Introduction - Santa Clara Law
Federal personal income tax
I. Some context and historical background
a. Current significance
b. History
Early American revenue came almost exclusively from tariffs.
Pollack v. Farmer’s Loan & Trust (1895): declared a tax on income unconstitutional.
Constitution give Congress the right to tax. Limitations on this right is also included in Article 1 § 2 and § 9. Means that any direct taxes must be apportioned among the states based on their population, so that it is equal per capita. There is no way to do this with personal income tax, so if you say that personal income tax is a direct tax, then it would be unconstitutional. Then comes the 16th Amendment passed in 1913. Allows Congress to tax with out apportionment.
c. Progressivity
d. The basic goals of any tax system
i. Fairness:
1. Horizontal equity: two similarly situated tax payers should pay the same amount. Difficulty is determining how people can be similarly situated.
2. Vertical equity: allocated tax burdens fairly as we go up the income scale.
ii. Economic rationality (Neutrality): All things being equal, we don’t want to distort normal economic behavior…we don’t want people doing something or refraining from doing something only for tax purposes. For example, A is willing to pay $100/wk to have her house cleaned. B is willing to clean the house for take-home pay of $80. There is $20 of available surplus benefit to society available in the transaction. However, if a 25% income tax is imposed, B’s take-home pay is only $75. This would distort/destroy an economic transaction that would otherwise happen. In reality, people do things for reasons unrelated to the economic elements of the transaction. Also, there is no way to have a tax without distorting behavior in some way, so the goal is to minimize the distortion.
iii. Administrability
II. The characteristics of income
1. A flow: Income can only be measured in time. Since 1913, we've had the measure of the flow over one year (annual accounting principal). Usually a calendar year.
1. Some examples
a. Paycheck: if an employee gets $5K in cash as a monthly salary, it is definitely income. If the employee gets the same amount in a check, it is counted as income, even if it hasn't cleared yet. It is considered a "cash equivalent." There is always some level of contingency. The tax code confronts the issue to determine what level of contingency is enough. Same for direct deposits.
a. Windfall: Outside of employee context, $5K cash found in a bag by TP is also income. Fairness (horizontal equity) because a person would have to claim the money if they got it by working, so it is fair for the TP who got the $ with no effort to also claim it.
a. "Swag bag:" A star agrees to host an award show for free. In her room is a gift basket worth $5K. Taxable compensation? Note that precise terms of the compensation are not negotiated in advance and there is no expectation or obligation to pay/give. Yes, a quid pro quo is taxable as compensation, however, this is not an easy case and it might be difficult to agree on the FMV.
a. Benefits in kind (Payments from 3rd parties): when an employer pays an employee's rent as part of his compensation, it is considered an "accession to wealth," and is taxable. This is fair (horizontally equity) because a similarly situated employee that gets paid the same amount in a cash salary and uses the salary to pay the landlord is in the same position.
Note that § 61 defines fringe benefits, etc. as income as the default position "unless otherwise excluded." So, exclusions such as health care benefits are income, but are not taxable because of specific exclusions in other areas of IRC.
1. Income in Kind/Non-cash receipts
a. Discharge of an obligation: Old Colony (p. 35)
i. Facts: Mr. Wood is the president of the American Woolen Company. His tax liability based on his salary earned in 1918 and 1919 was paid by the Company per a company resolution. Supreme Court says that taxes paid by employer is income.
ii. Rule: The discharge by a third person of an obligation to him is equivalent to receipt by the person taxed [CB 37]
iii. Income analysis: the fact that the expense being covered by the employer is taxes doesn't change the fact that it is a benefit.
iv. Held: It is an accession to wealth.
IRC § 61. Gross income defined.
(a) General definition. Except as otherwise provided in this subtitle [IRC Sections 1 et seq.], gross income means all income from whatever source derived, including (but not limited to) the following items:
(1) Compensation for services, including fees, commissions, fringe benefits, and similar items;
(2) Gross income derived from business;
(3) Gains derived from dealings in property;
(4) Interest;
(5) Rents;
(6) Royalties;
(7) Dividends;
(8) Alimony and separate maintenance payments;
(9) Annuities;
(10) Income from life insurance and endowment contracts;
(11) Pensions;
(12) Income from discharge of indebtedness;
(13) Distributive share of partnership gross income;
(14) Income in respect of a decedent; and
(15) Income from an interest in an estate or trust.
CFR § 1.61-1 Gross income.
(a) General definition. Gross income means all income from whatever source derived, unless excluded by law. Gross income includes income realized in any form, whether in money, property, or services. Income may be realized, therefore, in the form of services, meals, accommodations, stock, or other property, as well as in cash. Section 61 lists the more common items of gross income for purposes of illustration. For purposes of further illustration, § 1.61-14 mentions several miscellaneous items of gross income not listed specifically in section 61. Gross income, however, is not limited to the items so enumerated.
CFR § 1.61-2 Compensation for services, including fees, commissions, and similar items.
(a) In general. (1) Wages, salaries, commissions paid salesmen, compensation for services on the basis of a percentage of profits, commissions on insurance premiums, tips, bonuses (including Christmas bonuses), termination or severance pay, rewards, jury fees, marriage fees and other contributions received by a clergyman for services, pay of persons in the military or naval forces of the United States, retired pay of employees, pensions, and retirement allowances are income to the recipients unless excluded by law. Several special rules apply to members of the Armed Forces, National Oceanic and Atmospheric Administration, and Public Health Service of the United States; see paragraph (b) of this section.
(2) The Code provides special rules including the following items in gross income:
(i) Distributions from employees' trusts, see sections 72, 402, and 403, and the regulations thereunder;
(ii) Compensation for child's services (in child's gross income), see section 73 and the regulations thereunder;
(iii) Prizes and awards, see section 74 and the regulations thereunder.
(3) Similarly, the Code provides special rules excluding the following items from gross income in whole or in part:
(i) Gifts, see section 102 and the regulations thereunder;
(ii) Compensation for injuries or sickness, see section 104 and the regulations thereunder;
(iii) Amounts received under accident and health plans, see section 105 and the regulations thereunder;
(iv) Scholarship and fellowship grants, see section 117 and the regulations thereunder;
(v) Miscellaneous items, see section 122.
(d) Compensation paid other than in cash--(1) In general. Except as otherwise provided in paragraph (d)(6)(i) of this section (relating to certain property transferred after June 30, 1969), if services are paid for in property, the fair market value of the property taken in payment must be included in income as compensation. If services are paid for in exchange for other services, the fair market value of such other services taken in payment must be included in income as compensation. If the services are rendered at a stipulated price, such price will be presumed to be the fair market value of the compensation received in the absence of evidence to the contrary. For special rules relating to certain options received as compensation, see §§ 1.61-15, 1.83-7, and section 421 and the regulations thereunder. For special rules relating to premiums paid by an employer for an annuity contract which is not subject to section 403(a), see section 403(c) and the regulations thereunder and § 1.83-8(a). For special rules relating to contributions made to an employees' trust which is not exempt under section 501, see section 402(b) and the regulations thereunder and § 1.83-8(a).
III. Employer-provided food and lodging
1. Benaglia (p. 39):
2. Hired as the original manager of the Royal Hawaiian Hotel. He and his wife get a cash salary of ~$10K + they stay in the hotel and received their meals there, for a FMV of ~$7K.
a. Possible alternatives
i. No income or possibly no income to employee, but income to spouse
ii. FMV: too high because Benaglia wouldn't view the value as this.
iii. Cost to hotel
iv. Substitution Cost or cost of equivalent arrangements.
v. Subjective value to Benaglia himself. What is his accession of wealth that makes him better off. Theoretically, this is the best value to use, but not practical. His 6,000th meal at the hotel is going to be worth less to him than the first, and he has to eat what they serve and arrange his life around living there. This is very difficult to administer.
b. Holding: Board concludes that it is not income because the lodging and meals are provided for the convenience of the employer. The duties of the manager of the hotel cannot be performed unless he is always on call.
c. Fundamental problem: what does "convenience of the employer" have to do with it. Shouldn't the question be whether the employee has received an accession to wealth? Because it is presumed that something done for the convenience of the employer, the employee doesn't value it at a high level. Prof: we shouldn't assume that the employee has received no accession to wealth, but the Board errs on the side of assuming no income.
3. Present Treatment § 119: enacted after Benaglia, largely codifies the result. Can think of 119 of both adopting and repudiating Benaglia. Adopts the convenience of the employer doctrine. However, 119 is an exception, so but for this exception, the meals/lodging would be income under § 61.
a. Lodging is required to be accepted.
4. Questions pp. 49-50.
5. Employer Benefits are presumptively income @ FMV unless they fall into one of the exceptions. Difficulties:
a. valuation, since emp'e doesn't necessarily value the benefits as FMV.
b. Compliance: people don't think of these things as income. Also, people became accustomed to these benefits not being taxed before the IRC began focusing on it.
6. § 119: can think of it as having three components
a. Furnished
b. On employer's premises
c. For the convenience of employer
d. Lodging has additional component: employee must be required to accept as a condition of e'ment. Doesn’t have to be written in K, more of a substantive question.
7. Note that this essentially repudiates Benaglia to the extent that the case was talking about the general definition of income that would be defined under § 61, before the exceptions in § 119 were codified.
8. In applying a statute, each word really matters.
a. Business premises defined:
b. Place where e'ee performs most of his duties
c. Place where e'er does most of its business.
IRC § 119. Meals or lodging furnished for the convenience of the employer.
(a) Meals and lodging furnished to employee, his spouse, and his dependents, pursuant to employment. There shall be excluded from gross income of an employee the value of any meals or lodging furnished to him, his spouse, or any of his dependents by or on behalf of his employer for the convenience of the employer, but only if--
(1) in the case of meals, the meals are furnished on the business premises of the employer, or
(2) in the case of lodging, the employee is required to accept such lodging on the business premises of his employer as a condition of his employment.
(b) Special rules. For purposes of subsection (a)--
(1) Provisions of employment contract or state statute not to be determinative. In determining whether meals or lodging are furnished for the convenience of the employer, the provisions of an employment contract or of a State statute fixing terms of employment shall not be determinative of whether the meals or lodging are intended as compensation.
(2) Certain factors not taken into account with respect to meals. In determining whether meals are furnished for the convenience of the employer, the fact that a charge is made for such meals, and the fact that the employee may accept or decline such meals, shall not be taken into account.
(4) Meals furnished to employees on business premises where meals of most employees are otherwise excludable. All meals furnished on the business premises of an employer to such employer's employees shall be treated as furnished for the convenience of the employer if, without regard to this paragraph, more than half of the employees to whom such meals are furnished on such premises are furnished such meals for the convenience of the employer.
(d) Lodging furnished by certain educational institutions to employees.
(1) In general. In the case of an employee of an educational institution, gross income shall not include the value of qualified campus lodging furnished to such employee during the taxable year.
(2) Exception in cases of inadequate rent. Paragraph (1) shall not apply to the extent of the excess of--
(A) the lesser of--
(i) 5 percent of the appraised value of the qualified campus lodging, or
(ii) the average of the rentals paid by individuals (other than employees or students of the educational institution) during such calendar year for lodging provided by the educational institution which is comparable to the qualified campus lodging provided to the employee, over
(B) the rent paid by the employee for the qualified campus lodging during such calendar year.
The appraised value under subparagraph (A)(i) shall be determined as of the close of the calendar year in which the taxable year begins, or, in the case of a rental period not greater than 1 year, at any time during the calendar year in which such period begins.
(3) Qualified campus lodging. For purposes of this subsection, the term "qualified campus lodging" means lodging to which subsection (a) does not apply and which is--
(A) located on, or in the proximity of, a campus of the educational institution, and
(B) furnished to the employee, his spouse, and any of his dependents by or on behalf of such institution for use as a residence.
(4) Educational institution, etc. For purposes of this subsection--
(A) In general. The term "educational institution" means--
(i) an institution described in section 170(b)(1)(A)(ii) [IRC Sec. 170(b)(1)(A)(ii)] (or an entity organized under State law and composed of public institutions so described), or
(ii) an academic health center.
(B) Academic health center. For purposes of subparagraph (A), the term "academic health center" means an entity--
(i) which is described in section 170(b)(1)(A)(iii) [IRC Sec. 170(b)(1)(A)(iii)],
(ii) which receives (during the calendar year in which the taxable year of the taxpayer begins) payments under subsection (d)(5)(B) or (h) of section 1886 of the Social Security Act [42 USCS § 1395ww] (relating to graduate medical education), and
(iii) which has as one of its principal purposes or functions the providing and teaching of basic and clinical medical science and research with the entity's own faculty.
CFR § 1.119-1 Meals and lodging furnished for the convenience of the employer.
(a) Meals—
(1) In general. The value of meals furnished to an employee by his employer shall be excluded from the employee's gross income if two tests are met: (i) The meals are furnished on the business premises of the employer, and (ii) the meals are furnished for the convenience of the employer. The question of whether meals are furnished for the convenience of the employer is one of fact to be determined by analysis of all the facts and circumstances in each case. If the tests described in subdivisions (i) and (ii) of this subparagraph are met, the exclusion shall apply irrespective of whether under an employment contract or a statute fixing the terms of employment such meals are furnished as compensation.
(2) Meals furnished without a charge. (i) Meals furnished by an employer without charge to the employee will be regarded as furnished for the convenience of the employer if such meals are furnished for a substantial noncompensatory business reason of the employer. If an employer furnishes meals as a means of providing additional compensation to his employee (and not for a substantial noncompensatory business reason of the employer), the meals so furnished will not be regarded as furnished for the convenience of the employer. Conversely, if the employer furnishes meals to his employee for a substantial noncompensatory business reason, the meals so furnished will be regarded as furnished for the convenience of the employer, even though such meals are also furnished for a compensatory reason. In determining the reason of an employer for furnishing meals, the mere declaration that meals are furnished for a noncompensatory business reason is not sufficient to prove that meals are furnished for the convenience of the employer, but such determination will be based upon an examination of all the surrounding facts and circumstances. In subdivision (ii) of this subparagraph, there are set forth some of the substantial noncompensatory business reasons which occur frequently and which justify the conclusion that meals furnished for such a reason are furnished for the convenience of the employer. In subdivision (iii) of this subparagraph, there are set forth some of the business reasons which are considered to be compensatory and which, in the absence of a substantial noncompensatory business reason, justify the conclusion that meals furnished for such a reason are not furnished for the convenience of the employer. Generally, meals furnished before or after the working hours of the employee will not be regarded as furnished for the convenience of the employer, but see subdivision (ii)(d) and (f) of this subparagraph for some exceptions to this general rule. Meals furnished on nonworking days do not qualify for the exclusion under section 119. If the employee is required to occupy living quarters on the business premises of his employer as a condition of his employment (as defined in paragraph (b) of this section), the exclusion applies to the value of any meal furnished without charge to the employee on such premises.
(ii)(a) Meals will be regarded as furnished for a substantial noncompensatory business reason of the employer when the meals are furnished to the employee during his working hours to have the employee available for emergency call during his meal period. In order to demonstrate that meals are furnished to the employee to have the employee available for emergency call during the meal period, it must be shown that emergencies have actually occurred, or can reasonably be expected to occur, in the employer's business which have resulted, or will result, in the employer calling on the employee to perform his job during his meal period.
(b) Meals will be regarded as furnished for a substantial noncompensatory business reason of the employer when the meals are furnished to the employee during his working hours because the employer's business is such that the employee must be restricted to a short meal period, such as 30 or 45 minutes, and because the employee could not be expected to eat elsewhere in such a short meal period. For example, meals may qualify under this subdivision when the employer is engaged in a business in which the peak work load occurs during the normal lunch hours. However, meals cannot qualify under this subdivision (b) when the reason for restricting the time of the meal period is so that the employee can be let off earlier in the day.
(c) Meals will be regarded as furnished for a substantial noncompensatory business reason of the employer when the meals are furnished to the employee during his working hours because the employee could not otherwise secure proper meals within a reasonable meal period. For example, meals may qualify under this subdivision (c) when there are insufficient eating facilities in the vicinity of the employer's premises.
(d) A meal furnished to a restaurant employee or other food service employee for each meal period in which the employee works will be regarded as furnished for a substantial noncompensatory business reason of the employer, irrespective of whether the meal is furnished during, immediately before, or immediately after the working hours of the employee.
(e) If the employer furnishes meals to employees at a place of business and the reason for furnishing the meals to each of substantially all of the employees who are furnished the meals is a substantial noncompensatory business reason of the employer, the meals furnished to each other employee will also be regarded as furnished for a substantial noncompensatory business reason of the employer.
(f) If an employer would have furnished a meal to an employee during his working hours for a substantial noncompensatory business reason, a meal furnished to such an employee immediately after his working hours because his duties prevented him from obtaining a meal during his working hours will be regarded as furnished for a substantial noncompensatory business reason.
(iii) Meals will be regarded as furnished for a compensatory business reason of the employer when the meals are furnished to the employee to promote the morale or goodwill of the employee, or to attract prospective employees.
(b) Lodging. The value of lodging furnished to an employee by the employer shall be excluded from the employee's gross income if three tests are met:
(1) The lodging is furnished on the business premises of the employer,
(2) The lodging is furnished for the convenience of the employer, and
(3) The employee is required to accept such lodging as a condition of his employment.
The requirement of subparagraph (3) of this paragraph that the employee is required to accept such lodging as a condition of his employment means that he be required to accept the lodging in order to enable him properly to perform the duties of his employment. Lodging will be regarded as furnished to enable the employee properly to perform the duties of his employment when, for example, the lodging is furnished because the employee is required to be available for duty at all times or because the employee could not perform the services required of him unless he is furnished such lodging. If the tests described in subparagraphs (1), (2), and (3) of this paragraph are met, the exclusion shall apply irrespective of whether a charge is made, or whether, under an employment contract or statute fixing the terms of employment, such lodging is furnished as compensation. If the employer furnishes the employee lodging for which the employee is charged an unvarying amount irrespective of whether he accepts the lodging, the amount of the charge made by the employer for such lodging is not, as such, part of the compensation includible in the gross income of the employee; whether the value of the lodging is excludable from gross income under section 119 is determined by applying the other rules of this paragraph. If the tests described in subparagraph (1), (2), and (3) of this paragraph are not met, the employee shall include in gross income the value of the lodging regardless of whether it exceeds or is less than the amount charged. In the absence of evidence to the contrary, the value of the lodging may be deemed to be equal to the amount charged.
(c) Business premises of the employer--(1) In general. For purposes of this section, the term “business premises of the employer” generally means the place of employment of the employee. For example, meals and lodging furnished in the employer's home to a domestic servant would constitute meals and lodging furnished on the business premises of the employer. Similarly, meals furnished to cowhands while herding their employer's cattle on leased land would be regarded as furnished on the business premises of the employer.
(2) Certain camps. For taxable years beginning after December 31, 1981, in the case of an individual who is furnished lodging by or on behalf of his employer in a camp (as defined in paragraph (d) of this section) in a foreign country (as defined in § 1.911-2(h)), the camp shall be considered to be part of the business premises of the employer.
(f) Examples. The provisions of section 119 may be illustrated by the following examples:
Example (1). A waitress who works from 7 a.m. to 4 p.m. is furnished without charge two meals a work day. The employer encourages the waitress to have her breakfast on his business premises before starting work, but does not require her to have breakfast there. She is required, however, to have her lunch on such premises. Since the waitress is a food service employee and works during the normal breakfast and lunch periods, the waitress is permitted to exclude from her gross income both the value of the breakfast and the value of the lunch.
Example (2). The waitress in example (1) is allowed to have meals on the employer's premises without charge on her days off. The waitress is not permitted to exclude the value of such meals from her gross income.
Example (3). A bank teller who works from 9 a.m. to 5 p.m. is furnished his lunch without charge in a cafeteria which the bank maintains on its premises. The bank furnishes the teller such meals in order to limit his lunch period to 30 minutes since the bank's peak work load occurs during the normal lunch period. If the teller had to obtain his lunch elsewhere, it would take him considerably longer than 30 minutes for lunch, and the bank strictly enforces the 30-minute time limit. The bank teller may exclude from his gross income the value of such meals obtained in the bank cafeteria.
Example (4). Assume the same facts as in example (3), except that the bank charges the bank teller an unvarying rate per meal regardless of whether he eats in the cafeteria. The bank teller is not required to include in gross income such flat amount charged as part of his compensation, and he is entitled to exclude from his gross income the value of the meals he receives for such flat charge.
Example (5). A Civil Service employee of a State is employed at an institution and is required by his employer to be available for duty at all times. The employer furnishes the employee with meals and lodging at the institution without charge. Under the applicable State statute, his meals and lodging are regarded as part of the employee's compensation. The employee would nevertheless be entitled to exclude the value of such meals and lodging from his gross income.
Example (6). An employee of an institution is given the choice of residing at the institution free of charge, or of residing elsewhere and receiving a cash allowance in addition to his regular salary. If he elects to reside at the institution, the value to the employee of the lodging furnished by the employer will be includible in the employee's gross income because his residence at the institution is not required in order for him to perform properly the duties of his employment.
Example (7). A construction worker is employed at a construction project at a remote job site in Alaska. Due to the inaccessibility of facilities for the employees who are working at the job site to obtain food and lodging and the prevailing weather conditions, the employer is required to furnish meals and lodging to the employee at the camp site in order to carry on the construction project. The employee is required to pay $40 a week for the meals and lodging. The weekly charge of $40 is not, as such, part of the compensation includible in the gross income of the employee, and under paragraphs (a) and (b) of this section the value of the meals and lodging is excludable from his gross income.
Example (8). A manufacturing company provides a cafeteria on its premises at which its employees can purchase their lunch. There is no other eating facility located near the company's premises, but the employee can furnish his own meal by bringing his lunch. The amount of compensation which any employee is required to include in gross income is not reduced by the amount charged for the meals, and the meals are not considered to be furnished for the convenience of the employer.
Example (9). A hospital maintains a cafeteria on its premises where all of its 230 employees may obtain a meal during their working hours. No charge is made for these meals. The hospital furnishes such meals in order to have each of 210 of the employees available for any emergencies that may occur, and it is shown that each such employee is at times called upon to perform services during his meal period. Although the hospital does not require such employees to remain on the premises during meal periods, they rarely leave the hospital during their meal period. Since the hospital furnishes meals to each of substantially all of its employees in order to have each of them available for emergency call during his meal period, all of the hospital employees who obtain their meals in the hospital cafeteria may exclude from their gross income the value of such meals.
IV. Section 132
IRC § 132. Certain fringe benefits.
(a) Exclusion from gross income. Gross income shall not include any fringe benefit which qualifies as a--
(1) no-additional-cost service, [no discrimination allowed]
(2) qualified employee discount, [no discrimination allowed]
(3) working condition fringe,
(4) de minimis fringe,
(5) qualified transportation fringe,
(6) qualified moving expense reimbursement,
(7) qualified retirement planning services, or
(8) qualified military base realignment and closure fringe.
(b) No-additional-cost service defined. For purposes of this section, the term "no-additional-cost service" means any service provided by an employer to an employee for use by such employee if--
(1) such service is offered for sale to customers in the ordinary course of the line of business of the employer in which the employee is performing services, and
(2) the employer incurs no substantial additional cost (including forgone revenue) in providing such service to the employee (determined without regard to any amount paid by the employee for such service).
(c) Qualified employee discount defined. For purposes of this section--
(1) Qualified employee discount. The term "qualified employee discount" means any employee discount with respect to qualified property or services to the extent such discount does not exceed--
(A) in the case of property, the gross profit percentage of the price at which the property is being offered by the employer to customers, or
(B) in the case of services, 20 percent of the price at which the services are being offered by the employer to customers. [gross profit is irrelevant for services]
(2) Gross profit percentage.
(A) In general. The term "gross profit percentage" means the percent which--
(i) the excess of the aggregate sales price of property sold by the employer to customers over the aggregate cost of such property to the employer, is of
(ii) the aggregate sale price of such property.
(B) Determination of gross profit percentage. Gross profit percentage shall be determined on the basis of--
(i) all property offered to customers in the ordinary course of the line of business of the employer in which the employee is performing services (or a reasonable classification of property selected by the employer), and
(ii) the employer's experience during a representative period.
(3) Employee discount defined. The term "employee discount" means the amount by which--
(A) the price at which the property or services are provided by the employer to an employee for use by such employee, is less than
(B) the price at which such property or services are being offered by the employer to customers.
(4) Qualified property or services. The term "qualified property or services" means any property (other than real property and other than personal property of a kind held for investment) or services which are offered for sale to customers in the ordinary course of the line of business of the employer in which the employee is performing services.
(d) Working condition fringe defined. For purposes of this section, the term "working condition fringe" means any property or services provided to an employee of the employer to the extent that, if the employee paid for such property or services, such payment would be allowable as a deduction under section 162 or 167 [IRC Sec. 162 or 167].
(e) De minimis fringe defined. For purposes of this section--
(1) In general. The term "de minimis fringe" means any property or service the value of which is (after taking into account the frequency with which similar fringes are provided by the employer to the employer's employees) so small as to make accounting for it unreasonable or administratively impracticable.
(2) Treatment of certain eating facilities. The operation by an employer of any eating facility for employees shall be treated as a de minimis fringe if--
(A) such facility is located on or near the business premises of the employer, and
(B) revenue derived from such facility normally equals or exceeds the direct operating costs of such facility.
The preceding sentence shall apply with respect to any highly compensated employee only if access to the facility is available on substantially the same terms to each member of a group of employees which is defined under a reasonable classification set up by the employer which does not discriminate in favor of highly compensated employees. For purposes of subparagraph (B), an employee entitled under section 119 [IRC Sec. 119] to exclude the value of a meal provided at such facility shall be treated as having paid an amount for such meal equal to the direct operating costs of the facility attributable to such meal.
• Examples include the typing of personal letters by a company administrative assistant, the occasional personal use of a copy machine, occasional company cocktail parties or picnics, transportation provided for the security of the employee, occasional entertainment tickets, coffee, donuts, and soft drinks provided employees, to name a few.
• The regulations state that meals or meal reimbursement provided to employees who work late are excludable if three conditions are met:
o (1) they are only provided occasionally
o (2) they are provided when the employee works overtime, and
o (3) they are provided to enable the employee to work overtime. See Reg. §1.132–6(d)(2) [EE 59, Q 21(b)
(f) Qualified transportation fringe.
(1) In general. For purposes of this section, the term "qualified transportation fringe" means any of the following provided by an employer to an employee:
(A) Transportation in a commuter highway vehicle if such transportation is in connection with travel between the employee's residence and place of employment.
(B) Any transit pass.
(C) Qualified parking.
(D) Any qualified bicycle commuting reimbursement. [max of $20 per qualified bicycle commuting month.]
(2) Limitation on exclusion. The amount of the fringe benefits which are provided by an employer to any employee and which may be excluded from gross income under subsection (a)(5) shall not exceed--
(A) [Caution: For taxable years beginning in 2009, see § 3.12 of Rev. Proc. 2008-66 (26 USCS § 1 note) for provision that the monthly limitation under this subparagraph is $ 120.] $ 100 per month in the case of the aggregate of the benefits described in subparagraphs (A) and (B) of paragraph (1),
(B) [Caution: For taxable years beginning in 2009, see § 3.12 of Rev. Proc. 2008-66 (26 USCS § 1 note) for provision that the monthly limitation under this subparagraph is $ 230.] $ 175 per month in the case of qualified parking, and
(C) the applicable annual limitation in the case of any qualified bicycle commuting reimbursement.
In the case of any month beginning on or after the date of the enactment of this sentence [enacted Feb. 17, 2009] and before January 1, 2011, subparagraph (A) shall be applied as if the dollar amount therein were the same as the dollar amount in effect for such month under subparagraph (B).
(3) Cash reimbursements. For purposes of this subsection, the term "qualified transportation fringe" includes a cash reimbursement by an employer to an employee for a benefit described in paragraph (1). The preceding sentence shall apply to a cash reimbursement for any transit pass only if a voucher or similar item which may be exchanged only for a transit pass is not readily available for direct distribution by the employer to the employee.
(4) No constructive receipt. No amount shall be included in the gross income of an employee solely because the employee may choose between any qualified transportation fringe (other than a qualified bicycle commuting reimbursement) and compensation which would otherwise be includible in gross income of such employee.
(5) Definitions. For purposes of this subsection--
(A) Transit pass. The term "transit pass" means any pass, token, farecard, voucher, or similar item entitling a person to transportation (or transportation at a reduced price) if such transportation is--
(i) on mass transit facilities (whether or not publicly owned), or
(ii) provided by any person in the business of transporting persons for compensation or hire if such transportation is provided in a vehicle meeting the requirements of subparagraph (B)(i).
(B) Commuter highway vehicle. The term "commuter highway vehicle" means any highway vehicle--
(i) the seating capacity of which is at least 6 adults (not including the driver), and
(ii) at least 80 percent of the mileage use of which can reasonably be expected to be--
(I) for purposes of transporting employees in connection with travel between their residences and their place of employment, and
(II) on trips during which the number of employees transported for such purposes is at least 1/2 of the adult seating capacity of such vehicle (not including the driver).
(C) Qualified parking. The term "qualified parking" means parking provided to an employee on or near the business premises of the employer or on or near a location from which the employee commutes to work by transportation described in subparagraph (A), in a commuter highway vehicle, or by carpool. Such term shall not include any parking on or near property used by the employee for residential purposes.
(D) Transportation provided by employer. Transportation referred to in paragraph (1)(A) shall be considered to be provided by an employer if such transportation is furnished in a commuter highway vehicle operated by or for the employer.
(E) Employee. For purposes of this subsection, the term "employee" does not include an individual who is an employee within the meaning of section 401(c)(1) [IRC Sec. 401(c)(1)].
(F) Definitions related to bicycle commuting reimbursement.
(i) Qualified bicycle commuting reimbursement. The term "qualified bicycle commuting reimbursement" means, with respect to any calendar year, any employer reimbursement during the 15-month period beginning with the first day of such calendar year for reasonable expenses incurred by the employee during such calendar year for the purchase of a bicycle and bicycle improvements, repair, and storage, if such bicycle is regularly used for travel between the employee's residence and place of employment.
(ii) Applicable annual limitation. The term "applicable annual limitation" means, with respect to any employee for any calendar year, the product of $ 20 multiplied by the number of qualified bicycle commuting months during such year.
(iii) Qualified bicycle commuting month. The term "qualified bicycle commuting month" means, with respect to any employee, any month during which such employee--
(I) regularly uses the bicycle for a substantial portion of the travel between the employee's residence and place of employment, and
(II) does not receive any benefit described in subparagraph (A), (B), or (C) of paragraph (1).
(g) Qualified moving expense reimbursement. For purposes of this section, the term "qualified moving expense reimbursement" means any amount received (directly or indirectly) by an individual from an employer as a payment for (or a reimbursement of) expenses which would be deductible as moving expenses under section 217 [IRC Sec. 217] if directly paid or incurred by the individual. Such term shall not include any payment for (or reimbursement of) an expense actually deducted by the individual in a prior taxable year.
(h) Certain individuals treated as employees for purposes of subsections (a)(1) and (2). For purposes of paragraphs (1) and (2) of subsection (a)--
(1) Retired and disabled employees and surviving spouse of employee treated as employee. With respect to a line of business of an employer, the term "employee" includes--
(A) any individual who was formerly employed by such employer in such line of business and who separated from service with such employer in such line of business by reason of retirement or disability, and
(B) any widow or widower of any individual who died while employed by such employer in such line of business or while an employee within the meaning of subparagraph (A).
(2) Spouse and dependent children.
(A) In general. Any use by the spouse or a dependent child of the employee shall be treated as use by the employee.
(B) Dependent child. For purposes of subparagraph (A), the term "dependent child" means any child (as defined in section 152(f)(1) [IRC Sec. 152(f)(1)]) of the employee--
(i) who is a dependent of the employee, or
(ii) both of whose parents are deceased and who has not attained age 25.
For purposes of the preceding sentence, any child to whom section 152(e) [IRC Sec. 152(e)] applies shall be treated as the dependent of both parents.
(3) Special rule for parents in the case of air transportation. Any use of air transportation by a parent of an employee (determined without regard to paragraph (1)(B)) shall be treated as use by the employee.
(i) Reciprocal agreements. For purposes of paragraph (1) of subsection (a), any service provided by an employer to an employee of another employer shall be treated as provided by the employer of such employee if--
(1) such service is provided pursuant to a written agreement between such employers, and
(2) neither of such employers incurs any substantial additional costs (including foregone revenue) in providing such service or pursuant to such agreement.
(j) Special rules.
(1) Exclusions under subsection (a)(1) and (2) apply to highly compensated employees only if no discrimination. Paragraphs (1) and (2) of subsection (a) shall apply with respect to any fringe benefit described therein provided with respect to any highly compensated employee only if such fringe benefit is available on substantially the same terms to each member of a group of employees which is defined under a reasonable classification set up by the employer which does not discriminate in favor of highly compensated employees.
(ii) there are substantial restrictions on the personal use of such automobile by such salesman.
(4) On-premises gyms and other athletic facilities.
(A) In general. Gross income shall not include the value of any on-premises athletic facility provided by an employer to his employees.
(B) On-premises athletic facility. For purposes of this paragraph, the term "on-premises athletic facility" means any gym or other athletic facility--
(i) which is located on the premises of the employer,
(ii) which is operated by the employer, and
(iii) substantially all the use of which is by employees of the employer, their spouses, and their dependent children (within the meaning of subsection (h)).
V. Other fringe benefits
Tax Treatment of Insurance for Medical Care [CB 119]
| |Premiums |Proceeds |
|Employer-Provided Coverage |Excluded, § 106 |Excluded § 105(b) |
|Individually Purchased Insurance |Limited Deduction, § 213(d)(1)(D) |Excluded § 104(a)(3) |
|Self-insurance |N/A |Limited Deduction, § 213(a) |
§ 106. Contributions by employer to accident and health plans.
(a) General rule. Except as otherwise provided in this section, gross income of an employee does not include employer-provided coverage under an accident or health plan.
§ 125. Cafeteria plans.
(a) In General. Except as provided in subsection (b), no amount shall be included in the gross income of a participant in a cafeteria plan solely because, under the plan, the participant may choose among the benefits of the plan.
(d) Cafeteria plan defined. For purposes of this section
(1) In general. The term "cafeteria plan" means a written plan under which--
(A) all participants are employees, and
(B) the participants may choose among 2 or more benefits consisting of cash and qualified benefits.
(f) Qualified benefits defined. For purposes of this section, the term "qualified benefit" means any benefit which, with the application of subsection (a), is not includible in the gross income of the employee by reason of an express provision of this chapter [IRC Sections 1 et seq.] (other than section 106(b), 117, 127, or 132 [IRC Sec. 106(b), 117, 127, or 132]). Such term includes any group term life insurance which is includible in gross income only because it exceeds the dollar limitation of section 79 [IRC Sec. 79] and such term includes any other benefit permitted under regulations. Such term shall not include any product which is advertised, marketed, or offered as long-term care insurance.
Flexible Spending Arrangements [CB 122 Note 5]
§ 125 authorizes an employer-created programs known as flexible spending arrangements, which can be used to pay or reimburse otherwise uninsured employee out-of-pocket medical care expenses.
• Incurred during a 12-month coverage period, with grace period of 2 months 15 days after close of plan period
• For medical services and eligible drug store purchases
• Use it or lose it
• Reimbursed at the time of the expense, regardless of the amount contributed to the plan as of that date (usually through salary reduction).
• Election to contribute made in advance of coverage year. Irrevocable.
• Contributions are characterized as employer-provided health care coverage for tax purposes.
• Payments from the account are viewed as proceeds of employer-provided medical care insurance.
§ 129. Dependent care assistance programs.
(a) Exclusion.
(1) In general. Gross income of an employee does not include amounts paid or incurred by the employer for dependent care assistance provided to such employee if the assistance is furnished pursuant to a program which is described in subsection (d).
(2) Limitation of exclusion.
(A) In general. The amount which may be excluded under paragraph (1) for dependent care assistance with respect to dependent care services provided during a taxable year shall not exceed $ 5,000 ($ 2,500 in the case of a separate return by a married individual).
(B) Year of inclusion. The amount of any excess under subparagraph (A) shall be included in gross income in the taxable year in which the dependent care services were provided (even if payment of dependent care assistance for such services occurs in a subsequent taxable year).
(C) Marital status. For purposes of this paragraph, marital status shall be determined under the rules of paragraphs (3) and (4) of section 21(e).
(b) Earned income limitation.
(1) In general. The amount excluded from the income of an employee under subsection (a) for any taxable year shall not exceed--
(A) in the case of an employee who is not married at the close of such taxable year, the earned income of such employee for such taxable year, or
(B) in the case of an employee who is married at the close of such taxable year, the lesser of--
(i) the earned income of such employee for such taxable year, or
(ii) the earned income of the spouse of such employee for such taxable year.
(2) Special rule for certain spouses. For purposes of paragraph (1), the provisions of section 21(d)(2) [IRC Sec. 21(d)(2)] shall apply in determining the earned income of a spouse who is a student or incapable of caring for himself.
§ 79. Group-term life insurance purchased for employees.
(a) General rule. There shall be included in the gross income of an employee for the taxable year an amount equal to the cost of group-term life insurance on his life provided for part or all of such year under a policy (or policies) carried directly or indirectly by his employer (or employers); but only to the extent that such cost exceeds the sum of--
(1) the cost of $ 50,000 of such insurance, and
(2) the amount (if any) paid by the employee toward the purchase of such insurance.
VI. Barter exchanges
Revenue Ruling 79-24
Gross income; barter transactions. Certain members of barter clubs must include in income the fair market value of services received in exchange for services rendered. Likewise, the owner of an apartment building who receives a work of art created by a professional artist in return for the rent-free use of an apartment must include in income the fair market value of the work of art, and the artist must include the fair rental value of the apartment.
VII. Windfalls
a. Commissioner v. Glenshaw Glass Co. (p. 90)
Involves two cases that have been consolidated - Glenshaw and William Goldman Theaters. Both are Ps that had initiated anti-trust suits and won.
Glenshaw won a settlement : $800K, made up of $325K punitive + $475K compensatory.
William Goldman Theaters: $125K economic damages + $250K punitives
In both cases, Ps reported the compensatory portions of recovery, but not the punitives. They recognized that the compensatory damages replaced lost profits.
Replacement Rule: what does recovery replace? What would have been the tax treatment of the item that is being replaced? This will be the tax rate.
• Compensatory damages: make whole, compensate
• Punitive damages: Punish D and deter others. Considered a windfall to P because they just happen to be the beneficiary here, but this amount is not compensation for anything.
Issue: do punitive damages have to be included in income? Trial courts said no, but the USSCT says it is income.
Rule: definition of income on p. 92: "Here we have instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion." [EE 37]
b. Different sorts of damages
c. Treatment of punitive
d. Windfalls more generally
§ 85. Unemployment compensation.
(a) General rule. In the case of an individual, gross income includes unemployment compensation.
(b) Unemployment compensation defined. For purposes of this section, the term "unemployment compensation" means any amount received under a law of the United States or of a State which is in the nature of unemployment compensation.
(c) Special rule for 2009. In the case of any taxable year beginning in 2009, gross income shall not include so much of the unemployment compensation received by an individual as does not exceed $ 2,400.
VIII. Gifts
a. Alternatives
b. Justifications for §102
c. Duberstein
i. Background
ii. Legal standard
iii. Application
d. Employees
e. Section 274(b)
Transactions have Donor and Recipient
Hypo: A gives B $100. Under the "accession to wealth" definition, it would be includable income of $100 and a deduction for donor of $100. Under § 102(a), gifts are not included in income, which also means no deduction for the donor.
Why are gifts excluded from income?
• Administrability would be a nightmare to track the gifts and to value them. Enforcement would also be difficult. Also think about progressivity, where the IRC is a progressive code, and wants to prevent a significant evasion of progressivity, where people could shift income from higher tax payers to lower tax payers through gifts.
Because gifts are treated differently than income, we need a rule to define them. See Duberstein
Commissioner v. Duberstein (and Stanton (p. 179))
Berman (President of Mohawk Metal Corporation) gives Duberstein a Cadillac as a "thank you" for giving him some business leads.
Stanton gets $20K from the Trinity Church as a "gratuity" for his years of service to the church.
Rule: Justice Brennan defines a gift (p. 182): "A gift in the statutory sense, proceeds from a detached and disinterested generosity, out of affection, respect, admiration, charity, or the like impulse." Look at transferor’s intent. This is a much narrower conception of income than the common law definition, which treats as a gift anything that is not given out of "legal or moral obligation." Trier of fact must weigh all of the factors.
Was the Cadillac a gift? Factual question to be reviewed on a "clearly erroneous" standard of review. = No, not a gift. USSCT upheld the lower court's finding of fact that the car was payment for services rendered.
Stanton is a little more complicated because the trial court determined it was a gift, but provided no factual background. On remand, trial court determines it was an unselfish gift.
Statutory Framework to add on:
§ 102(c) Employee gifts. Per se, there are so gifts from employers to employees. If Stanton were tried today, it would probably not be a gift because of this provision.
§ 274(b): provides a limited deduction for limited business-related gifts of up to $25 per person/yr.
§ 102. Gifts and inheritances.
(a) General rule. Gross income does not include the value of property acquired by gift, bequest, devise, or inheritance.
(b) Income. Subsection (a) shall not exclude from gross income--
(1) the income from any property referred to in subsection (a); or
(2) where the gift, bequest, devise, or inheritance is of income from property, the amount of such income.
Where, under the terms of the gift, bequest, devise, or inheritance, the payment, crediting, or distribution thereof is to be made at intervals, then, to the extent that it is paid or credited or to be distributed out of income from property, it shall be treated for purposes of paragraph (2) as a gift, bequest, devise, or inheritance of income from property. Any amount included in the gross income of a beneficiary under subchapter J [IRC Sections 641 et seq.] shall be treated for purposes of paragraph (2) as a gift, bequest, devise, or inheritance of income from property.
(c) Employee gifts.
(1) In general. Subsection (a) shall not exclude from gross income any amount transferred by or for an employer to, or for the benefit of, an employee.
(2) Cross references. For provisions excluding certain employee achievement awards from gross income, see section 74(c) [IRC Sec. 74(c)].
For provisions excluding certain de minimis fringes from gross income, see section 132(e) [IRC Sec. 132(e)].
§ 274. Disallowance of certain entertainment, etc., expenses.
(b) Gifts.
(1) Limitation. No deduction shall be allowed under section 162 or section 212 [IRC Sec. 162 or 212] for any expense for gifts made directly or indirectly to any individual to the extent that such expense, when added to prior expenses of the taxpayer for gifts made to such individual during the same taxable year, exceeds $ 25. For purposes of this section, the term "gift" means any item excludable from gross income of the recipient under section 102 [IRC Sec. 102] which is not excludable from his gross income under any other provision of this chapter [IRC Sections 1 et seq.], but such term does not include--
(A) an item having a cost to the taxpayer not in excess of $ 4.00 on which the name of the taxpayer is clearly and permanently imprinted and which is one of a number of identical items distributed generally by the taxpayer, or
(B) a sign, display rack, or other promotional material to be used on the business premises of the recipient.
(2) Special rules.
(A) In the case of a gift by a partnership, the limitation contained in paragraph (1) shall apply to the partnership as well as to each member thereof.
(B) For purposes of paragraph (1), a husband and wife shall be treated as one taxpayer.
IX. Transfers of unrealized gain and loss
a. Basis and cost recovery
b. Taft v. Bowers
c. Surrogate taxation
d. Current statutory framework
i. §1001
ii. §1011
iii. §1012
iv. §1015
v. §1014
e. Handout 3
Taft v. Bowers (p. 165)
Issue: When we have a gift of property, what is the basis in the property that was received? Whether § 1015 is unconstitutional because it would require a person to report income that wasn't all gained during the time they held the asset.
A buys shares for $1,000
A gives shares to B when FMV = $2,000. No tax consequence here, b/c = gift.
B sells shares for $5K. What is tax consequence here?
§ 1015 carry-over basis. Presumptively, recipient assumes basis of donor.
Amount realized: $5K.
Basis (carried over from A): $1,000
Gain = difference of $4K
Current Statutory Framework
§ 1001:
• Gain = amount realized - adjusted basis
• Loss = adjusted basis - amount realized
• Amount realized = FMV of everything received in the transaction ($ + property)
§ 1011 & § 1012:
• Basis: a measure of the TP's investment in the proprty in already taxed dollars.
o Original basis = original costs
§ 1015: Threshold question: was FMV less than donor's basis at time of transfer?
| |Gain Basis |Loss Basis |
|FMV (at time of gift) > donor's basis |Carry-over |Carry-over |
|FMV(at time of gift) < donor's basis |Carry-over |FMV @ time of gift |
Exception requiring use of FMV where property is valued below basis at the time of gift prevents gifting of losses to shift deductions to people in a higher tax bracket.
Note: this results in a gain basis and a loss basis.
§ 1014: Gift at death: basis = FMV at time of decedent's death (stepped-up basis)
This is the 4th or 5th biggest tax subsidy in the IRC.
Comment: this also wipes out any unrealized losses, so if a person knows they are going to die soon, they should sell any property that has declined in value to be able to recognize the losses.
Note: estate and gift tax is phased out in 2010, but then everything goes back to its 2001 state in 2011. Part of this bill is that § 1014 gets replaced by § 1022, which is a modified version of § 1015 that imposes a stepped-up basis for property transferred at death. However, it is very likely that the law will be modified before it takes effect in 2011 and § 1022 will probably never go into effect.
All of the problems on Handout 3 are when the gift/property is given in its entirety. What do we do when the property is split, say between the underlying property and the income from the property? How do we allocate basis between those two recipients? See Irwin v. Gavit.
§ 1001. Determination of amount of and recognition of gain or loss.
(a) Computation of gain or loss. The gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis provided in section 1011 [IRC Sec. 1011] for determining gain, and the loss shall be the excess of the adjusted basis provided in such section for determining loss over the amount realized.
(b) Amount realized. The amount realized from the sale or other disposition of property shall be the sum of any money received plus the fair market value of the property (other than money) received. In determining the amount realized--
(1) there shall not be taken into account any amount received as reimbursement for real property taxes which are treated under section 164(d) [IRC Sec. 164(d)] as imposed on the purchaser, and
(2) there shall be taken into account amounts representing real property taxes which are treated under section 164(d) [IRC Sec. 164(d)] as imposed on the taxpayer if such taxes are to be paid by the purchaser.
(c) Recognition of gain or loss. Except as otherwise provided in this subtitle [IRC Sections 1 et seq.], the entire amount of the gain or loss, determined under this section, on the sale or exchange of property shall be recognized.
§ 1011. Adjusted basis for determining gain or loss.
(a) General rule. The adjusted basis for determining the gain or loss from the sale or other disposition of property, whenever acquired, shall be the basis (determined under section 1012 [IRC Sec. 1012] or other applicable sections of this subchapter [IRC Sections 1001 et seq.] and subchapters C [IRC Sections 301 et seq.] (relating to corporate distributions and adjustments), K [IRC Sections 701 et seq.] (relating to partners and partnerships), and P [IRC Sections 1201 et seq.] (relating to capital gains and losses)), adjusted as provided in section 1016 [IRC Sec. 1016].
§ 1012. Basis of property--cost.
(a) In general. The basis of property shall be the cost of such property, except as otherwise provided in this subchapter [IRC Sections 1001 et seq.] and subchapters C [IRC Sections 301 et seq.] (relating to corporate distributions and adjustments), K [IRC Sections 701 et seq.] (relating to partners and partnerships), and P [IRC Sections 1201 et seq.] (relating to capital gains and losses).
(b) Special rule for apportioned real estate taxes. The cost of real property shall not include any amount in respect of real property taxes which are treated under section 164(d) [IRC Sec. 164(d)] as imposed on the taxpayer.
(c) Determinations by account [Caution: This subsection takes effect on January 1, 2011, as provided by § 403(e)(1) of Act Oct. 3, 2008, P.L. 110-343, which appears as a note to this section.].
(1) In general. In the case of the sale, exchange, or other disposition of a specified security on or after the applicable date, the conventions prescribed by regulations under this section shall be applied on an account by account basis.
(2) Application to certain funds.
(A) In general. Except as provided in subparagraph (B), any stock for which an average basis method is permissible under section 1012 [this section] which is acquired before January 1, 2012, shall be treated as a separate account from any such stock acquired on or after such date.
(B) Election fund for treatment as single account. If a fund described in subparagraph (A) elects to have this subparagraph apply with respect to one or more of its stockholders--
(i) subparagraph (A) shall not apply with respect to any stock in such fund held by such stockholders, and
(ii) all stock in such fund which is held by such stockholders shall be treated as covered securities described in section 6045(g)(3) [IRC Sec. 6045(g)(3)] without regard to the date of the acquisition of such stock.
A rule similar to the rule of the preceding sentence shall apply with respect to a broker holding such stock as a nominee.
(3) Definitions. For purposes of this section, the terms "specified security" and "applicable date" shall have the meaning given such terms in section 6045(g).
(d) Average basis for stock acquired pursuant to a dividend reinvestment plan [Caution: This subsection takes effect on January 1, 2011, as provided by § 403(e)(1) of Act Oct. 3, 2008, P.L. 110-343, which appears as a note to this section.].
(1) In general. In the case of any stock acquired after December 31, 2010, in connection with a dividend reinvestment plan, the basis of such stock while held as part of such plan shall be determined using one of the methods which may be used for determining the basis of stock in an open-end fund.
(2) Treatment after transfer. In the case of the transfer to another account of stock to which paragraph (1) applies, such stock shall have a cost basis in such other account equal to its basis in the dividend reinvestment plan immediately before such transfer (properly adjusted for any fees or other charges taken into account in connection with such transfer).
(3) Separate accounts; election for treatment as single account. Rules similar to the rules of subsection (c)(2) shall apply for purposes of this subsection.
(4) Dividend reinvestment plan. For purposes of this subsection--
(A) In general. The term "dividend reinvestment plan" means any arrangement under which dividends on any stock are reinvested in stock identical to the stock with respect to which the dividends are paid.
(B) Initial stock acquisition treated as acquired in connection with plan. Stock shall be treated as acquired in connection with a dividend reinvestment plan if such stock is acquired pursuant to such plan or if the dividends paid on such stock are subject to such plan.
§ 1014. Basis of property acquired from a decedent.
(a) In general. Except as otherwise provided in this section, the basis of property in the hands of a person acquiring the property from a decedent or to whom the property passed from a decedent shall, if not sold, exchanged, or otherwise disposed of before the decedent's death by such person, be--
(1) the fair market value of the property at the date of the decedent's death,
(2) in the case of an election under either section 2032 or section 811(j) of the Internal Revenue Code of 1939 where the decedent died after October 21, 1942, its value at the applicable valuation date prescribed by those sections,
(3) in the case of an election under section 2032A [IRC Sec. 2032A], its value determined under such section, or
(4) to the extent of the applicability of the exclusion described in section 2031(c) [IRC Sec. 2031(c)], the basis in the hands of the decedent.
(b) Property acquired from the decedent. For purposes of subsection (a), the following property shall be considered to have been acquired from or to have passed from the decedent:
(1) Property acquired by bequest, devise, or inheritance, or by the decedent's estate from the decedent;
(2) Property transferred by the decedent during his lifetime in trust to pay the income for life to or on the order or direction of the decedent, with the right reserved to the decedent at all times before his death to revoke the trust;
(3) In the case of decedents dying after December 31, 1951, property transferred by the decedent during his lifetime in trust to pay the income for life to or on the order or direction of the decedent with the right reserved to the decedent at all times before his death to make any change in the enjoyment thereof through the exercise of a power to alter, amend, or terminate the trust;
(4) Property passing without full and adequate consideration under a general power of appointment exercised by the decedent by will;
• Referred to as stepped-up basis [CB 169]
• Converts the deferral inherent in the realization requirement into outright tax forgiveness.
• Encourages people to hold on to their appreciated property until death.
• Avoids forced liquidation of property in order to pay tax at time of transfer
§ 1015. Basis of property acquired by gifts and transfers in trust.
(a) Gifts after December 31, 1920. If the property was acquired by gift after December 31, 1920, the basis shall be the same as it would be in the hands of the donor or the last preceding owner by whom it was not acquired by gift, except that if such basis (adjusted for the period before the date of the gift as provided in section 1016 [IRC Sec. 1016]) is greater than the fair market value of the property at the time of the gift, then for the purpose of determining loss the basis shall be such fair market value. If the facts necessary to determine the basis in the hands of the donor or the last preceding owner are unknown to the donee, the Secretary shall, if possible, obtain such facts from such donor or last preceding owner, or any other person cognizant thereof. If the Secretary finds it impossible to obtain such facts, the basis in the hands of such donor or last preceding owner shall be the fair market value of such property as found by the Secretary as of the date or approximate date at which, according to the best information that the Secretary is able to obtain, such property was acquired by such donor or last preceding owner.
X. Gifts of divided interests in property
a. Introduction
b. Irwin v. Gavit
c. Justifications
d. Handout 4
Irwin v. Gavit (p. 157) continued on 9/9/09
Holding now codified in § 102(b)(2)
• Can be analogized by the hypo:
o Trust distributes:
▪ income for the next 15 years to son-in-law (Palmer) and
▪ property to granddaughter in 15 years when she turns 21 (Marcia)
Discussion: if the gift were given outright to Marcia, she would pay tax on the income generated from the property, so the court says Congress couldn't possibly have intended the statute to allow the income from the property to be tax exempt merely because the gift is split between income and principal.
What does this mean for basis?
Because the property is transferred to her at the death of the transferor, she receives it at the stepped-up basis (assume = $100K). So, when Marcia sells for $125K, she gets to exclude $100K from her income.
o None of the basis goes with the person who receives the income stream from the property. It all goes with the person who gets the property.
How basis is allocated has nothing to do with the value of the respective interests. It is more administrable to just have the entire basis go to the person receiving the property.
DISCUSSION OF HANDOUT 4
XI. Capital gains
a. A form of income
b. Not a separate tax
c. Definition
d. A preference
e. Capital losses
Merely another form of income, like wages, compensation, dividends, interest, windfalls, etc.
o Principal rules: [CB 24]
o Unrealized appreciation is not taxed
o Income may be realized from an item of appreciated property by sale, by exchange for other property, or in a variety of other ways.
o Even if income is realized, there may be statutory provisions providing that it will not be recognized. Recognition may be postponed or eliminated.
o Recognized gain may be classified as long-term capital gain if it arises from the sale or exchange of a capital asset held for more than one year.
o Gain on the sale or other disposition of any property is the amount realized on the disposition, less the TP’s adjusted basis. [CB 26]
o Basis is usually cost, but there are exceptions.
o Capital losses are subtracted from capital gains before applying any of the special capital gain rate provisions. If capital losses exceed capital gains, deductibility of the excess losses is generally limited to $3,000 per year. § 1211 [CB 1056]
▪ Disallowed losses carry over to future years. § 1212. [CB 1057]
o Short-term capital gains [CB 1057 § 1222]: net against short-term capital losses. Don’t get preferential rate treatment like long-term capital gains.
▪ First step: ST gains are offset against ST losses and LT gains are offset against LT losses.
▪ If there is an excess of losses in either category (ST or LT), these are offset against one another as the last step.
▪ Capital loss limitation draws no distinction between ST and LT losses.
Capital Gains (§ 1221): gain on the disposition of a capital asset.
Capital Asset: (generally) all property other than inventory.
Capital Loss: only deductible to the extend of capital gains in the same year + $3,000 (any remainder carries over)
Preferential Treatment: Currently, highest marginal rate for ordinary income is 35%. Highest marginal rate for long-term capital gains is 15%. Long-term generally means property held for at least one year.
XII. The recovery of capital: the concept of basis
a. The timing of cost recovery
b. Inaja Land Co. v. Commissioner
i. Background
ii. Competing arguments
iii. How much recovery?
iv. Current rule
c. Adjustments to basis
Inaja Land Company, Ltd., v. Commissioner of IRS (1947)
Inaja owns land along the Owens river, which gets polluted when the City of Los Angeles builds an aqueduct upstream. Inaja paid $61K for the property. Recovered $49K ($50K less $1000 spent on attorney) from L.A. in settlement for the overflow onto his property from the city.
o IRS contends that the $49K is lost profits based on the recovery theory, which would make the entire recovery taxable at ordinary income rates.
o Inaja contends that the $49K is payment for an easement (sale of a portion of the property). Tax consequences flowing from this: he would have to report income from the sale, but he gets to exclude the amount of his basis and he will be taxed on his gain at a capital gains rate.
Initial fight is about the $$ being recovery of lost profits as income (Commissioner's view) or recovery for a sale or damage to underlying property (TP's view). TP's view allows him to allocate basis.
Held: Court buys TP's arg that the payment was for damage to the property itself, not income from the property.
Orig. Cost: $61K. So, how much is treated as recovery of capital? If exactly half the property were affected, it would be easy to allocate basis from half of the original cost. Issue here is that it is difficult to describe the property interest conveyed and how it affects the land. Here, it is not possible for Inaja to determine the percentage of his property that has been allocated to the City of Los Angeles.
General Rule: § 1.61-6 where a TP sells a portion of his property, he must allocate his basis ratably among the parts.
• Rule for speculative allocation: A taxpayer should not be charged with gain on pure conjecture unsupported by any foundation of ascertainable fact.
Applied/Holding: Since Inaja cannot determine the portion of the property conveyed by the easement, the Court allows the entire payment he received ($49K) to be considered return of basis.
Prof: this almost never applies because it is usually possible to allocate basis.
SUPPOSE INAJA SELLS THE PROPERTY LATER . . .
Amount realized: $70K
Basis: $61K - $49K = $12K
Gain: $70K - 12K basis = $58K
COUNTER FACTUAL
If Inaja had lost and reported the $49K as income, when he sells for $70K, his basis is still $61K and gain is $9K. Total reported income is still $58K.
XIII. Annuities
a. Alternative timing rules
b. Section 72
c. Handout 5
Annuity [CB 305]: a simple annuity contract is one under which an issuer, usually a life insurance company, promises to make periodic payments for the life of an annuitant. Annuity payments are income to the recipient to the extent they represent some gain over what was paid for the K.
(p. 291 - 294)
Annuitant pays $3,790 for an annuity that pays $1,000 per year for 5 years, which is an annual rate of return of 10%.
Proposals for timing of income:
| |YR 1 |YR 2 |YR 3 |YR 4 |YR 5 |
|Inaja application (not the rule) |0 |0 |0 |basis is down to $790, so income is $210|$1000 |
|Income as Earned: Every payment makes up|379 |317 |249 |174 |91 |
|a different proportion of interest and | | | | | |
|principle. | | | | | |
|§ 72: Income = pmt less amount excluded |242 |242 |242 |242 |242 |
|($758) under excl. ratio: (3790/5000 = | | | | | |
|75.8%) | | | | | |
Exclusion Ratio: investment/expected return.
Note: that § 72 is a preferential tax treatment because it allows you to defer some of the tax on the gain you have earned on the policy into the future.
SEE HANDOUT #5
§ 72. Annuities; certain proceeds of endowment and life insurance contracts.
(a) General rule for annuities. Except as otherwise provided in this chapter [IRC Sections 1 et seq.], gross income includes any amount received as an annuity (whether for a period certain or during one or more lives) under an annuity, endowment, or life insurance contract.
(b) Exclusion ratio.
(1) In general. Gross income does not include that part of any amount received as an annuity under an annuity, endowment, or life insurance contract which bears the same ratio to such amount as the investment in the contract (as of the annuity starting date) bears to the expected return under the contract (as of such date).
(2) Exclusion limited to investment. The portion of any amount received as an annuity which is excluded from gross income under paragraph (1) shall not exceed the unrecovered investment in the contract immediately before the receipt of such amount.
(3) Deduction where annuity payments cease before entire investment recovered.
(A) In general. If--
(i) after the annuity starting date, payments as an annuity under the contract cease by reason of the death of an annuitant, and
(ii) as of the date of such cessation, there is unrecovered investment in the contract,
the amount of such unrecovered investment (in excess of any amount specified in subsection (e)(5) which was not included in gross income) shall be allowed as a deduction to the annuitant for his last taxable year.
(c) Definitions.
(1) Investment in the contract. For purposes of subsection (b), the investment in the contract as of the annuity starting date is--
(A) the aggregate amount of premiums or other consideration paid for the contract, minus
(B) the aggregate amount received under the contract before such date, to the extent that such amount was excludable from gross income under this subtitle [IRC Sections 1 et seq.] or prior income tax laws.
(3) Expected return. For purposes of subsection (b), the expected return under the contract shall be determined as follows:
(A) Life expectancy. If the expected return under the contract, for the period on and after the annuity starting date, depends in whole or in part on the life expectancy of one or more individuals, the expected return shall be computed with reference to actuarial tables prescribed by the Secretary.
(B) Installment payments. If subparagraph (A) does not apply, the expected return is the aggregate of the amounts receivable under the contract as an annuity.
(4) Annuity starting date. For purposes of this section, the annuity starting date in the case of any contract is the first day of the first period for which an amount is received as an annuity under the contract; except that if such date was before January 1, 1954, then the annuity starting date is January 1, 1954.
CFR § 1.61-6 Gains derived from dealings in property.
(a) In general. Gain realized on the sale or exchange of property is included in gross income, unless excluded by law. For this purpose property includes tangible items, such as a building, and intangible items, such as goodwill. Generally, the gain is the excess of the amount realized over the unrecovered cost or other basis for the property sold or exchanged. The specific rules for computing the amount of gain or loss are contained in section 1001 and the regulations thereunder. When a part of a larger property is sold, the cost or other basis of the entire property shall be equitably apportioned among the several parts, and the gain realized or loss sustained on the part of the entire property sold is the difference between the selling price and the cost or other basis allocated to such part. The sale of each part is treated as a separate transaction and gain or loss shall be computed separately on each part. Thus, gain or loss shall be determined at the time of sale of each part and not deferred until the entire property has been disposed of. This rule may be illustrated by the following examples:
Example (1). A, a dealer in real estate, acquires a 10-acre tract for $10,000, which he divides into 20 lots. The $10,000 cost must be equitably apportioned among the lots so that on the sale of each A can determine his taxable gain or deductible loss.
Example (2). B purchases for $25,000 property consisting of a used car lot and adjoining filling station. At the time, the fair market value of the filling station is $15,000 and the fair market value of the used car lot is $10,000. Five years later B sells the filling station for $20,000 at a time when $2,000 has been properly allowed as depreciation thereon. B's gain on this sale is $7,000, since $7,000 is the amount by which the selling price of the filling station exceeds the portion of the cost equitably allocable to the filling station at the time of purchase reduced by the depreciation properly allowed.
XIV. Recovery of loss
a. Clark v. Commissioner
i. Background
ii. Old Colony revisited
iii. Analysis
b. Handout 6
Edward H. Clark [CB 82]
Illustrates annual accounting principal.
1932: Clark and his wife file a joint return on the advice of tax counsel.
IRS contacts Clark about a shortfall of $34,590.27, of which, $19,941.10 was avoidable if they had filed separate returns.
1934: Tax counsel pays Clarks $19,941.10 as compensation for the mistake. IRS says they have to claim this as income.
Issue: does this payment constitute income?
IRS cites Old Colony and says that the payment is a situation where a third party paid the tax liabiltiy for the Clarks.
Prof: in Old Colony the payment of taxes was part of the compensation package. Here, not so. If Clarks hadn't had to pay the $19K to the IRS, these are after tax dollars that they would have been able to enjoy. The payment just restores this loss.
Point: the restoration of a loss is not thought of as a restoration of wealth.
• Damages for personal injury are likewise not income [CB 85]
Does Clark create horizontal equity? He would be equal with a taxpayer that received good tax advice and didn't overpay his taxes, but unequal to the person who got bad tax advice and received no recovery from the negligent advisor.
• No real answer. There is inequity with one group or the other.
Discussion of Handout 6
Amending tax returns:
• Statute of limitations is generally 3 years
• Amend when the filing was in error. The TP discovers a mistake on the return that has already been filed, and that was plainly a mistake at the time she filed her return based on the facts that existed at the time of the filing.
• There was no error at the time of filing: Account for the occurrence of something that makes the filing erroneous in retrospect in the year of such occurrence.
RECOVERY OF LOSSES
Two steps to the inquiry:
1. Is the recovery income under § 61? (Raytheon)
1. If yes, is it nonetheless excludable? (such as by § 104(a))
§ 165. Losses.
(a) General rule. There shall be allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise.
(b) Amount of deduction. For purposes of subsection (a), the basis for determining the amount of the deduction for any loss shall be the adjusted basis provided in section 1011 [IRC Sec. 1011] for determining the loss from the sale or other disposition of property.
(c) Limitation on losses of individuals. In the case of an individual, the deduction under subsection (a) shall be limited to
(1) losses incurred in a trade or business;
(2) losses incurred in any transaction entered into for profit, though not connected with a trade or business; and
(3) except as provided in subsection (h), losses of property not connected with a trade or business or a transaction entered into for profit, if such losses arise from fire, storm, shipwreck, or other casualty, or from theft.
XV. Recovery of damages for personal and business injuries
a. Overview
b. Raytheon
i. Recoveries for lost profits
ii. Recoveries for damage to goodwill
iii. Court’s holding
c. Section 104
d. Handout 7
e. Other recoveries
Raytheon Production Corp. v. Commissioner (p. 86)
Raytheon manufactures tubes very profitably. RCA makes radios and has patents that allow it to control the market. RCA decides to make tubes and requires everyone who has a license from it to manufacture radios to buy its tubes, leading to a monopoly that drives Raytheon out of business. Raytheon becomes a licensee of RCA and waives its counter-claims. Later finds out that RCA has settled other anit-trust actions, dissolving Raytheon's waiver and Raytheon brings an anti-trust suit.
Raytheon gets a $410K settlement. Says $60K is profits and $350K is recovery for injury and not includable in income. Court addresses whether this is correct or if it is income.
Replacement Rule [CB 88-89]: the test is not whether the tort was one in tort or K, but the question is "In lieu of what were the damages awarded?"
• If the $350K were recovery of lost profits, it would be income.
Court says the $350K is recovery for injury to goodwill (reputation). So is this taxable?
Rule: "Although the injured party may not be deriving a profit as a result of the damage suit itself, the conversion thereby of his property into cash is realization of any gain made over the cost or other basis of the good will prior to the illegal interference." Thus, compensation for the loss of Raytheon's good will in excess of its cost is gross income.
Holding/Application: amount realized ($350K) - basis ($0) = gain ($350K income)
Why is goodwill basis $0? Self-generated good will that wasn't paid for, just earned from doing business, often don't create basis.
§ 104(a): creates an exclusion for items that would otherwise be includable in income. Excludes:
• (1) Workmen's comp recoveries
• (2) damages (not punitive) received on account of personal physical injury or physical sickness. Look at triggering event.
• [CB 98-99] under the reaonsing in Burke, damages for sex discrimination and racial discrimination under Title VII and damages under the Americans with Disabilities Act would all be exempt under § 104(a)(2). But not age discrimination.
§ 104. Compensation for injuries or sickness.
(a) In general. Except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 [IRC Sec. 213] (relating to medical, etc., expenses) for any prior taxable year, gross income does not include--
(1) amounts received under workmen's compensation acts as compensation for personal injuries or sickness;
(2) the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness;
(3) amounts received through accident or health insurance (or through an arrangement having the effect of accident or health insurance) for personal injuries or sickness (other than amounts received by an employee, to the extent such amounts (A) are attributable to contributions by the employer which were not includible in the gross income of the employee, or (B) are paid by the employer);
(4) amounts received as a pension, annuity, or similar allowance for personal injuries or sickness resulting from active service in the armed forces of any country or in the Coast and Geodetic Survey or the Public Health Service, or as a disability annuity payable under the provisions of section 808 of the Foreign Service Act of 1980 [22 USCS § 4048]; and
(5) amounts received by an individual as disability income attributable to injuries incurred as a direct result of a terroristic or military action (as defined in section 692(c)(2) [IRC Sec. 692(c)(2)]).
For purposes of paragraph (3), in the case of an individual who is, or has been, an employee within the meaning of section 401(c)(1) [IRC Sec. 401(c)(1)] (relating to self-employed individuals), contributions made on behalf of such individual while he was such an employee to a trust described in section 401(a) [IRC Sec. 401(a)] which is exempt from tax under section 501(a) [IRC Sec. 501(a)], or under a plan described in section 403(a) [IRC Sec. 403(a)], shall, to the extent allowed as deductions under section 404 [IRC Sec. 404], be treated as contributions by the employer which were not includible in the gross income of the employee. For purposes of paragraph (2), emotional distress shall not be treated as a physical injury or physical sickness. The preceding sentence shall not apply to an amount of damages not in excess of the amount paid for medical care (described in subparagraph (A) or (B) of section 213(d)(1) [IRC Sec. 213(d)(1)]) attributable to emotional distress.
§ 105. Amounts received under accident and health plans.
(a) Amounts attributable to employer contributions. Except as otherwise provided in this section, amounts received by an employee through accident or health insurance for personal injuries or sickness shall be included in gross income to the extent such amounts (1) are attributable to contributions by the employer which were not includible in the gross income of the employee, or (2) are paid by the employer.
(b) Amounts expended for medical care [Caution: For provisions applicable to taxable years beginning on or before December 31, 2004, see 2004 amendment note below.]. Except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 [IRC Sec. 213] (relating to medical, etc., expenses) for any prior taxable year, gross income does not include amounts referred to in subsection (a) if such amounts are paid, directly or indirectly, to the taxpayer to reimburse the taxpayer for expenses incurred by him for the medical care (as defined in section 213(d) [IRC Sec. 213(d)]) of the taxpayer, his spouse, and his dependents (as defined in section 152 [IRC Sec. 152], determined without regard to subsections (b)(1), (b)(2), and (d)(1)(B) thereof). Any child to whom section 152(e) [IRC Sec. 152(e)] applies shall be treated as a dependent of both parents for purposes of this subsection.
(c) Payments unrelated to absence from work [Caution: For provisions applicable to taxable years beginning on or before December 31, 2004, see 2004 amendment note below.]. Gross income does not include amounts referred to in subsection (a) to the extent such amounts--
(1) constitute payment for the permanent loss or loss of use of a member or function of the body, or the permanent disfigurement, of the taxpayer, his spouse, or a dependent (as defined in section 152 [IRC Sec. 152], determined without regard to subsections (b)(1), (b)(2), and (d)(1)(B) thereof), and
(2) are computed with reference to the nature of the injury without regard to the period the employee is absent from work.
§ 1.104-1 Compensation for injuries or sickness.
(c) Damages received on account of personal injuries or sickness. Section 104(a)(2) excludes from gross income the amount of any damages received (whether by suit or agreement) on account of personal injuries or sickness. The term “damages received (whether by suit or agreement)” means an amount received (other than workmen's compensation) through prosecution of a legal suit or action based upon tort or tort type rights, or through a settlement agreement entered into in lieu of such prosecution.
[Joondeph] On the recovery of damages when the triggering event is emotional (rather than a personal physical injury or physical sickness), the lower courts have uniformly held that the recoveries must be included in income (except to the extent that they cover actual medical expenses incurred as a result of those emotional injuries). This is a defensible reading of the exclusion under 104(a)(2). Notice, though, that it does not really answer whether such recoveries are income within the meaning of § 61 in the first place. One could make a pretty strong argument that, when a taxpayer suffers emotional distress and then is merely compensated for it, or made whole, she has not experienced an "accession to wealth" and thus does not have income. But the courts have uniformly drawn a strong negative inference from 104(a)(2)'s exclusion. If it is a personal injury that falls outside the exclusion, they have held it included.
XVI. Income from the discharge of indebtedness
a. Loan proceeds
b. Kirby Lumber
i. Corporate bonds
ii. The fluctuating value of debt
iii. Analysis
iv. The use of loan proceeds
c. Section 108
i. Purchase-money debt
ii. Insolvency relief
d. Diedrich
i. Background
ii. Competing arguments
iii. Alternative approach: part sale, part gift
iv. [Joondeph] Let me repeat something for emphasis: the fact that the liability at issue in Diedrich was a "gift tax" is irrelevant. Totally. What matters is that it was a liability. It was a financial obligation of the parents. As you well know by now, there are no income taxes for gifts. There are sometimes excise taxes imposed on the transfer of wealth, both at the federal and state level. But those are not income taxes, and they are not really a part of this class. Again, what matters to understanding Diedrich is that it was a financial liability owed by the parents, paid by the children, in exchange for the stock.
e. Reg. §1.1001–1(e)
f. Section 1011(b)
Loan proceeds do not equal income. Because the money comes with an offsetting liability, so there is no accession to wealth. However, if the debt is not fully repaid, the underlying assumption for the exclusion of income (that the debt will be repaid) is not applicable and the unpaid amount is income.
United States v. Kirby Lumber Co. (p. 416)
Kirby issues stock, which is a loan from the bondholders to the issuer (Kirby). K buys back $1M of bonds (face value) for $862,000. Difference is $137,521.30, which should be reported as gain. Note that it doesn't matter what the person receiving the loan does with the money.
Potential reasons that value of debt may change after issuance:
1. Market Interest Rate goes up. Perhaps the value of the bond went down because the interest rate on the market has gone up, making current bond holders willing to sell their bonds at a discount to recover principal back and reinvest at a higher rate.
1. Calculation of risk. As risk of default increases the value of holding onto the debt goes down.
§ 108. Income from discharge of indebtedness.
Discussion of sub point (a): Note that these are all deferral privileges. It defers the recognition to some future time.
Sub point (e)(5). Purchase-money reduction for solvent debtor treated as price reduction. Occurs such as when a buyer is making payments on a dishwasher, has some issues with the product, and the seller forgives the last payment as a concession for defects. This forgiveness of the amount due would be considered a purchase price adjustment and not forgiveness of debt.
Diedrich v. Commissioner (p. 491)
Parents transfer stock to their three children on the condition that the children pay the gift tax for the stock.
Parents' basis in stock: $50K ($51,073)
Recipients agree to pay: $60K ($62,992)
FMV of stock at the time of the transfer: $300K
Kids arg: the amount of the tax is a gift to their parents and should be excluded under § 102(a). Problem with this argument: a gift must be motivated be a detached and disinterest generosity (Duberstein). Transfer by the kids was not disinterested, it was more like an exchange.
Court says this is more like an exchange. Kids are relieving parents of their tax liability, so it falls under income "from discharge of indebtedness."
Gain: Amount realized (~$60K) - basis (~$50K) = ~$10K.
Effects on the children:
Generally, a person's basis in stock is the price paid. Same applies here because this is treated as a sale for $60K. Thus, this is their basis.
Counterfactual Analogy to part sale/part gift scenario:
100,000 shares with FMV of $300K = $3/share.
Amount realized by parents: ~$60K = 20,000 shares
Parents basis: ~$50K = $.50/share
Basis in shares sold at FMV = $.50 * 20,000 = $10,000.00
Thus, gain is $60,000-$10,000 (basis) = $50,000.00. Then the gift is 80,000 shares.
Children's basis in the shares when they subsequently sell:
1. Shares received by gift = carry over basis of $.50 per share * 80,000 shares = $40,000
1. Shares purchased basis: $60K
1. Total basis: $40K + $60K = $100K
Gain on sale for FMV $300K - $100K basis = $200K
Because of Time value of money, Deidrich is better because it defers recognition of income until later. Also, it is likely that parents are in a higher tax bracket than children, so it might be better for them to shift the tax liability to the children.
Hypo demonstrating exception
$300K straight gift of shares to kids from parents. Tax consequences for straight gift is no gain to parents and kids get the carry-over basis from parents as $50K.
But, if parents "sell" shares to kids for 1 cent, the kids's basis is 1 cent, parents don't get to take the loss (basis $50K - amount realized 1 cent = $49,999.99 loss). See IRC § 1001
Also note the gift/sale split as shown by § 1011(b) when a charitable organization involved as a good example of how this works. Applying that here:
FMV: $100
Donor's basis: $5
"Sells" to charity at the bargain price of $20
The portion sold is ratio ($20 sale price/FMV $100) = 20%. Basis in the amount sold is 20% * donor's basis ($5) = $1. Gain is $20 amount realized - $1 basis = $19 gain. Gift is remaining portion of 80%.
§ 108. Income from discharge of indebtedness.
(a) Exclusion from gross income.
(1) In general. Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if--
(A) the discharge occurs in a title 11 case,
(B) the discharge occurs when the taxpayer is insolvent,
(C) the indebtedness discharged is qualified farm indebtedness,
(D) in the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness, or
(E) the indebtedness discharged is qualified principal residence indebtedness which is discharged before January 1, 2010.
(d) Meaning of terms; special rules relating to certain provisions.
(1) Indebtedness of taxpayer. For purposes of this section, the term "indebtedness of the taxpayer" means any indebtedness--
(A) for which the taxpayer is liable, or
(B) subject to which the taxpayer holds property.
(2) Title 11 case. For purposes of this section, the term "title 11 case" means a case under title 11 of the United States Code (relating to bankruptcy), but only if the taxpayer is under the jurisdiction of the court in such case and the discharge of indebtedness is granted by the court or is pursuant to a plan approved by the court.
(3) Insolvent. For purposes of this section, the term "insolvent" means the excess of liabilities over the fair market value of assets. With respect to any discharge, whether or not the taxpayer is insolvent, and the amount by which the taxpayer is insolvent, shall be determined on the basis of the taxpayer's assets and liabilities immediately before the discharge.
(e) General rules for discharge of indebtedness (including discharges not in title 11 cases or insolvency). For purposes of this title--
(5) Purchase-money debt reduction for solvent debtor treated as price reduction. If--
(A) the debt of a purchaser of property to the seller of such property which arose out of the purchase of such property is reduced,
(B) such reduction does not occur--
(i) in a title 11 case, or
(ii) when the purchaser is insolvent, and
(C) but for this paragraph, such reduction would be treated as income to the purchaser from the discharge of indebtedness,
then such reduction shall be treated as a purchase price adjustment.
CFR § 1.1001-1 Computation of gain or loss.
(e) Transfers in part a sale and in part a gift. (1) Where a transfer of property is in part a sale and in part a gift, the transferor has a gain to the extent that the amount realized by him exceeds his adjusted basis in the property. However, no loss is sustained on such a transfer if the amount realized is less than the adjusted basis. For the determination of basis of property in the hands of the transferee, see § 1.1015-4. For the allocation of the adjusted basis of property in the case of a bargain sale to a charitable organization, see § 1.1011-2.
(2) Examples. The provisions of subparagraph (1) may be illustrated by the following examples:
Example 1. A transfers property to his son for $60,000. Such property in the hands of A has an adjusted basis of $30,000 (and a fair market value of $90,000). A's gain is $30,000, the excess of $60,000, the amount realized, over the adjusted basis, $30,000. He has made a gift of $30,000, the excess of $90,000, the fair market value, over the amount realized, $60,000.
Example 2. A transfers property to his son for $30,000. Such property in the hands of A has an adjusted basis of $60,000 (and a fair market value of $90,000). A has no gain or loss, and has made a gift of $60,000, the excess of $90,000, the fair market value, over the amount realized, $30,000.
Example 3. A transfers property to his son for $30,000. Such property in A's hands has an adjusted basis of $30,000 (and a fair market value of $60,000). A has no gain and has made a gift of $30,000, the excess of $60,000, the fair market value, over the amount realized, $30,000.
Example 4. A transfers property to his son for $30,000. Such property in A's hands has an adjusted basis of $90,000 (and a fair market value of $60,000). A has sustained no loss, and has made a gift of $30,000, the excess of $60,000, the fair market value, over the amount realized, $30,000.
XVII. Transfers of property subject to debt
a. A primer on depreciation
b. Crane v. Commissioner
i. Crane’s original basis
ii. Crane’s amount realized
iii. Tax logic
c. Nonrecourse debt in excess of the property’s value
d. The problem
e. Tufts v. Commissioner
i. Partnerships and motives
ii. Competing arguments
iii. Holding
iv. The O’Connor alternative
f. Handout 8
Depreciation: is a deduction (or allowance) to account for the expected decline in value of a long-lived wasting asset used to generate income (in a business or for investment)
• Example: TP buys machine for $10,000 with a 5 year life. Straight line depreciation allows a deduction of $2k per year and it is worthless after 5 years.
• Requires an adjustment to basis for any basis that has been recovered.
Crane v. Commissioner [CB 456]
Note that the numbers in the case don't exactly add up, so #s from class discussion are slightly different.
Acquisition of property through inheritance from deceased husband:
FMV at time of death: $262,000
Debt: $262,000
Issue 1: FMV of what?
Crane argues that she only receives the equity, which is $0.
Prof: if this were true, how much depreciation would she be entitled to take? None. Depreciation is merely a means of recovering basis in an asset. Here, Crane took depreciation deductions of $25,500 on the building/improvements (not on the land because it is not a wasting asset)
IRS argues that Crane's basis is the FMV of the property. Court has a detailed analysis to support that it is not the FMV of the equity, but the property itself. Thus, this is her basis, which is $262K.
Broader principle: we treat debt proceeds the same as cash.
Issue 2: Where depreciation is appropriate (because the court deems her to have positive basis), what adjustments are appropriate [CB 460].
Her basis is adjusted based on the adjustments she took of $25,500.
Thus, her updated basis is $262,000 - $25,500 = $236,500.00 (note this is slightly different than amounts in case)
Issue 3: what is her amount realized? [CB 461]
She sells for net cash proceeds of $2500 and recipient assumes all of the debt on the property. She must include this in the amount realized, along with the amount outstanding on the mortgage.
Amount realized: $262K debt relief + $2500 net cash received
Gain: Amount realized - basis ($236,500)
Commissioner v. Tufts [CB 468]
Using round numbers . . .
$1,850,000 borrowed to purchase apartment building. Mostly funded by debt. No initial equity.
$45,000 cash contributions at later dates.
$440,000 depreciation deductions
In 1972, FMV = $1.4M. Partners walk away from property. Sell their interests to Fred Bayles for ................
................
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