Chapter 3                  p.195
Problems of Timing

Possible relevance of timing considerations:  

•                     the acceleration or (2) the postponement of: (a) income or (b) deductions.

Important factors:

1) Changes in tax rates (whether changes in statutory tax rates or individual circumstances);

2)  Time value of money, i.e., the interest rate benefit on deferred income tax payments.  What is the “present value” of the future payment?

The “Realization” Doctrine                p.196

See IRC §1001(a) concerning realization being required to have an income event from a property disposition transaction. 

I.e, more than an economic increase in the value of the property owned must occur.

Cf., Haig-Simons definition of income (here not necessitating a “realization” event).

Does the 16th Amendment require a “realization event” for gain recognition on property?  No.

Eisner v. Macomber
p.197

Does the 16th Amendment permit taxation of a “stock dividend” distributed by a corporation.

Thus, a U.S. constitutional inquiry:  Does U.S. Congress have power to require income recognition for a distributed stock distribution?

After the distribution the total value of each shareholder’s shares remained unchanged. 

USG says GI inclusion is required to the extent of par value (not fmv) of new shares.

Majority: income is “gain derived from.”  cont.

Eisner v. Macomber,
cont.

Majority opinion:  Reference to the 16th Amend.  Income “from whatever source derived.”

A stock dividend represents a “capitalization” of accumulated profits (& not income).

Here nothing is received from the corp. in the manner of recognizable income. 

Held: 16th Amend. precludes this taxation.

Holmes dissent:  This proposed taxation does not violate 16th Amendment requirements.

Include in GI Unrealized Appreciation?          P.205

A constitutional requirement for a realization event to occur to have income?   Or, permit “mark to market” gross income determination? Non-taxation of accrued stock appreciation as distorting investment decisions”?

See §305 re corporate stock distributions.  Note, further: (1) basis allocation (§307), and (2) tacking of holding period (§1223(5)).

Cf., Glenshaw Glass (1955) as permitting inclusion in gross income of a “windfall.”   P.207.

 

 

Bruun – p. 208
Lease Cancellation

Tenant constructs (in 1929) 50 year life building on owner’s land.  Term of lease is 99 years.

Tenant defaults and lease is cancelled in 1933.

Did owner realize income at lease cancellation when owner has possession of the building?

Held:  yes, gain realized in 1933 (at forfeiture).

Cf., Blatt case (Sup. Ct., p. 209):  income from improvements each year of the lease until expiration?  Held: not income (p. 209).

Timing Choices & Leasehold Improvements

1) Time the lease is agreed, with the lessee’s promise to build an improvement to property.

2) When the building is built – to the extent of the anticipated FMV at the end of the lease.

3) Each year as the lease is getting shorter.

4) When the lease expires (Bruun).

5) When the land and building are subsequently sold. See  §§109 and 1019.  Except where the building is constructed “in lieu of rent.”

Code §109 & §1019
Deferral Is Permitted

Deferral  of the recognition of the gain realized at the lease termination is authorized.

Tax basis for the improvements received is zero under §1019 - since no gross income inclusion.

Subsequent rental income from the property is not reduced by depreciation (since no depreciable tax basis is available).

Therefore, a portion of the deferred income is actually realized prior to disposition of the property.

Nonrecourse Borrowing Exceeding Basis     p.212

Remember Tufts:  Original nonrecourse purchase debt is included in tax basis.

Cf., effect of  later debt when borrowing exceeds tax basis for the collateralized property.

Woodsam Associates, p. 213:  Taxpayer borrows nonrecourse in excess of tax basis.

Argues borrowing was a gain event & basis then stepped-up – to avoid gain treated as realized on a mortgage foreclosure.  Held: gain at later disposition, and not when borrowing.

Cottage Savings Assn.-
Loan Package Swap p.166

Facts:  Financial institution exchanges one group of residential mortgage loans for another institution’s mortgage loan package.

A swap of “participation interests” occurs.  Long-term low interest existing mortgage obligations had declined in value due to a significant increase in market interest rates.

Seller did not want to record losses on its “books”, i.e. for regulatory and financial accounting (i.e., shareholder) purposes.     Cont.

Cottage Savings Association,           cont.

Issue:  Did a tax disposition event occur? Were  the new properties “materially different”?

Holding:  This exchange does cause losses to be realized for federal income tax purposes (even though not for regulatory purposes).  Cf.,  Memo R-49.  An exchange did occur of “materially different” properties.

Cf., inclusion in gross income when based merely on property appreciation in value, i.e., an economic accretion to wealth.

Cottage Savings Association,           cont.

Consider the IRS litigating position in Cottage Savings.  What was achieved by IRS losing this case?  Should the Cottage Savings tax litigation result have been controlled by the reporting for financial accounting purposes (particularly when the financail accounting is dictated by another government agency)?

Consider that this transaction was done “solely” for a tax avoidance purpose (i.e. no business purpose – except to survive with reduced tax liability).

Debt Modification as a “Disposition”            p.224

Is the modification of a debt a realization event?   Reg. §1.1001-3 states that a “significant modification” of a debt instrument is an “exchange” for FIT purposes.

Consider a change in (1) length of term, (2) interest rate, (3) another element (e.g., priority).

Exception from realization treatment for a “unilateral option”  or a change in an “index rate” where a variable rate obligation.

Nonrecognition Treatment
p.227

Code §1001(c) provides that “except as otherwise provided in this subtitle” gain or loss shall be recognized.

How retain the future potential for recognition of that gain?  Answer: Preservation of the unrecognized gain (or loss) in determining tax basis for replacement property. See §1031(d).

Why provide for nonrecognition in certain situations?  A concern about illiquidity and/or valuation?  Mitigation of a “lock-in effect”?

Like-Kind Exchanges
p.228

Code §1031 provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if exchanged solely for property of a “like kind.” 

But, gain recognition treatment is required if “boot” is received (gain is limited to the extent of the boot). §1031(b).

Tax basis is shifted to the replacement property, except for a FMV basis for the boot.  §1031(d).

PLR 200203033
p.229

Private letter ruling request re §1031 tax free exchange eligibility for a swap of a conservation easement in Property A for a fee interest in real estate (also subject to a conservation easement).

Treated as “like kind” real estate – assuming held for productive use in business or for investment. 

Identifying “Like Kind” Property                   P.232

Is like-kind treatment permitted for:

1) Different types of real estate? Cf., TICs; sale-leasebacks (how long a lease?);  oil and gas properties?

2)  Auto/truck trade-ins?  Low tax basis when prior tax depreciation; not for personal auto.

•                     Professional athlete contract swaps?

•                     Partnership interest swaps?

See limits in §1031(a)(2).  Liquid securities and inventory are not eligible.  Coins?  Rare coins?

How is the Gain Potential Kept for Tax Purposes?

Tax basis for the replacement property is:

1)  Same as the tax basis for the property transferred;

•                     Decreased by the boot received;

•                     Increased by the gain recognized on the exchange.

See §1031(d) providing the rules for a transferred tax basis for the replacement property. 

Like Kind Exchange with No “Boot” Received

Example 1:  Client owns property A.  Exchange of Property A worth 10x, basis 4x, for like-kind property B, also fmv 10x.

Taxable inclusion of 6x gain is postponed.

Tax basis for the replacement property is 4x (to preserve the income tax potential on the 6x deferred gain).  §1031(d).

Like Kind Exchange with “Boot” Received

Example 2:  Client transfers Property A worth 10x (basis 4x, accrued gain 6x) for like-kind property B, fmv 8x, plus 2x cash received (“boot”) by Client from Property A “buyer.”

§1031(b) - 6x gain is realized.  Gain to be recognized to the extent of the 2x “boot.”

Tax basis for the replacement Property B (fmv 8x) is 4x (to preserve the 4x deferred gain). 

Tax basis for 2x cash received is (obviously) 2x.

Like Kind Exchange with “Boot” Received

Example 3:  Client transfers Property A worth 10x (basis 4x, accrued gain 6x) for like-kind property B, fmv 3x, plus 7x cash received (“boot”) by transferor.

§1031(b) - 6x gain (not 7x cash amount) is realized and recognized.

Tax basis for the replacement Property B is 3x (fmv). 

Tax basis for 7x cash received is (obviously) 7x.

Loss - Like Kind Exchange Provision is Not Elective

Example 4:  Client transfers Property A worth 10x (basis 12x, accrued loss 2x) for like-kind property B, fmv 10x (same fmv).

No loss can be recognized. §1031(a) .

Tax basis for the replacement Property B is 12x (the 2x potential loss is retained in the replacement property for possible future loss recognition, unless subsequent appreciation of replacement property occurs).  

Loss - Like Kind Exchange Provision is Not Elective

Example 5 (boot received):  Transfer of Property A worth 10x (basis 12x, accrued loss 2x) for (1) like-kind property B, fmv 8x and (2) 2x cash boot received by the “seller.”

No loss can be recognized. §1031(a) .

Tax basis for the replacement Property B is 10x (the basis of the transferred property, as reduced by the 2x cash); 2x potential loss is retained in replacement property (8x fmv); 

2x basis for the 2x cash received.

Like Kind Exchange with “Boot” Received in Kind

Example 6:  Client transfers Property A worth 10x (basis 4x, accrued gain 6x) for (1) like-kind property B, fmv 8x, plus (2) other property (e.g., listed stock) worth 2x.

§1031(b) - 6x gain is realized; recognition only to the extent of the boot.

Tax basis for the replacement Property B is 4x (& remaining 4x gain potential).  Tax basis for the other property is 2x.

Like Kind Exchange & Taxpayer Adds Cash Boot

Example 7:  Client transfers (1) Property A worth 10x (basis 4x, accrued gain 6x) and (2) 5x cash for replacement property B with a 15x fmv.

§1031(a) - 6x gain is realized; no gain recognition is required.

Tax basis for the replacement Property B (fmv 15x) is 9x (4x old basis plus 5x new cash paid to other party in exchange transaction).

Multiparty Transactions
p.234

How arrange a tax-free swap when only one party wants a tax-free swap?

Consider a three-party (or more) transaction.

Consider the potential applicability of the federal income tax doctrine of “substance over form.”

What other possibilities exist for intermediaries (e.g., exchange agents)?

Like-Kind Exchange
Deferred Property Receipt

“Starker” exchange – p. 237.

Delayed receipt of the exchange property – by relying on the creditworthiness of the other exchanging party.  Does this qualify as a §1031 exchange (when initially receiving a promise)?

See §1031(c) re: (1) 45 day (identification) & (2) 180 day (completion) limits.

What if an interest charge equivalent is credited to add value to the replacement property purchase?

Involuntary Conversion Gains & &1033 Deferral

P.232. Postponement of realized gain occurs if:

1) A gain is derived from an involuntary conversion, e.g., theft, casualty, seizure, or eminent domain (or a taking “threat”?).

Consider:  proceeds received from insurance.

2)  An acquisition occurs within the required time period (before the close of the 2nd taxable year of gain) of a replacement property “similar or related in service or use.”  Cf., the more expansive §1031 “like kind” property concept. 

§1033 Example:  Business Property Destroyed

Building destroyed by fire is business property.

Taxpayer receives 350x insurance proceeds;  200x tax basis for the old property and 325x reinvestment in the replacement property.

Under §1033(a)(2)(A) the 150x of realized gain is included in GI only to the extent of 25x (350x insurance proceeds less the 325x reinvestment). 

The 125x of unrecognized gain reduces the tax basis for the replacement property to 200x.  Unrecognized gain is preserved for the future with this tax basis adjustment.

Corporate Transaction Nonrecog. Rules      p.238

Note §1001(c).  Consider the formation of a corporation (a separate taxable entity):

•                     Transfer occurs of appreciated assets into

corporation in exchange for stock of corp.

Gain recognition required?  No, per §351.

2)  §1032 – corp. does not recognize gain on exchange of its shares for shareholder’s assets.

3)  What about multiple individuals contributing various assets (e.g., traded shares) to a corporate investment fund?                   Cont.

Corporate Transaction Nonrecog. Rules      cont.

4) What tax basis to the shareholder for the stock received? See §358 re substituted basis.

•                     What tax basis to the corporation for the

assets received from the shareholder?  §362(a) .

Consider the effect of two levels of gain now.

6) Property subject to debt is transferred to corporation in §351 transaction.  See §357(c) for gain recognized when liabilities exceed tax basis. 

7)  What if services are rendered to the corp. in exchange for shares?  Percentage limit?

Tax-free Reorganizations
p.240

•                     Change place of corp. organization from

California to Delaware.  Why?  How? Taxable?

Nonrecognition occurs and substituted tax basis applies for the replacement shares.

2)  What if a merger occurs of A corp into B corp and the A shareholders receive shares of B Corp.?  Is gain recognition required to A shareholders on the exchange? Not if occurring in a “tax-free reorganization.”   See §§354 and 368.

Deemed Realization – Constructive Sales   P.241

How to (1) raise cash, (2) protect against downside, and (3) postpone tax realization?

E.g., “sale against the box” – sell borrowed shares (possible?) - assuming the loan of the borrowed shares can be subsequently closed (e.g., when the appreciation has disappeared with a §1014 tax basis step-up at death). 

§1259 – gain is to be recognized on a constructive sale of an “appreciated financial position.” Similar- futures or forward contracts.

Original Issue Discount
P.245

Debt instrument does not provide for (1) any current interest or (2) adequate (i.e., market) interest.  Then, interest income must be accrued – whether for a cash basis or an accrual basis taxpayer, i.e., treated as “original issue discount” (or “OID”, the unstated interest).

OID is the difference between the (1) issue price and (2) the redemption price.  §1273. 

Tax policy objective:  To avoid delay of interest income recognition while enabling a current interest expense (for accrual basis deduction).

Income on Maturity of the OID Obligation?

What is the tax treatment on the receipt of proceeds of the OID obligation at the time of its maturity? Capital gain?  Basis recovery?

However, all OID has previously been included in gross income, and this inclusion enables an addition to the tax basis of the debt instrument.

At maturity (1) the tax basis and (2) the proceeds are the same – producing no realized gain.   Before the OID rules:  treat all this gain as capital gain when the obligation matures and is then paid.

Debt Obligation Issued for Property   §1274       p.246

Not a readily determinable issue price.  Is interest rate adequate? Apply a discount (interest) rate to the anticipated payments?  

What is the appropriate interest rate for this purpose? – the “applicable federal rate” (AFR).

What is the present value of the imputed principal amount – based on the current AFR?

Any difference will be OID – to be reported on a current basis (although not actually received).

See Table, p. 247.

 

Treatment of Deferred Rent Payments         p.247

§467provides for application of OID concepts to deferred rent payments: 

(1) (Cash basis) lessor to include both deferred rent and interest on deferred rent in current income (as if accrual basis taxpayer).

•                     (Accrual basis) lessee can deduct similar

amount each year.

Not applicable to total payments not exceeding $250,000.  §467(d)(2).

Market Discount & Income Tax Effect    p.248

Borrower issues debt at a 5% market rate (e.g., receiving 100x par value at time of issuance).

Interest rate in the market then increases (e.g., to 8%) and 100x obligation declines to 70x fmv.

Purchaser then acquires this discounted obligation for 70x and receives (1) the 5% interest (current income) and (2) 30x profit when the debt instrument matures.  How treat the 30x?  §§1276 and 1278 specify this gain is ordinary income – but not until the debt proceeds are actually received.   Prior sale?

Exceptions to OID Current Inclusion Rules         P.248

Sale for deferred payment(s) of a principal residence or farm for less than $1 million (e.g., for a principal amount without any interest).

See §483 – provides for the treatment of the discount portion (1) as interest income (and not as capital gain), but (2) only when the payment is received, i.e., a recharacterization rule, but not a timing acceleration (i.e., accrual) rule for the cash basis seller.

Open Transactions
Burnet v. Logan        p.249

 Transfer of corporate shares in exchange for (1) cash and (2) a promise of future payments (iron ore royalties).  Was the contract to be currently valued (discounted cash flow) and treated as received currently by the owner?

IRS claims a “closed transaction,” with tax basis to be recovered in the future.

Held:  Open (not closed) transaction treatment;  no current value for the promise of future payments.  Entitled to return of all capital first.

 

Open Transactions, cont.       p.251

Possible approaches to the timing of gain recognition when a promise/contract (not a promissory note) is received:

1)  Open transaction – all payments are tax basis components until full basis recovery.

•                     Value the stream of expected payments as of

date of sale. Compare this amount with basis.

Closed transaction status immediately.

3)  Open transaction, but allocate basis to each expected payment (i.e., an installment method).

 

Open Transaction Treatment              p.252

Is available only in “rare and extraordinary circumstances.”  Reg. §1.1001-1(a).

See Warren Jones case, p. 252:  Limited cash and a 133x contract received (fmv 77x).  Fair market value is treated as GI when received.

Why wanting “open transaction” treatment?

•                     Postpone inclusion in gross income.

2)  All proceeds treated as capital (gains) while the transaction is “open.”  No receipts are considered as being interest (ordinary) income.

Installment Method
§§453, 453A, 453B   p.254

Objective:  coordinate income tax reporting with the taxpayer’s actual receipt of cash.

Assuming no OID or unstated interest (§483):

What is the ratio of (1) gain to (2) the total expected payments? Apply that ratio to each payment to determine the amount of gain embedded in each payment.  §453(c).

Alternative:  Elect out of §453 treatment for “closed transaction” treatment, unless (unlikely) possible open transaction treatment is available. 

Second Disposition by Related Person       p.255

§453(e) re:  (1) 1st disposition of property is to a “related person,” and,  (2) 2nd disposition by the related person to another before all installments are paid on 1st disposition.  Then,  the 1st disposition is treated as closed when the related person sells.

E.g., 1st sale on installment basis to related person and 2nd sale for cash,  related person can not hold cash pending installment payments with tax deferral to the 1st seller.

Planning Around §453(e)
p.255

How avoid this “second disposition by related person” rule of  §453(e)?  Transfer to a person other than a “related person”?

Who is a “related person”?  See §453(f) re cross-reference to §318(a) or §267(b) related party definitions. Does not include (1) a nephew or niece, or (2) same-sex relationship person (whether marriage or otherwise).  See DOMA which precludes latter as a defined relationship.

Then, a form over substance argument by IRS?

 

 

Limitations on Installment Sales Eligibility

See §§453(b)(2) and (k).  Installment sales provision is not available for (1) inventory sales or (2) sales of publicly traded securities. 

See §453A – interest charge is applicable if aggregate obligations from sales of $150,000 plus exceed $5 million.

§453A(d) – a loan is treated as payment if the installment obligation is pledged for bank loan.

§453(i) – no deferral for installment obligation when “recapture of depreciation” income arises.

Additional Limitations on §453 Eligibility         p.256

No §453 eligibility where payment in the sale is made by buyer with (1) demand notes or (2) publicly traded debt obligations.  §453(f)(4).

But, no limitation applies where:

•                     the debt is guaranteed, §453(f)(3), or

(2) a bank guarantee with a “standby letter of credit” is provided by the buyer to seller.  Reg. §15a.453-1(b)(3)(iii)

Sales with Contingent Payments               p.256

What if the amount of the payments is actually contingent?  Note: Burnet v. Logan.

Apply §453 in this order:
1) Allocate basis over the maximum to be paid.

2) Allocate tax basis over the maximum payment period.

3) Allocate tax basis in equal annual amounts over a 15 year period.

Constructive Receipt Doctrine                   p.256

Cash taxpayers include an item in income when actually or constructively received.  See Reg. §1.451-2(a) re constructive receipt, i.e.,  when set aside or otherwise made available.

See Amend case, p. 257.  Cash basis taxpayer.

Deal to deliver grain under an oral agreement to get payment in the subsequent year. 

No constructive receipt.  A bona fide deal.

No right to currently demand funds.  Therefore, no GI inclusion currently.  Cf., §453 treatment.

Pulsifer v. Commr.
P.262

Minors win Irish Sweepstakes but not entitled to current funds until (1) becoming of majority or (3) court approval for funds release.

Held:  Winnings are to be included in GI for the year of the award, and not for the subsequent year when actually retrieved.

The funds were irrevocably assigned for benefit of minors and only need apply for the funds.

“Economic benefit” occurred in the earlier year.

 

Non-Qualified Deferred Compensation          p.263

See Rev. Rul. 60-31 identifying “non-qualified” compensation whose income is deferred for tax recognition in a future year. 

Cf., a “qualified” deferred compensation plan. 

No monetary limit on the deferrable amount.

Consider: A “cash method” taxpayer receiving only a “promise to pay.”   What credit risk?

Immediate income recognition if the funds are paid into an escrow account for the employee (i.e., funds are not controlled by the employer).

Minor v. U.S.             p.264
Unfunded/Unsecured Plan

Contributions made to a deferred compensation plan held not currently includible in GI.

Supplemental agreement with employer that compensation for future services paid to a trust & retirement annuity policies to be purchased.

Does “economic benefit” rule require inclusion?  

- “Constructive receipt” doctrine not applicable.

- Economic benefit?  Not here; assets remain subject to the employer’s creditors; & risk of forfeiture arises with non-compete requirement.

 

Deferred Compensation Tax Issues                p.268

- When can an employer deduct future payment to be made?  Only in the future when paid, even though an accrual basis taxpayer.  §404(a)(5).

- §457 – dollar limitations on plans of state agencies; payor is not subject to tax.

- §403(b) – Tax-exempt charities and public educational agencies have limitations.

- §409A – no employee deferral if an election exists to accelerate benefits - even though based on an external condition.

Deferred Compensation
Problems                   p.270

•                     Nonassignable annuity policy naming employee as beneficiary.

•                     Contribution to a trust for employee, with interim investment and deferred payout to employee.

•                     Contribution to trust and at end of deferral period, paid to employer.

•                     Corporation with unconditional agreement to pay, guaranteed by corporation owner.

 

Qualified Pension/Profit Sharing Plans           p.270

Personnel objectives:  Enable employee loyalty and employee incentives (including investing in the employer’s stock;  cf., Enron Corp.).

Defined benefit (DB) plan:  employer agrees to pay fixed retirement benefits based, e.g., on

•                     years of service,  and (2) final pay amount.

Defined contribution (DC) plan:  amount contributed based on formula (e.g., 5% of current compensation) and the amount paid at retirement is based on investment returns.                       continued

 

Qualified Pension/Profit Sharing Plans           p.270

Qualified plan & income tax results:

1) Employer deduction for plan contributions.

2) No current GI to the employee-participant; GI inclusion upon later distribution to retiree.

3) No GI for investment returns received by the intermediary holding entity (e.g., trust).

4) Non-tax benefit – funds are protected from employer’s financial risks (although possible actuarial underfunding for DB plans).  Cont.

Qualified Pension/Profit Sharing Plans           p.273

Limitations on qualified plan structuring:

1) Non-discrimination rules – can not favor highly-paid employees (but social security “integration” permitted).

2) Vesting  – benefit becomes nonforfeitable;

cf., effect of termination before retirement.

3) Funding – infusion of contributions into a separate trust enables security of funds.

4) Limits on contributions made by employer.

Special Retirement Plan Structures              p.273-4

- Self-employed persons – use a Keogh (HR-10) plan when only one (or several) employees.

- But, other mechanisms for corporate plans?

- IRAs – individual retirement accounts – e.g., when employer not providing benefits. §408.

- Roth IRA –nondeductible contributions, but non-inclusion for accruals and distributions.

Note: (1) Penalties for early withdrawals, &

(2) Required minimum distributions (70 ½).

-

 

Stock Options & Restricted Property  P.275

What is a “stock option”?  Answer:  Employee’s right to buy stock (employer’s common stock?) at a specified price during a defined period of time.  Cf., a “listed option.”

Compensation –as additional work inducement.

Should the issuance of an option to purchase employer’s stock (or other property) constitute employment income when issued to an employee?   Yes, benefit derived for rendered services.  See LoBue, p. 276.

Options – Timing & Characterization Issues

Option One: 

1) Employee includes value of option in GI for the year of the grant of the option. How valued?

2) Employer deducts that amount as compensation in the year of grant.

3) Later, employee increases tax basis for shares when exercising option at the option price.

4) Employee has capital gain when subsequently selling shares at a price above tax basis.

Options – Timing & Characterization Issues

Option Two: 

1) Employee includes nothing in GI in the year of grant of the option.  Possible forfeiture?

2) Employer deducts nothing  as compensation in the year of grant, but later when exercised.

3) Later employee exercises option & compensation income for FMV less option price.

4) Employee has capital gain when subsequently selling shares at price above tax basis.

Options – Timing & Characterization Issues

Option Three (i.e., bargain purchase): 

1) Employee includes nothing in GI in the year of grant of the option.  Possible forfeiture?

2) Employer deducts nothing  as compensation in year of grant but later when exercise.

3) Employee exercises but no compensation income (for FMV of stock less option price).

4) Employee has capital gain when subsequently selling shares at price above tax basis (and no compensation income).

Current Stock Option Taxation Alternatives

•                     Statutory stock options, i.e., incentive stock

options.  §422

Treatment:  Capital gain on stock disposition.

 

•                     Nonstatutory stock options, i.e., dependent

upon tax accounting rules.  But, treatment under §83.

 

 

Incentive Stock Option (ISO) Rules §422      P.278

Statutory structure permitting GI inclusion limited to capital gain upon sale of stock.

What is ISO stock?  See §422 rules:

1) Stock retention requirements.

2) Option price at FMV when granted.

3) Granted under an option plan.

4) $100,000 limit on option stock amount.

5) No employer deduction for compensation.

Net benefit if employer loses immediate deduction but deferral of cap. gain for EE?

Nonstatutory Stock Options                     p.280

Stock is available to employee but is subject to restrictions on transferability and a risk of forfeiture.  No inclusion since a valuation issue?

Note §83(a) – inclusion in GI when stock option is issued if a “readily ascertainable” FMV.

No current inclusion when the option is “nontransferable” and a “substantial risk of forfeiture” – inclusion when conditions lapse.

GI inclusion when exercise for the difference between exercise price and stock value.

 

Election to Accelerate Inclusion re NSO     p.281

§83(b) – employee can elect current inclusion (even if forfeiture risk) to the extent of FMV.

GI inclusion based on the value of stock (not options?) without restrictions.

No tax deduction by an employee who made a §83(b) election if forfeiture of the option subsequently occurs.

But, §83(b) not applicable if an option “lacks a readily ascertainable fair market value.”  §83(e)(3). 

 

Cramer                     p.283
§83(b) & Sale of Options

Options provided to acquire non-publicly traded stock.  Vesting and transfer restrictions applied to induce continued employment.

§83(b) elections filed to include value at grant as ordinary income & to enable future capital gains.  Elections reported fmv at grant as zero.

Reported option gain as LTCG.

But, upholding Reg. §1.83-7(b)(2)  (& no ascertainable FMV & therefore ordinary income).  Plus, serious penalties are applicable. 

Cramer                     p.283
& Penalties

§6662 – Accuracy related penalty on underpayments.

Amount of 20 percent of the underpayment where penalty applies:

•                     Negligence or disregard of rules.

•                     Substantial understatement of income tax.

•                     Substantial valuation misstatement.

•                     Transaction lacking economic substance.

§6663 – fraud penalty – 75% of underpayment.

Transfers Incident to Marriage & Divorce  p.290

1) Should transfers of property (including cash) from one divorced spouse to another cause realized ordinary income to the transferee?

2) Should such a transfer enable a tax deduction to the transferor (particularly if sourced from the transferor’s current income stream)?

3) Should a transfer of appreciated property from one spouse to another be treated as (a) a sale of property, and (b) the transfer of proceeds to the other spouse (with a §1012 tax basis)?

Davis                      p.291
Transfers in Divorce

The property transfer to an ex-spouse of appreciated property in the divorce context (in exchange for a release) is a gain recognition event to the property transferor – since a “sale or exchange.”  How value the transaction? Are rights given up equal to property transferred?

What is the income tax treatment to the other party who is acquiring the property?  What tax basis for that property to transferee?

What did that person transfer in the exchange?  

Code §1041
p.295

§1041 provides for (1) no recognition to the transferor on a property transfer in divorce; and, (2) a transferred tax basis for the property when held by the recipient.

Further, no deduction is available for the property transfer to the other (ex)spouse.

Limits on §1041 – see Rev. Rul. 87-112 re no tax-free transfer of accrued interest income.

Does the Davis case survive the enactment of §1041?

Property Transfers –
Example

H and W together own investment property: 

1) W receives Property One – 90x tax basis and 100x fair market value (appreciated).

2) H receives Property Two – 110x tax basis and 100x fair market value (depreciated).

Equal property division on a pre-tax basis (but not on an after-tax basis).

What happens when they sell these properties?  Consider the impact of §1041.

 

Farid es Sultaneh
p.296

He transferred appreciated shares to her in contemplation of marriage. An antenuptial agreement was concluded for gift (after stock transfer) where she released (any) dower rights.

What tax basis when she sells (for $19) shares transferred to her?  15 cents or $10 per share?

Held:  She took the shares as a purchaser.

What did she sell?  Gain treatment to her?

What did he sell?  Gain treatment to him?

Dissent: He was married to another when gift.

Alimony & Child Support
p.300

Certain payments (alimony) after divorce: 

- Income to recipient (§71(a)), and,

- Deduction to the payor spouse (§215), “above the line” (§62(a)(10)).

A federal definition of alimony applies to determine whether the payment constitutes gross income.

Impact of the Windsor/DOMA case?

No deduction to the payor parent for child support payments made to the other ex-spouse. 

 

Alimony Requirements §71(b)                       p.300

1) Cash payments (not property transfers).

2) Termination of this obligation occurs at the death of the payee spouse.  §71(b)(1)(D).

3) No excessive front-loading. §71(f).  P.301.

4) No disguised child support. §71(c).  Note “deadbeat dad” treatment. §71(c)(3).                   

5) Parties are not living in the same household. §71(b)(1)(c). 

Under §71(b)(1)(B) parties can opt out of alimony tax status (and agree on no deduction).

Indirect Alimony Payments

H pays (in cash):

(1) W’s mortgage payments on her residence (paid directly to the lender bank); and,

(2) Premiums on a life insurance policy on his life (paid to the insurer) & she owns the policy.

Result:  Taxable alimony to her if she owns (1) the house and/or (2) the life insurance policy, even though she does not receive the funds.

Remember the Old Colony Trust Co. case.

Child Support Obligations
P.304

Child support is (1) not deductible by the payor and (2) not gross income to payee (custodian?).

Diez-Arguelles v. Commr., p.304.

Failure to pay child support and custodial parent deducts amount as nonbusiness bad debt

Held:  No tax basis for the bad debt (§166(b)) and no income tax deduction to the payor.

But, was an indirect loan made to the obligor parent when the custodian pays child expenses and a bad debt occurs when no reimbursement?

Theoretical Issues
p.307-8

What should be the income tax treatment of “imputed income”?

What should be the treatment of the value derived from the use of human capital?

What should be the income tax treatment of human capital derived from the benefits of “genetic inheritance”?

Consumption Tax
p.308

Should a “consumption tax” be implemented as an alternative to the current income tax?

What is a consumption tax?  I.e., taxation only on consumption but a deduction is permitted for income from savings.  The current income tax is between a wealth tax and a consumption tax.

How determine the consumption tax base? 

(1) Income, plus (2) borrowings (& dis-savings) , less (3) savings (zero basis), equals (4) the consumed amount tax base times (5) the applicable tax rate.

Value Added Tax
p.310

A transactions tax similar to a retail sales tax, but imposed at the national level (in all OECD countries except U.S.).  A significant foreign country source of revenue.

Cf., a wealth tax (constitutional?).

VAT applies at each stage of production, with an immediate credit for the VAT taxes previously paid in the chain of supply as attributable to the manufacturing of that specific item.

Accrual Method Taxpayers                p.312

Fundamentals of the accrual method of accounting (businesses: required for tax - §448):

1)  Income inclusion for amounts earned (even though not received); and,

2)  Deduction for obligations incurred, even though not paid.

However, federal income tax exceptions: 

(1) not permitting deferral of prepaid income or (2) no accrual of estimated future expenses.

 

Delay in the Receipt of Cash                       p.313

Georgia School Book Depository case – p. 313.

Accrual basis taxpayer: Should school book commissions be accrued when books are sold?

Is expectation reasonable that claims would be paid? Here, current fund insufficient to pay bill.

But, all duties were performed for the accrual of income.  And, payment would eventually occur from the collection of the beer excise tax.

No serious doubt as to ultimate collection and the sales commission should have been accrued.

Hallmark Cards case
p. 316 (note)

Hallmark cards – shipped Valentine cards to retailers in December, but retailers did not want ownership on 12-31 for personal property tax purposes.

Then, Hallmark retained title until January 1.

Hallmark’s income was permitted to be accrued in the subsequent year when title passed to the retailer and “all events” occurred to fix the right to income when title passed.

Prepaid Income
p.316

American Automobile Association – p. 317

One year membership fee paid in advance.

When earned by AAA?  Ratable allocation to each month (& a partial deferral to next year).

IRS says immediate inclusion in gross income. 

Ratable reporting was not permitted.

What if proof of delivery of services is provided?

What if the method is consistent with GAAP?

Effect of repeal of §452 & §462?  Note § 455?

Cf., dissent:   What about expenses?

Subsequent Prepaid Income Cases          p.321

Schlude (Sup. Ct., p.321):  prepaid dance lessons; inclusion at time of receipt of payment. 

Artnell (7th Cir.) – deferral until games played.

Boise Cascade (Ct. Cl.) – consistently reporting income when services rendered (not requiring any earlier reporting if advance receipt).

Rev. Proc. 2004-34  (re: services) – reporting in the current or subsequent year, if consistent with financial accounting; Regs. §1.451-5 (sales of goods) & similar treatment as services.

Deposits v. Advance Payments                 p.323

Indianapolis Power & Light,  p. 323

Advance deposits to enable establishing electric service received by customer.   Interest paid by utility on the deposit amount. Eventually credited against the customer’s account. No separate escrow or segregation of funds.

Held:  Equivalent to loans by customers, rather than advance payments. Loan repayment was possible and not a prepaid amount received.

Same treatment for lease deposit amounts?

Westpac Pacific Food
p.324

Is an “advance trade discount” paid (for volume purchase commitment) to retailer gross income?

Taxpayer treated up-front cash as a liability. Then applied the discount pro-rata to full purchase price as paid.

This method was consistent with GAAP. 

Tax Court says advance payment was income.

Reversed, as advance trade discounts not constituting GI.  Not an “accession to wealth.”

Current Deduction of Future Expenses      P.329

Can an income tax deduction be available before the liability is actually paid?

Deductions are subject to the “all events” test for the accrual basis taxpayer. 

Question:  Is the fact of liability firmly established and the amount determined with reasonable accuracy. 

General Dynamics Corp.
Sup.Ct.                   P.329

Deduction was claimed for medical expenses reimbursable to employees

•                     when the expense was incurred, but

•                     no current claim to the employer had been

made as of the end of the tax year.

Amount claimed based on estimates of past experience.  Sup. Ct.:  “All events” test was not satisfied;  some employees might not file a claim for reimbursement.

The “Economic Performance” Test  P.330

§461(h)(1) enacts the “all events” test.

This provision also specifies that the “all events” test is not treated as met any earlier than when economic performance for that item occurs. 

A fixed obligation to pay an amount next year can not be deducted currently.