Chapter 7                p. 437
Receipts and Liabilities              

Borrowing of funds does not result in receipt of gross income.  Borrowing proceeds are offset by a liability to repay and, consequently, no net accretion to wealth occurs.

No deduction is allowed for repayments of the loan, i.e., merely a rearrangement of items on  personal balance sheet.  Cf., consumption tax.

But, what if an adjustment (reduction?) of the debt amount occurs?

 

Kirby Lumber Co.
Bond Buy-back         p.437

Company issues its own bonds and later buys back bonds for $.862 per $1.00 par face  value.

Is the “gain” taxable to the borrower?

The excess of the issue price first received over the purchase price constitutes realized gain.

An increase in the corporation’s net worth has resulted from this reduction of the debt amount.

How is the issuer able to buy bonds at less than their par value (or their original issue price)?

An accession to wealth here and GI is realized.

Code §61(a)(12)

§61(a)(12) specifies that gross income includes “income from the discharge of indebtedness” (treated as “ordinary income”). This results from assets being “freed from indebtedness.”

Alternative scenarios (not gross income):

Parent forgives debt owing from child.

Corporation forgives debt owed by

shareholder (dividend?).

3)  Shareholder forgives debt owed by corp. (capital contribution?)

 

Code §108 - Possible COD Income Relief           p.439

§108 provides various relief from this rule for insolvent (§108(d)(3)) & Chapter 11 debtors (and others); i.e.,  not all taxpayers recognize COD income.  Also relief for:

Qualified farm indebtedness - §108(a)(1)(C).

Qualified real property debt - §108(a)(1)(D).

Qualified principal residence debt discharged before 1-1-2017 - §108(a)(1)(E).

Reduction of tax attributes is required -§108(b). continued

 

 

 

Code §108 - Possible COD Income Relief, cont. p.439

1) §108(h) provides for reduction of tax basis for the residence when debt reduced.

2) §108(e)(5) provides that the reduction in debt for a purchase price is a reduction in purchase price, and not COD income to the purchaser.

3) §108(f)(2) – COD income relief on cancellation of a student loan – under limited circumstances.

.

Zarin v. Commr.
P.442

Discharge of gambling debt occurs.

Taxpayer delivered his personal checks for $3.435 million and the checks were not good.

State court collection action was filed.

Settled this action for $500,000 and IRS then asserts $2.9 million COD income to taxpayer.

Not a purchase money debt reduction (?).

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

Tannenwald dissent: not a genuine debt.    Cont.

Zarin v. Commr.
Appeal                     P.450

3rd Cir. reverses Tax Court and treats the cancelled debt as a “disputed debt” or a “contested liability.”  Treated as if the initial loan was actually made for the eventual settlement amount.  Treatment of  the 2.9 mil.?

Was this debt enforceable?  See state law.

3rd Cir. dissent:  COD income and this was a bona fide debt situation.  Assets of the taxpayer were “freed from liability.”

Claim of Right Doctrine
p.453

North American Oil Consolidated case

1) In 1917 taxpayer receives (from receiver) earnings (from 1916) under a “claim of right.” 

2) Therefore, 1916 earnings are to be included in taxpayer’s GI for 1917.  Taxpayer says 1916.

3) GI inclusion was not delayed until 1922 when litigation over amount was finally terminated.

4) If taxpayer makes refund in 1922 taxpayer would be entitled to a deduction in 1922.

Why such an issue over timing for GI inclusion?

Cont.

Claim of Right Doctrine, continued

North American Oil Consolidated case

What is the income tax status of the (intermediary) receiver?

Is the receiver a taxpayer?  Or, is the income the receiver obtains merely “suspended from tax” until later distributed to the person determined to be the owner?

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

U.S. v. Lewis
Cash Method            p.455

Taxpayer in 1944 reported the receipt of a 22x bonus.  A state court judgment required repayment (in 1946) of 11x portion of bonus.

Deduct 11x on 1946 return (IRS position); or, recompute for 1944 (per Court of Claims) because excess received under a mistake in fact?

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

But, subject to amending returns (within S/L) to correct facts which were existent for the particular year (as of the end of that tax year). 

“Claim of right” doctrine & §1341 Relief        p.458

What if tax rate in the earlier year was higher?

Assume a later year restoration of an amount earlier received under a “claim of right.”

§1341 permits a reduction of income tax liability in the year of repayment by amount of excess tax paid on that income when 1st included.

Must have earlier received the income under a “claim of right.”  Cf., restoration of embezzlement income received.  Voluntary payments are not eligible for this treatment. 

Deductions Contested
p. 458                               

ConEd case, p. 458  All real estate tax is paid but some portion is contested.  IRS says the entire payment is immediately deductible and any refund is to be restored to income in the year of the refund.  Taxpayer says only currently deduct the uncontested amount.

Holding:  Only the uncontested amount is deductible.  See §461(f) subsequently enacted to provide a full deduction.  Why?  Implementing North American Oil on the deduction side?

Alcoa, Inc.             P. 458            
“Apparent claim of right”?

Motion for Summary Judgment granted to IRS.

Issue:  Alcoa spends funds for environmental remediation (after CERCLA mandate enacted).

Alcoa claims a deduction and then claims §1341 claim of right treatment, i.e., income earlier received was not really Alcoa’s since required to be used for CERCLA purposes.

Compliance with §1341 criteria?  Does gross income include money taxpayer did not spend?

Here not a “restoration of income.”

Executive Compensation  “Clawbacks”          p.468                         

Sarbanes-Oxley requires a clawback of an executive’s bonus compensation when an erroneous financial report has been issued.

Similarly, Dodd-Frank “Wall Street Reform and Consumer Protection Act” requires this.

Do these executive compensation clawbacks qualify for §1341 claim of right relief? 

But, what if the executive is the wrongdoer?

Other compensation clawbacks - §162.

Embezzled Funds
James case            p.468                             

Are embezzled funds includible in §61 gross income?  Here: Criminal conviction for tax fraud for failing to report embezzled income.

Assume that no intent to repay existed at the time of the embezzlement (& therefore, an accession to wealth)?  What if intent to repay?

But, here, confusion from prior Wilcox case (embezzled money not income – duty to repay) and, therefore, difficulty in proving willfulness.

(1) Dismiss the case or (2) remand for new trial?

Embezzlement Income - Collateral Issues

Who has priority (as a creditor) for the funds (if the funds are still held by the embezzler):  

the embezzled party, or

2) the IRS (for the income tax on the embezzled funds treated as gross income)?

What is the income tax treatment of the proceeds received from a bribery?

Appropriate to use criminal tax proceedings to pursue “organized crime”?  Ask Al Capone!

 

McKinney case
p.476                

Embezzler claims “trade or business” status as an embezzler and being entitled to an NOL deduction when paying back embezzled funds. 

Held:  not engaged in a trade or business. 

Not reported as business income on return.

Further, not entitled to use §1341 for relief since funds were not received under a “claim of right” both (1) as a matter of law, and (2) based on the facts here (admission against interest).

Acquisition of Property with Debt Financing

Examples: 

Purchase of residence or (investment

Property) with 100x cash (i.e., only cash and no borrowing).  Tax basis to the purchaser is 100x (§ 1012).

2)  Purchase of residence (or investment property) with 10x cash and 90x borrowed from a bank.  Is the tax basis to the purchaser for this acquired property (1) 10x or (2) 100x?  See §1012.

Transfer of Property with Debt Attached         p.479 

Alternative types of secured debt arrangements (see p. 487-491):

Recourse – personal liability for the debt by

the borrower (to the extent of all the assets of the borrower) & the mortgaged property.

Nonrecourse – the debt is secured only by

the pledged asset (and its income stream), but no personal liability of the property owner exists.  Why might a lender agree to this latter type of  lending arrangement?

Crane v. Commr.      P.479
Debt in Tax Basis?

Crane case:  recourse and nonrecourse debt is

to be treated similarly for federal tax purposes.  Here: TP claimed debt was (1) in the original tax basis (& for tax depreciation) computation,

but, (2) not treated as an amount realized upon “debt relief” when the property sale occurred.

Property was inherited when fmv was 262x & nonrecourse debt was 262x.  She then claimed 25x depreciation.  Later she received 2x cash on the property disposition.  Gain of 2x or 24x? 

Crane v. Commr.      P.479
Debt in Tax Basis?    Cont.

Does the income tax basis include the

nonrecourse debt at the time of acquisition?

2)  At the time of disposition does the amount realized include the nonrecourse debt transferred with the property?

Note the famous footnote 37 (p. 485) re the possibility of the value of the property being less than the amount of the mortgage, i.e., the property is “under water” (not the Crane case).

 

Crane v. Commr.      Cont.
Origin of “Tax Shelters”

Consider the impact of the successful litigating position of the IRS in the Crane case when

borrowed funds are included in tax basis.

For depreciable property a depreciation deduction is available for the entire cost basis.

Example:   10x cash and 90 borrowed.

Assume 1st year depreciation of 40x and 50% tax rate.  This enables tax savings of 20x and 10x positive cash flow to the investor.

Parker v. Delaney
p.486                

Taxpayer in default on a mortgage conveyed property by a quit-claim deed to the lender & received nothing.  No proof re the actual value of property as being less than the mortgage.

Judge Magruder concurrence:  Use (1) the “equity” cost and (2) a negative basis approach to determine the amount includible in gross income when property disposition event occurs.

In the interim who gets the tax depreciation with an “equity” investment approach?

Tufts case                p.491
Debt Exceeds FMV 

Facts:  Property purchased for $1.85 million nonrecourse debt.  Initial tax basis of $1.85 million. $400,000 tax depreciation was claimed.

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

FMV of property at disposition was $1.4 mil.

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

(2) the FMV of the property at disposition.

Tax issues:  Gain or other income? Loss? Tax character?  How much?  COD income?

Majority holding:  400,000 capital gain realized.

Tufts case                p.491
Concurring Opinion

Two transactions have actually occurred:

Property ownership purchase transaction. 

Basis is established at acquisition;  FMV at disposition identifies the proceeds then received.

Debt/loan transaction,  including the

termination of the loan.  Original loan establishes obligation;  repayment for less than debt creates cancellation of debt income (COD).

3)  Property gain is cap. gain;  COD income is current ordinary income.

Tufts choices for decision:
One or Two Transactions?

Integrated Transaction

1.850 debt

Less:  1.450 basis

Equals:  400 gain

(capital gain?)

Note: Why this litigation approach? 

As reported: 50 cap. loss

(1.45 basis less 1.4 value)

Two Transactions

1.850 debt relief

Less:  1.400 value

= 450 COD income

 

2) 1.450 basis

Less: 1.400 value

= 50 capital loss (property sale)

Tufts case                p.491
Effect of the Tufts Opinion

Assuming two transactions have actually (economically) occurred: 

Why did IRS litigate on the basis of only one (integrated) transaction, i.e., a property sale?

Possible explanation:  At that time gain postponement (through basis adjustment, e.g., Code §108) applied to all COD income realized.

Was the successful litigation position of the IRS ultimately counterproductive? No COD income exists to be recognized.

Treasury Regulations & Nonrecourse Debt Effect  

Reg. §1.1001-2(a)(1) – the amount realized includes the amount of liabilities from which the transferor is “discharged.”

Reg. §1.1001-2(a)(4)(i) – the sale of property that secures a nonrecourse liability “discharges” the transferor from the (nonrecourse) liability.

Reg. §1.1001-2(b) – the fair market value of the security is not relevant for determining the amount of liabilities being discharged.

Rev. Rul. 91-31         p.501 
Debt Reduced-No Transfer          

Lender agreed to reduce nonrecourse debt when the value of the building (800x) was less than the  mortgage debt (1 mil.) & no insolvency.   Reduction of the undersecured non-recourse debt by the holder of debt & not the seller.

Debt reduction produces realization of (non-exempt) COD income (even in the non-recourse context) – since no disposition of collateral has occurred by owner (& bank gets tax deduction).

Result: 200x COD income to property owner.

Nonrecourse Borrowing Exceeding Basis     p.504

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

Cf., what effect of a  later (i.e., post-acquisition) debt when:

borrowing against the (significantly

appreciated?) property, and

(2) the loan amount exceeds the then current income tax basis for the collateralized property?

Nonrecourse Borrowing Exceeding Basis     p.504

Woodsam Associates:  Individual borrows on a nonrecourse basis an amount in excess of the tax basis for the property.  Later transfer of the property into corp. & corp. argues:  (1) the borrowing was a gain (disposition) event, &

(2) the property basis was then stepped-up.

Corp objective: to avoid gain treated as being realized on a mortgage foreclosure. 

Held: gain was realized at the later disposition, and not when original borrowing occurred.

Gifts of Encumbered Property                  p.507                         

Estate of Levine, p. 507.   Gift of property in a donative transaction (to trust) with transferred liabilities in excess of the tax basis for property.

Includes current expenses assumed and paid by the donee.  Gift tax based on excess of (1) the fair market value over (2) the debt liability.

Here:  (1) partial sale & (2) partial gift?

This transfer (liability in excess of basis) constituted a “disposition” of property for §1001(a) income tax purposes. Capital gain(?).

Diedrich v. Commr.
P.514                

Gifts are transferred subject to condition that donees agree to pay gift tax on the gift.  The gift tax was 63x and the tax basis for the transferred property was 51x.   Gain of 12x realized?

The gift tax liability is imposed on the donor under gift tax rules - §2502(d).

Gross income was deemed realized to the extent of (1) the gift tax amount (2) in excess of the tax basis for the gifted property.  Note no tax basis proportionate allocation here;  Cf., §1011(b).  See next slide.

 

Basis Allocation in a Gift Situation with Debt                   

Net current FMV of property is 10x; §1012 cost basis is 4x; Appreciation portion is 6x.

Gift to child, but subject to child paying 4x debt to which transferred property is subject.

Options re gain amount on the debt assumption:

Basis of 4x less 4x assumed debt equals zero.

Allocated basis of 1.6 (4x times 40% of sale

part of transaction) & gain of 2.4 (4.0 less 1.6); basis for the gift portion (6x) is 2.4 (60% of 4x).