebuttable presumption that

compensation has been received. See §102(c).

But, see Prop. Reg. §1.102-1(f)(2). Valid reg.?

- See §274(b) re deduction limit on §102(a) gifts

in the business context. 10/24/2013 (c) William P. Streng 30

U.S. v. Harris

Convictions reversed p.91

Tax evasion criminal convictions for two sisters

receiving “gifts” from an older man.

Gift tax returns filed by the man, but only for

small amounts. How prove criminal intent by

the recipients on their failure to report “gifts”

as income for FIT purposes? What is her belief

re the purpose of this payment?

Court says donor’s letters should have been

permitted into evidence. Too much uncertainty

for a criminal conviction here? How establish

tax criminality?10/24/2013 (c) William P. Streng 31

Criminal Tax Evasion

p.98 §§7201 & 7203

Criminal tax conviction is for willful failure

either to pay tax or to file a return.

Must know that the amount constituted income

and no tax reporting occurred so as to enable a

criminal tax conviction.

Not required for civil tax liability.

What if two unmarrieds live together “in sin”

and one contributes funds to the other “to cover

household expenses”? Gross income (for FIT

purposes) to the other party?10/24/2013 (c) William P. Streng 32

Are “Tips” Gross Income?

P.100

Are “tips” includible in gross income – or are

these excludible “gifts”?

How enforce: information reporting - §6053 re

reporting of tips to the employer.

The scourge of income tax evasion on tips:

credit cards billings where the tip is added.

See Olk, p. 100 – tips to the craps dealer by the

winner to “appease the gambling gods.” GI?

What about significant receipts realized by the

local street beggar?10/24/2013 (c) William P. Streng 33

Prizes, Awards &

Fellowships p.100

§74 – inclusion of awards and prizes in GI.

What about winning the Nobel prize?

What about winning the Olympic gold medal?

See the §74(b) exception from income inclusion

– when deflection of the amount to charity.

See §117 re a limited exclusion from GI for

scholarships. For tuition and books, but not for

room and board. Not for payment for teaching.

What about amounts provided to “student

athletes”?10/24/2013 (c) William P. Streng 34

Bequests

p.101

§102(a) excludes from gross income receipts of

“real” gifts, bequests and inheritances.

What if a bequest is made to a neighbor

friend/attorney who has provided legal

assistance for a long time based on the

neighbor’s promise to make a sizeable bequest?

See Wolder case.

What if an amount is received by a disappointed

heir as a result of the settlement of a will

contest?10/24/2013 (c) William P. Streng 35

Welfare Payments &

Recipients p.101

A tax “common law” general welfare exception

is applicable to welfare payments and similar

government support.

Unemployment compensation benefits are

included in GI. §85. Why?

What about those welfare recipients who are

forced “from welfare to work”? Do they receive

taxable pay for work? If so, what about Social

Security taxes applying (where no floor before

tax commences; cf., income tax)? 10/24/2013 (c) William P. Streng 36

Social Security Benefits

p.102

The amount of gross income inclusion depends

upon the taxpayer’s adjusted gross income.

E.g., joint return couples with AGI less than 32x

can exclude all payments received.

1/2 included when moving from 32x to 44x.

85% included when AGI is above 44x.

Why include so much? Is this just a return of

one’s prior investment in a Social Security

account? Or is this something different?


Gift Transfer of

Unrealized Gain p.103

What is “tax basis”? Consider purchase of

item for10x & sale for 100x. Realized gain is

90x. See §61(a)(3) which includes in GI “gains

from dealing in property.” How define “gains”?

§1001 provides that gain is the excess of the

amount realized over the adjusted basis.

§1012 – tax basis is cost.

Exceptions: (1) §1015 provides for a

“transferred basis” for gifts; and, (2) §1014

provides basis step-up to FMV at death.10/24/2013 (c) William P. Streng 38

Taft v. Bowers

§1015 p.104

A purchases shares for 1000x and holds until

FMV is 2,000x. A then gives shares (worth

2,000x) to B who sells shares for 5000x.

Is B’s realized gain 3000x or 4000x?

Held: 4000x gain is realized and is includible in

gross income – even though not all gain was

accrued while B was owner of the sold property.

The U.S. Constitution permits the transferred

value increase to be taxed to the transferee.

Otherwise – what result?10/24/2013 (c) William P. Streng 39

Taxation Options When

Gain Property Transferred

Appreciated property transferred by gift:

1) Tax the accrued gain when the property is

transferred by gift to donee; a recognition event.

2) Transfer basis to the donee and subsequent

recognition of all accrued gain by the donee.

3) Tax basis step-up to FMV when gift transfer

occurs – no gain recognition then; accrued gain

disappears from the tax base.


Taxation Options When

Loss Property Transferred

Assume that depreciated property is transferred

by gift. What is the treatment upon a

subsequent sale of the property by the donee?

How much loss deduction available?

See Code §1015(a).

See problem 2 at p. 109 for three alternative

situations for determining gain/loss.


Transfers of Appreciated

Property to Pay Debt

Variation on the Taft vs. Bowers situation (see p.

106): L (lawyer) provides legal service to C

(Client). Fee statement for 2,500x to C.

C transfers to L shares of stock with 1000x cost

basis when the shares are worth 2,500x.

Result? 1500x gain recognition to C from “sale.”

L has 2,500x compensation income.

L has tax basis (§1012) of 2,500x for stock.


Transfers of Appreciated

Property to Political Org.

Code §84 (p. 107) provides for gain recognition

to person who transfers appreciated property to

a political organization. Cf., transfer to charity.

Why gain recognition? No inclusion in income

of transferee – since a tax-exempt organization.

Therefore, if tax basis carryover the accrued

gain would vanish from the tax base. Under

Code §84 the transferee has a cost basis.

Further, is this a “quid pro quo” situation?10/24/2013 (c) William P. Streng 43

Transfers at Death

§1014 p.108

§1014 provides that the tax basis of property

received from a decedent is the FMV of that

property as of time of decedent’s death (or as of

alternate valuation date - §2032).

Any accrued gain disappears from the tax base.

Is this a “tax expenditure” item? How much?

Does this produce a “lock-in” effect for the

appreciated property holding? But, possible to

borrow against the property? E.g., consider

effects of a “reverse mortgage”?10/24/2013 (c) William P. Streng 44

Alternative to §1014 Tax

Basis Step-up?

See §1022 – in effect for (only) year 2010 when

an estate had an option to elect out of estate tax

– in which event a modified carryover tax basis

applied. Subject to various exceptions, e.g.,

basis step-up of $1.3 million permitted.

What would be the prospects for accurately

reporting tax gain in the future, when realized

by a beneficiary who has a §1022 basis for

property received from a decedent?


Income in Respect of a

Decedent p.109

What is “income in respect of a decedent”?

See §1014(c) and §691.

Example: Cash basis taxpayer’s estate does not

get an income tax basis step-up (under §1014)

for such items as “accounts receivable” held by

a decedent at death.

Note: a cash basis taxpayer would not actually

have “accounts receivable” - since on a cash

basis and not an “accrual basis” taxpayer.


Allocation of Tax Basis -

Sale of Only a Part p.111

How is tax basis to be allocated when only a

portion of a property interest is sold?

Example: Purchase of 100 shares for 100x; then

sell 40 shares for 80x (shares doubled in value).

Choices for gain determination: (1) Gain of

40x (each 2x FMV share has a 1x basis), or

(2) 80x basis recovery (no reported gain) and

20x basis (of 100x) still remains for the shares

held (having a 120x value and a 100x gain).

Reg.§1.61-6(a) - pro-rata allocation of basis.10/24/2013 (c) William P. Streng 47

Allocation of Tax Basis -

Sale of Only a Part, cont.

Reg.§1.61-6(a) - pro-rata allocation of basis

when a sale of some of land but not all of the

land? E.g., 40 acres of 100 acres is sold?

Or, consider where some lots in a subdivision

are sold but not other lots – are all these lots (if

of equal size) of equal value?


Division of Horizontal

Interests in Real Property

Consider the possible allocation of real property

purchase price between these components:

1) Land & shrubbery/landscaping

2) Building/improvements

3) Subsurface (e.g., mineral) rights

4) Air rights

5) Environmental rights

6) Easement/other rights?


Recovery of Capital

Inaja Land case p.111

Consideration received for an easement (for

fishing rights) in water adjacent to owned land.

Amount received was less that the total basis for

the land. How allocate this amount received?

Exclude entire amount and reduce tax basis by

that those proceeds received? Yes, here.

Note reference to Burnet v. Logan (p. 249) re

“open transaction” treatment – basis recovery

to occur first. See, also Reg. §1.1001-1(a).


Life Insurance

p.113

What is “life insurance”? A payment for dying –

ordinarily paid in a lump sum. Why not call this

arrangement “death insurance,” rather than

“life insurance”?

Code §101(a) excludes from gross income

amounts received under a life insurance

contract if paid upon the death of the insured.

Cf., income tax treatment of a “mutual fund”

investment and the return on this investment

(no actuarial factor involved).10/24/2013 (c) William P. Streng 51

Life Insurance – Policy

Types p.114

1) Term insurance – payment only for actuarial

risk. Small investment return during coverage

period. No value at expiration of the term.

2) Whole life – often level payments and early

year payments exceed actuarial risk cost. The

savings element produces investment return

which is used to reduce insurance cost (but is

not included in GI).

3) Other types – single-premium life; universal

life; endowment10/24/2013 (c) William P. Streng 52

Life Insurance & Income

Tax Questions, p.116

Gross income exclusion is available for both:

1) Pre-death interest build-up, and

2) Mortality gain (or loss), if realized at death.

But, “transfer for consideration” limitations

may apply to limit exclusion at death (p. 117) –

Code §102(a)(2), but, see exceptions for:

(1) transfers with a transferred basis, or

(2) transfers to partners, partnership or a

corporation (but not other shareholders). 10/24/2013 (c) William P. Streng 53

Life Insurance Taxation

Pre-death p.116

1) No tax deduction for premiums paid –

§264(a)(1). Or, for interest, §264(a)(3); any

exception to this treatment – see §264(d)(1)?

2) No current inclusion of policy earnings.

3) Policy loans to owner of policy are not treated

as distributions - §72(e)(5)(A) & (C).

4) Life insurance policy - if terminated before

death - gain derived (if any) is subject to GI

inclusion (but, no GI inclusion for the benefit of

insurance coverage during policy existence).10/24/2013 (c) William P. Streng 54

Life Insurance Taxation

Post-death Payout p.117

1) Gross income exclusion is not applicable to

interest accrued on policy proceeds invested

after death. §101(c) & (d).

2) Various settlement options are available –

- All cash proceeds after death.

- Deferred settlement arrangements, e.g.,

annuity or installment payments

3) Cf., what is a “viatical settlement”? See

§101(g). P.117.10/24/2013 (c) William P. Streng 55

Annuities (& Pensions)

p.117

What is an “annuity” (contract)? Payments are

made periodically – for a life (lives) or a term.

How is an annuity purchased? Annuity can be

purchased for (1) a lump sum, or (2) with

periodic payments (including under a qualified

retirement plan – with a zero tax basis then

since the plan contributions are deductible).

From whom is the annuity contract purchased?

(cf., a possible “private annuity”).


Annuity Payouts

p.117

Types of annuity contract payout arrangements

(other than a lump sum payment only annuity):

1) Fixed payments – an agreed sum (for a term)

or at intervals (for a life, i.e., actuarial factor).

2) Variable payments – based on results from

equity security investments through an annuity.

3) Joint and survivorship payment – until the

death of the survivor of multiple annuitants.

Usually results in a longer payout period since

based on two life expectancies (lesser amounts).10/24/2013 (c) William P. Streng 57

Annuity Income Taxation

– Options p.117

What tax policy choices exist for determining

the timing of gross income inclusion?

1) As value accrues to the contract. Cf.,

amounts credited to a bank savings account or a

money market mutual fund – current inclusion;

otherwise, a “tax shelter” through deferral.

2) As payments are made either (a) before, or

(b) after annuity contract payments commence

(see next slide).


Annuity Income Inclusion

Options p.117

1) Recovery of the entire tax basis first.

2) All income first – as reserved by the insurer.

3) A specified percentage of each payment as the

includible interest equivalent income amount.

4) Current method – a specified percentage of

each payment is included, based on the expected

total return from the contract (see next slide).

5) Apply a constant interest rate, similar to

mortgage amortization (but how deal with the

life expectancy factor?). See p. 118, fn. 19.10/24/2013 (c) William P. Streng 59

Annuity Income Current

Inclusion Method - §72(b)

1) Determine the total income tax basis.

2) Determine the expected return, i.e., (a) the

payment amount times (b) the anticipated

number of payments (how determine this?).

3) Ratio as determined is applied to each

payment when received. The formula is:

a) Total tax basis/expected payments times

b) Each payment equals

c) Amount excluded from gross income.


Annuity Income –

Variations

1) Borrowing before the annuity payments

commence – income inclusion. §72(e)(4)(A).

2) After annuity payments commence –

- Living too long - §72(b)(2) – no exclusion after

basis fully recovered.

- Dying too soon (i.e., not full recovery of cost

basis) - §72(b)(3) – deduction for the

unrecovered tax basis (final individual return).


Annuity Income – “Refund

Feature” Considered

What is the impact of a “refund feature” in

determining the annuitant’s “investment in the

contract?

What is the purpose of a “refund feature”? Is

this a life insurance equivalent?

See Code §72(c)(2) concerning the impact of the

refund feature on (a) the “investment in the

contract,” and (b) the annuity income

inclusion/exclusion fraction under §72(b).


Gambling Gains/Losses

p.120

Gambler collects gambling winnings – any tax

basis offset? Cost basis for the price of other

(losing) gambling tickets & capital recovery?

How prove the losses? Gambling tickets?

Gambling losses can only offset gambling

winnings. §165(d) – a separate “basket” for

gambling winnings and losses.

Are net (excess) losses not deductible because

gambling is a personal expense (entertainment)?

Another reason for this limitation? Morality?10/24/2013 (c) William P. Streng 63

Gambling Winnings

Enforcement p.122

1) Withholding at source (including state

lotteries)? Yes, for large winnings. §3402(q) –

withholding at 31% rate (on gross proceeds)

when $5,000 or greater. Made “permanent” in

2013 Act, at “third lowest §1(c) rate.”

Previously, a 2012 “sunset” was to occur.

2) Information return to IRS – for winnings of

$600 or more. §6041(a) & IRS Form W-2G.

3) Self-assessment – signing one’s tax return

“under penalties of perjury.”10/24/2013 (c) William P. Streng 64

Loss Recovery

Clark case p.122

What tax characterization when a recovery of a

prior (non tax-deducted) loss occurs?

Clark case facts: Tax return preparer makes a

mistake in preparing joint tax return rather

than separate returns – costing taxpayers 19x

extra taxes. Tax preparer reimburses taxpayer

clients for the 19x amount. No refund claim is

possible since statute of limitations has run.

Held: No GI inclusion - an after-tax (not tax)

reimbursement received. Tax basis recovered?10/24/2013 (c) William P. Streng 65

Loss Recovery

Clark case, etc. , cont.

Is this similar to Old Colony case (or not)?

Paying someone else’s taxes?

Or, is this really paying someone else’s taxes?

What treatment of an income tax refund when

one’s income tax has been overpaid?

E.g., after excess wage withholding by employer

– not gross income upon receipt of the refund.

Cf., refund of (deductible) state taxes (although

refunds at state level are difficult to obtain).


Annual Accounting

p.127

More than merely timing questions?

Burnet v. Sanford & Brooks Co., p.127

Cash basis taxpayer. Expenses exceeded income

by 176x in various years; large income later.

Issue: Offset earlier year losses against current

year gross income in determining current year

income? Answer: no; each year stands on own.

P. 128: Does the 16th amendment require

“transactional accounting” (i.e., tax on net

income combining all related transactions)?10/24/2013 (c) William P. Streng 67

Burnet v. Sanford &

Brooks, cont.

Should the court have looked to prior years for

“characterization” of the transaction to avoid

the result in this case, i.e., to recognize some

type of capital investment in the project?

Should the court have mandated filing amended

returns (per Court of Appeals)?

Did the court have an obligation to fix the

problem presented here (tax common law?) – or

is this exclusively within the prerogative of the

U.S. Congress?10/24/2013 (c) William P. Streng 68

Loss Carryovers

p.130

Net operating loss (NOL) deduction enables

averaging of business income (& losses) over

multiple years, i.e., two years back and 20 years

forward. §172. Not filing amended returns.

For individuals those are only business losses,

i.e., not investment losses, personal deductions

in excess of income, etc. §172(d)(4).

Capital losses limited - §172(d)(2).

Separate treatment applies for the carryforward

of capital losses (no carryback). §1212. 10/24/2013 (c) William P. Streng 69

Accounting for Long-Term

Contracts p.131

Situation: Long term contract for the

construction or manufacture of property – for

tax a person must account for the profit under a

“percentage of completion” method, i.e., accrue

profit as progress is made towards finalizing the

project. See §460 mandating the % of

completion method for LT contracts (and not

the “completed contract” method).

Applicable to: (1) large construction projects;

(2) space vehicle projects; (3) others?10/24/2013 (c) William P. Streng 70

Capital expenditures

p.131

Consider the purchase of an item having a

useful life more than the current year: auto,

truck, airplane, building, oil well.

Should that cost be immediately deductible or is

a long-lived asset being created?

If income and cost is to be matched that

purchase cost must be “capitalized”, i.e., tax

basis is created, with that basis recovered over

the anticipated useful life of the asset.

This facilitates a “matching” principle.10/24/2013 (c) William P. Streng 71

Claim of Right Doctrine

p.132

North American Oil Consolidated

1) In 1917 taxpayer receives earnings (from

1916) under a “claim of right.”

2) Therefore, 1916 earnings are to be included

in taxpayer’s GI for 1917. Taxpayer says 1916.

3) GI inclusion was not delayed until 1922 when

litigation over amount was finally terminated.

4) If a taxpayer refund in 1922 the taxpayer

would be entitled to a deduction in 1922.

Why such an issue over timing for GI inclusion?10/24/2013 (c) William P. Streng 72

Claim of Right Doctrine,

continued

North American Oil Consolidated

What is the tax status of the (intermediary)

receiver?

Receiver as a taxpayer? Or, is the income it

receives merely “suspended from tax” until

distributed to the person determined to be the

owner?

What is the tax status of an “escrow agent”?


Proper Taxable Year?

p.135

§446(a) – taxpayer shall compute taxable

income under method of accounting on which

taxpayer “regularly computes his income in

keeping his books.”

§446(b) – exception where the taxpayer’s

method “does not clearly reflect income.”

Cf., what is the purpose of “accrual

accounting”?


U.S. v. Lewis

p.136

Taxpayer in 1944 reported receipt of a 22x

bonus. State court judgment required

repayment (in 1946) of 11x portion of bonus.

Deduct 11x on 1946 return (IRS position); or,

recompute for 1944 (per Court of Claims)

because excess received under a mistake in fact?

Note: “Each tax year stands on its own.”

But, subject to amending returns to correct

facts which were existent for the particular year

(as of the end of the tax year). 10/24/2013 (c) William P. Streng 75

“Claim of right” doctrine

& §1341 Relief p.137

What if tax rate is the earlier year was higher?

Assume a later year restoration of an amount

received earlier under a “claim of right.”

§1341 permits a reduction of income tax liability

in the year of repayment by the amount of the

tax on repaid income in the year of inclusion.

Must have earlier received the income under a

“claim of right.” Cf., restoration of

embezzlement income received. Voluntary

payments are not eligible for this treatment. 10/24/2013 (c) William P. Streng 76

Tax Benefit Rule

p.139

Taxpayer claims a tax deduction in 1st year and

then receives a recovery for the deducted item

in a later year.

E.g., deduction for bad debt, taxes paid or losses

and then a recovery of the deducted item.

Inclusion in gross income in the later year? Yes.

This effectively produces transactional

accounting, rather than annual accounting, for

this particular item.


Tax Benefit Rule & GI

Inclusion p.140

Example: Alice Phelan Sullivan case, p.140:

1) Property was transferred to charity

2) Charitable deduction was claimed for federal

income tax purposes.

3) Property was returned to the donor.

4) Inclusion in the donor’s gross income?

Yes – to the extent of the lesser of (a) the earlier

deduction or (b) the fair market value of the

property. What if property is significantly

appreciated?10/24/2013 (c) William P. Streng 78

“Inconsistent Events”

Rule p.140

Hillsboro and Bliss Dairy cases:

1) Repayment to bank shareholders of taxes on

shareholders previously paid by the bank

corporation. No recognition required of the

banks when refunds were made to shareholders.

2) Distribution of previously expense assets

(cattle feed) in a corporate liquidation.

Recovery was required to the corporation on the

distribution.

Dissent: file amended returns (if S/L not run).10/24/2013 (c) William P. Streng 79

Assume No Actual Tax

Benefit Earlier p.139

Deduction available in earlier year; but, no tax

benefit realized in the earlier year; then later,

when reversal of the earlier transaction, no

gross income inclusion required since no tax

benefit realized earlier.

See §111 – an exclusionary provision – recovery

of a loss deductible in the earlier year is

excluded from gross income to the extent the

earlier deduction produced no income tax

benefit in that earlier year.


Damage Recoveries

Summarized - p.142

1) Recovery of lost profits – ordinary income

when received; Sanford & Brooks, p.127.

2) Punitive damages – includible in ordinary

income (as a windfall or “accession to wealth”).

Glenshaw Glass, p. 78.

3) Recovery for destroyed property – inclusion

in gross income as a property sale; gain for the

proceeds in excess of the tax basis; but, possible

gain postponement through reinvestment of

proceeds in similar property. See §1033.10/24/2013 (c) William P. Streng 81

Damage Recoveries, cont.

p.143 §104(a)(2)

Personal injury damages – exclusion of damages

from GI if a personal physical injury. §104.

What about a “tax basis recovery”?

What about emotional distress damages?

This personal injury GI exclusion does not

encompass libel and discrimination awards.

No exclusion for punitive damages (even if

received in personal injury context). §104(a)(2).

No exclusion for lost profits/lost compensation

reimbursements.10/24/2013 (c) William P. Streng 82

Deferred Payments and

Structured Settlements

P.144. See §104(a)(2) re exclusion for personal

injury damages - whether received as a lump

sum or in “periodic payments.”

What is a “structured settlement” in this

context - where an intermediary agrees to

provide periodic settlement payments?

What about interest income from the deferral?

Result: Tortfeasor deduction: yes, immediately

with structured settlement; even though any GI

inclusion (?) for plaintiff is delayed until receipt.10/24/2013 (c) William P. Streng 83

Medical Expense

Recoveries p.145

Earlier: No inclusion for employer provided

medical insurance coverage. §106.

Recoveries under a medical insurance policy are

excluded from GI (even when recoveries exceed

the cost of medical care). See §104(a)(3).

Workers’ compensation payments are excluded

from gross income. §104(a)(1).

Taxpayer’s disability insurance benefits

excluded from GI under §104(a)(3).


Loan Proceeds as

Producing GI? p.145

§61(a)(12) provides for inclusion of “income

from discharge of indebtedness.”

P. 146 - Loan proceeds are not includible in

gross income (because of an offsetting liability

that produces no net accession to wealth).

Loan repayments are not deductible (similarly,

no accession to wealth occurs). P.146.

Rules are applicable to “nonrecourse” loans.

See examples re borrowings (p. 146) – e.g., tax

loan proceeds received in excess of tax basis?10/24/2013 (c) William P. Streng 85

Discharge of

Indebtedness p.147

Example:

(1) Borrow 50x for a three year term at 8% per

year from a bank.

(2) Market interest rates increase (e.g., to 10%)

and the fair market value of this loan/note

declines (e.g. to 45x). Why does this happen?

(3) Borrower then pays off this loan at the bank

which accepts a 45x agreed settlement. Why does

the bank agree to this settlement?

(4) GI inclusion to borrower when settlement?10/24/2013 (c) William P. Streng 86

Kirby Lumber Co.

Bond Buy-back p.147

Company issues its own bonds and later buys

back some bonds for $.862 per face $1.00 par.

Is the gain taxable to the borrower company?

Excess of the issue price received over the

purchase price is realized gain.

An increase in the corporation’s net worth has

resulted from this debt reduction.

How is the issuer able to buy bonds at less than

their par value (or their original issue price)?

Accession to wealth here and GI is realized.10/24/2013 (c) William P. Streng 87

Code §108 - Possible COD

Income Relief p.149

§108 provides various relief from this rule for

insolvent debtors (and others), but not all.

§108(e)(5) provides that the reduction in debt

for a purchase price is a reduction in purchase

price, and not COD income to the purchaser.

§108(f)(2) – COD income relief on cancellation

of a student loan – under limited circumstances.

§108(h) provides relief from COD income when

mortgage lender forecloses on taxpayer’s

residence. But, reduce tax basis for residence.10/24/2013 (c) William P. Streng 88

Zarin v. Commr.

P.150

Discharge of gambling indebtedness occurs.

Taxpayer delivered his personal checks for

$3.435 million and the checks were invalid.

State court collection action was filed.

Settled this action for $500,000 and IRS then

asserts $2.9 million COD income to taxpayer.

Not a purchase money debt reduction (?).

Tax Court: Inclusion of 2.9 mil. as COD income.

Tannenwald dissent: no genuine debt. Cont.10/24/2013 (c) William P. Streng 89

Zarin v. Commr.

Appeal P.150

3rd Cir. reverses Tax Court and treats the

cancelled debt as a “disputed debt” or a

“contested liability.” Treated as if the initial

loan was made for the eventual settlement

amount.

Was this debt enforceable? See state law.

3rd Cir. dissent: COD income and this was a

bona fide debt situation. Assets of the taxpayer

were “freed from liability.”


Diedrich v. Commr.

Net Gift p.159

Gift of property is made subject to an obligation

assumed by donee to pay gift tax arising from

the transfer. Is this a satisfaction of the

taxpayer’s (gift tax) liability by a 3rd party?

Does the donor have (12x capital gain) income to

the extent (1) gift tax amount (63x) exceeds (2)

the donor’s tax basis (51x) for the transferred

property? A discharge of the donor’s gift tax

obligation has occurred in their “deal.”

Note the interrelated computation required here.

Cf., §1011(b) in charitable bargain sale context.10/24/2013 (c) William P. Streng 91

Example re “Net Gift”

Transaction

Gift transfer of stock: Basis is 10x; fmv is 100x.

Condition that donee pay 25x gift tax liability.

Gain of 15x arising (25x tax less 10x basis)?

Is the donee’s tax basis for the acquired

property then 25x? See Reg. §1.1015-4.

Or, is a sale made of 1/4th of the property?

(25/100; tax basis of 2.5x or 1/4th of 10x basis)

for the 25x proceeds deemed received and,

therefore, gain to donor of 22.5x (25x less 2.5x)?

Cf., bargain sale to charity rule of §1011(b). 10/24/2013 (c) William P. Streng 92

Transfer of Property with

Debt p.163

Alternative types of debt arrangements:

1) Recourse – personal liability for the debt by

the borrower.

2) Nonrecourse – the debt is secured only by

the pledged asset (and its income stream) but no

personal liability of the property owner exists.

Why might a lender agree to this type of

lending arrangement?


Crane v. Commr.

Debt in Tax Basis? P.165

Crane case: recourse and nonrecourse debt is

to be treated similarly for federal tax purposes.

Here, the claimed debt was (1) in the original

tax basis (and tax depreciation computation),

but (2) not treated as an amount realized upon

the “debt relief” occurring when sale occurred.

Property inherited when fmv was 262x & the

nonrecourse debt was 262x. She then claimed

25x depreciation. Later she received 2x cash on

property disposition. Gain of 2x or 24x?

Does the tax basis includes nonrecourse debt?10/24/2013 (c) Willia.m P. Streng 94

Debt and Property

Purchases

What is the effect of debt on the income tax

basis of an acquired property? Answer:

Acquisition debt is to be included in the buyer’s

tax basis for an acquired property.

This can include “seller financed” debt.

Further, property can be acquired with debt

attached.

Cf., post-acquisition debt (e.g., borrowing with

existing property as collateral).


Estate of Franklin

p.172 (pre-Tufts)

Is the purchase money debt includible in basis?

Facts: Purchase of a motel for only prepaid

interest and a nonrecourse debt (with a balloon

payment). Warranty deed is in escrow.

Leaseback to sellers & the lease payment from

sellers is equal to the P&I amount on the debt.

Value of the property not shown, but

presumably far less than the promissory note.

Held: No real investment in the property and no

depreciation & no interest expense deduction.10/24/2013 (c) William P. Streng 96

Pleasant Summit Land

p.172 (post Tufts)

Different approach than the Franklin case.

Depreciation deduction was allowed – but only

to the extent that the nonrecourse debt did not

exceed the FMV of the property. That amount

was effectively recognized as the tax basis on the

property acquisition.

Consider the tax basis to Bayse (Tufts case,

next) – the purchaser in the Tufts case. Is his

tax basis limited as in (1) the Franklin case, or

(2) the Pleasant Summit case?10/24/2013 (c) William P. Streng 97

Tufts case

p.173

Facts: Property purchased for $1.85 million

nonrecourse debt. Initial tax basis of $1.85

million. $400,000 tax depreciation claimed.

Tax basis is reduced to $1.45 million (§1016).

Property FMV at disposition was $1.4 million.

The $1.850 debt exceeds (1) the tax basis &

(2) the FMV of the property at disposition.

Tax issues: Gain or other income? Loss? Tax

character? How much? COD income?


Tufts choices for decision

One or Two Transactions?

Integrated Transaction

1.850 debt

Less: 1.450 basis

Equals: 400 gain

(capital gain?)

Two Transactions

1) 1.850 debt relief

Less: 1.400 value

= 450 COD income

2) 1.450 basis

Less: 1.400 value

= 50 capital loss


Treasury Regulations &

Nonrecourse Debt

Reg. §1.1001-2(a)(1) – the amount realized

include the amount of liabilities from which the

transferor is “discharged.”

Reg. §1.1001-2(a)(4)(i) – the sale of property

that secures a nonrecourse liability “discharges”

the transferor from the (nonrecourse) liability.

Reg. §1.1001-2(b) – the fair market value of the

security is not relevant for determining the

amount of liabilities being discharged.


Rev. Rul. 90-16

p.181

Assume: Acquisition of property with recourse

liability (i.e., borrower’s personal liability).

Subsequently, property is transferred to lender

and borrower is released from liability.

Debt balance 45x

Property FMV 30x (15x COD income?)

Tax basis 10 (20x property gain?)

Foreclosure proceeding: same tax result

Cf., nonrecourse debt – 35x property gain.10/24/2013 (c) William P. Streng 101

“Illegal” Income

P. 181

Inclusion in gross income?

- Proceeds of a bank robbery

- Proceeds from illegal activity, e.g., sales of

illegal drugs, or operating an illegal gambling

operation.

These items constitute an “accession to wealth”

– even though subject to retrieval by authorities.


Embezzlement Income

Gilbert case p.181

Consensual recognition of an obligation to repay

existed even though absence of a loan

agreement. Gilbert, as President of Bruce,

acquired stock on margin, got overextended,

“borrowed” money from company, but the

transactions were not accepted by Directors.

Did the unauthorized withdrawal of funds

produce gross income? Or, a borrowing?

Held: consensual recognition of the debt and no

embezzlement occurred (and no GI). Correct? 10/24/2013 (c) William P. Streng 103

James case

p.185

Embezzled funds do constitute gross income.

Assume that no intent to repay existed at the

time of the embezzlement.

Cf., the Bernie Madoff embezzled funds

(through a “Ponzi” scheme).

Note: Who then has the priority for the funds

(if still held by embezzler): (1) the embezzled

party, or (2) the IRS (for the income tax on the

embezzled funds as gross income)?


State & Local Bond

Interest p.186

IRC §103 provides a gross income exclusion for

state and local bond interest paid. Why?

Tax-exempts normally pay a lesser amount of

interest than taxable bonds.

But, is the transfer system inefficient?

Is this an indirect form of “revenue sharing”?

Would income taxation of muni-bond interest

by US Government be constitutional? Would it

impair the rights of the states (and local

governments)? Consider the Tenth Amendment10/24/2013 (c) William P. Streng 105

State & Local Bond

Interest p.188

Limits on tax-exempt bond issuances:

1) Private activity bonds §§141(e) & 142;

- Cf., school bonds

2) Registration requirement; cf., bearer bonds.

3) Arbitrage bonds - §148; what objective of

the arbitrage transaction?


Residence Sale Gain

p.191

§121 provides for an exclusion from GI of gain

realized on the sale of a principal residence.

Requirements: principal residence; used for

two of last five years; limit to $250,000 gain,

unless married; then a $500,000 exclusion.

Exclusion available only once every two years.

Exception enabling shortened period for sale

gain exclusion when necessitated by change in

employment or for health reasons.

What tax planning opportunities here? 10/24/2013 (c) William P. Streng 107

Special Tax Rate for

Dividends p.193

§61(a)(7) specifies inclusion of dividends in GI.

But, 20% rate, since classified as equivalent to

LTCG. §1(h)(11)(A). Cf., 39.6% rate.

Does this provision tilt the income tax burden to

workers and away from investors (i.e., capital)?

Is the objective of this provision to reduce the

perceived double tax impact of corporate -

shareholder income taxation? Cf. conduit

system for partnerships & E.U. corporations.


chapter 2 p.45 characteristics of income · an accretion to wealth: 1) accrued but unrealized...

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