Chapter 3



Chapter 4Digging DeeperContents: | CONSTRUCTIVE RECEIPT | SERVICES OF A CHILD | INCOME IN COMMUNITY PROPERTY STATES | INCOME FROM PROPERTY | INTEREST ON CERTAIN STATE AND LOCAL GOVERNMENT OBLIGATIONS | ACCELERATED DEATH BENEFITS | INCOME FROM DISCHARGE OF INDEBTEDNESS | GAINS AND LOSSES FROM PROPERTY TRANSACTIONS | CONSTRUCTIVE RECEIPT1. Example: Rick owns interest coupons that mature on December 31. The coupons can be converted to cash at any bank at maturity. Thus, the income is constructively received by Rick on December 31, even though Rick failed to cash in the coupons until the following year. Dove Company mails a dividend check to Rick on December 31, 2014. Rick does not receive the check until January 2015. Rick does not realize gross income until 2015. Income set apart or made available is not constructively received if its actual receipt is subject to substantial restrictions. The life insurance industry has used substantial restrictions as a cornerstone for designing life insurance contracts with favorable tax features. Ordinary life insurance policies provide (1) current protection—an amount payable in the event of death—and (2) a savings feature—a cash surrender value payable to the policyholder if the policy is terminated during the policyholder’s life. The annual increase in cash surrender value is not taxable because the policyholder must cancel the policy to actually receive the increase in value. Because the cancellation requirement is a substantial restriction, the policyholder does not constructively receive the annual increase in cash surrender value. Employees often receive from their employers property subject to substantial restrictions. Generally, no income is recognized until the restrictions lapse.Example: Carlos is a key employee of Red, Inc. The corporation gives stock with a value of $10,000 to Carlos. The stock cannot be sold, however, for five years. Carlos is not required to recognize income until the restrictions lapse at the end of five years.SERVICES OF A CHILD2. In the case of a child, the Code specifically provides that amounts earned from personal services must be included in the child’s gross income. This result applies even though the income is paid to other persons (e.g., the parents).1INCOME IN COMMUNITY PROPERTY STATES 3. General. State law in Louisiana, Texas, New Mexico, Arizona, California, Washington, Idaho, Nevada, and Wisconsin is based on a community property system. Alaska residents can elect community property treatment. All other states have a common law property system. The basic difference between common law and community property systems centers around the property rights of married persons. Questions about community property income most frequently arise when a husband and wife file separate returns. Under a community property system, all property is deemed either to be separately owned by the spouse or to belong to the marital community. Property may be held separately by a spouse if it was acquired before marriage or received by gift or inheritance following marriage. Otherwise, any property is deemed to be community property. For Federal income tax purposes, each spouse is taxed on one-half of the income from property belonging to the community. The laws of Texas, Louisiana, Wisconsin, and Idaho distinguish between separate property and the income it produces. In these states, the income from separate property belongs to the community. Accordingly, for Federal income tax purposes, each spouse is taxed on one-half of the income. In the remaining community property states, separate property produces separate income that the owner-spouse must report on his or her Federal income tax return. What appears to be income, however, may really represent a recovery of capital. A recovery of capital and gain realized on separate property retain their identity as separate property. Items such as nontaxable stock dividends and gains and losses from the sale of property take on the same classification as the assets to which they relate. Example: Bob and Jane are husband and wife and reside in California. Among other transactions during the year, the following occurred. Nontaxable stock dividend received by Jane on stock that was given to her after her marriage by her mother Gain of $10,000 on the sale of unimproved land purchased by Bob before his marriage. Oil royalties of $15,000 from a lease Jane acquired after marriage with her separate funds. Since the stock dividend was distributed on stock held by Jane as separate property, it also is her separate property. The same result occurs for the oil royalties Jane receives. All of the proceeds from the sale of the unimproved land (including the gain of $10,000) are Bob's separate property. In all community property states, income from personal services (e.g., salaries, wages, income from a professional partnership) is generally treated as if one-half is earned by each spouse. Example: Fred and Wilma are married but file separate returns. Fred received $25,000 salary and $300 taxable interest on a savings account he established in his name. The deposits to the savings account were made from Fred's salary that he earned since the marriage. Wilma collected $2,000 taxable dividends on stock she inherited from her father. Wilma's gross income is computed as follows, under three assumptions as to the state of residency of the couple. ?CaliforniaTexasCommonLaw StatesDividends$ 2,000$ 1,000$2,000Salary?12,500?12,500??? ?-0-Interest???? 150???? 150??? ?-0-?$14,650$13,650$2,000The savings account is a community asset because it was established with community funds (i.e., Fred’s salary).Do not confuse community property with jointly owned property, as a number of differences can exist.Jointly owned property (i.e., tenants in common, joint tenants) is not limited to husband and wife.More than two owners can be involved. Thus, three brothers can be joint owners of a tract of land.Joint ownership interests need not be equal. Of the three brothers who own a tract of land, one can hold a one-half interest, while each of the other two brothers owns a one-quarter munity Property Spouses Living Apart. The general rules for taxing the income from services performed by residents of community property states can create complications and even inequities for spouses who are living apart. Congress has developed a simple solution to the many tax problems of community property spouses living apart. A spouse (or former spouse) is taxed only on his or her actual earnings from personal services if the following conditions are met. The individuals live apart for the entire year. They do not file a joint return with each other. No portion of the earned income is transferred between the individuals. Example: Jim and Lori reside in a community property state, and both are gainfully employed. On July 1, 2014, they separated, and on June 30, 2015, they were divorced. Assuming their only source of income is wages, one-half of such income for the year is earned by June 30, and they did not file a joint return for 2014, each should report the following gross income. ?Jim's SeparateReturnLori's SeparateReturn2014One-half of Jim's wages One-half of Jim's wages ?One-half of Lori's wages One-half of Lori's wages 2015All of Jim's wages All of Lori's wages Planning with Community Property. The classification of income as community or separate property becomes important when either of two events occurs.Husband and wife, married taxpayers, file separate income tax returns for the year.Husband and wife obtain a divorce and therefore file their own returns for the year.For planning purposes, it behooves married persons to keep track of the source of income (community or separate). To be in a position to do this effectively when income-producing assets are involved, it may be necessary to distinguish between separate and community property.INCOME FROM PROPERTY 4. Dividends. The following payments frequently are referred to as dividends but are not treated as dividends for tax purposes. Dividends received on deposits with savings and loan associations, credit unions, and banks are actually interest (a contractual rate paid for the use of money). Patronage dividends paid by cooperatives (e.g., a farm cooperative) are rebates made to users and are considered reductions in the cost of items purchased from the association. The rebates usually are made after year-end (after the cooperative has determined whether it has met its expenses) and are apportioned among the members on the basis of their purchases. Mutual insurance companies pay dividends on unmatured life insurance policies that are considered nontaxable rebates of premiums. Shareholders in mutual investment funds report as capital gains their proportionate share of the funds’ gains that are realized and distributed. Capital gain and ordinary income portions are reported on the Form 1099 that funds supply to shareholders each year. When a corporation issues a stock dividend (e.g., common stock issued to common shareholders), the shareholder merely has received additional shares that represent the same total investment. Thus, the shareholder does not recognize gross income. INTEREST ON CERTAIN STATE AND LOCAL GOVERNMENT OBLIGATIONS5. The lower cost for the state and local governments is more than offset by the revenue loss of the Federal government. Many consider the exclusion of tax-exempt interest to be a substantial loophole for the very wealthy. For these reasons, bills have been introduced in Congress calling for Federal government subsidies to state and local governments that voluntarily choose to issue taxable bonds. Thus, the state/local government benefit would remain, but the taxpayer subsidy would be eliminated. Under the proposals, the tax-exempt status of existing bonds would not be eliminated. ACCELERATED DEATH BENEFITS6. Generally, if the owner of a life insurance policy cancels the policy and receives the cash surrender value, the taxpayer recognizes gain equal to the excess of the amount received over premiums paid on the policy (a loss is not deductible). The gain is recognized because the general exclusion provision for life insurance proceeds applies only to life insurance proceeds paid upon the death of the insured. If the taxpayer cancels the policy and receives the cash surrender value, the life insurance policy is treated as an investment by the insured. In a limited circumstance, however, the insured is permitted to receive the benefits of the life insurance contract without having to include the gain in gross income. Under the accelerated death benefits provisions, exclusion treatment is available for insured taxpayers who are either terminally ill or chronically ill.2 A terminally ill taxpayer can collect the cash surrender value of the policy from the insurance company or assign the policy proceeds to a qualified third party. The resultant gain, if any, is excluded from the insured’s gross income. A terminally ill individual is one whom a physician certifies as having an illness that is reasonably expected to cause death within 24 months.In the case of a chronically ill patient, no gain is recognized if the proceeds of the policy are used for the long-term care of the insured. A person is chronically ill if he or she is certified as being unable to perform without assistance certain activities of daily living. These exclusions for the terminally ill and the chronically ill are available only to the insured. Thus, a person who purchases a life insurance policy from the insured does not qualify.L E 3 Example: Tom owned a term life insurance policy at the time he was diagnosed as having a terminal illness. After paying $5,200 in premiums, he sold the policy to Amber Benefits, Inc., a company that is authorized by the State of Virginia to purchase such policies. Amber paid Tom $50,000. When Tom died six months later, Amber collected the face amount of the policy, $75,000. Tom is not required to include the $44,800 gain ($50,000 $5,200) on the sale of the policy in his gross income. Assume Amber pays additional premiums of $4,000 during the six-month period. When Amber collects the life insurance proceeds of $75,000, it must include the $21,000 gain [$75,000 proceeds ($50,000 cost + $4,000 additional premiums paid)] in gross income.INCOME FROM DISCHARGE OF INDEBTEDNESS7. Shareholder Cancellation of DebtExample: Red Corporation owes Connor $10,000. Connor is a shareholder of Red. If Connor cancels the debt in exchange for $9,000 of Red’s stock, Red reports gross income of $1,000. If Connor’s basis for the Red corporation debt is $10,000, Connor reports a bad debt of $1,000 (see Chapter 6 for a discussion of the bad debt deduction). GAINS AND LOSSES FROM PROPERTY TRANSACTIONS8. Capital Gains and Losses. In applying the capital gain/loss netting procedure, losses are netted first against gains in the category carrying the highest tax rate. Notes: 1 § 73. For circumstances in which the child’s unearned income is taxed at the parents’ rate, see Kiddie Tax—Unearned Income of Children Taxed at Parents’ Rate in Chapter 9.2 § 101(g). ? 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. ................
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