Chapter 1 - Introduction: Code - 1 (A) - (F), (I) A. Orientation The Tax Practitioner's Tools (P. 1-11, 24-30, 42-46)
Chapter 1 - Introduction: Code - 1 (A) - (F), (I) A. Orientation The Tax Practitioner's Tools (P. 1-11, 24-30, 42-46)
Chapter 1 - Introduction: Code - 1 (A) - (F), (I) A. Orientation The Tax Practitioner's Tools (P. 1-11, 24-30, 42-46)
C. Introduction to Tax Policy and Rate Structure (p. 11-24) (Code §1(a)-(f), (i)
C. Theory and Policy
1.Taxation and “Ability to Pay”
“Head tax” – a tax of equal dollar amount on everyone
Our income tax is based on an “ability to pay;” a phrase of which the meaning is
disputed. Consumption tax has been seriously considered
“Imputed income” – value of goods and services one provides to oneself
6 aspects of a good tax
1. Uniformity – geographical uniformity
2. Equity – horizontal (people with same accessions to wealth pay same tax amount –
same income, same tax liability. People making the same amount of income should
pay the same amount of tax. If I make $50,000 and my neighbor makes $50,000, we
should both pay the same tax); vertical (different accessions to wealth have different
tax liability. Different income, different tax liability. Up and down the economic scale. )
3. Predictability – a good tax should have the same effect from year to year
4. Simplicity – good tax law should be easy enough for average taxpayer to fill out their
own tax return. Our current tax law is not very simple
5. Administrability – related to simplicity; what does government have to do in order to
enforce tax laws? Do they spend more than they collect?
6. Neutrality – a good tax shouldn’t effect non-tax business decisions
2. What Should We Tax?
Once one accepts that some variant of ability to pay ought to serve as the touchstone
for allocating tax burdens, the question becomes how to implement it. Since the thing
we really want to tax may not be directly observable, we must rely on some proxy
measure. There are numerous possibilities (income, consumption, and wealth being
some).
A consumption tax is simply an income tax with a deduction for savings in any form
and with the inclusion in the tax base of amounts drawn down from savings and used
for consumption. IRA
3. What Do We Tax?
Income
Haig-Simons definition of income calls it the sum of the taxpayer’s consumption plus
the change in net worth, each defined in terms of market value, during some specified
accounting period
In practice, the US federal income tax liability depends on the statutory concept of
“taxable income,” rather than on any abstract definition
4. The Tax Expenditure Budget
Tax scholars often refer to a concept called the “tax expenditure budget,” under which
certain tax benefits are equated with direct subsidies. The general approach is to
identify various exclusions (such as interest on state and local bonds), deductions
(such as deduction for charitable contributions), deferrals (such as for employer
payments to pension plans), and credits (such as the child-care credit or the credit for
investment in new equipment) that are seen as departures from a neutral concept of
income taxation; then to figure out the cost of these special provisions; and then
attribute these costs to various budget functions.
Depends on the notion that there is a natural, neutral, or normal income tax and that it
is possible to identify departures without great difficulty or dissent.
5. Tax Incidence
The incidence of a tax is its ultimate burden
To determine incidence of a tax (burden/effect of particular provision of a tax system),
compare the world with the tax provision to the worth without it. It’s generally assumed
that the burden of the income tax, so far as it falls on income from wages, salaries,
and other earnings from services, is, for the most part, not shifted from the individuals
to whom it is imposed.
6. Inflation
Section 1(f) and 151(f)
Income makes it difficult to levy the right amount of tax on investment income.
D. Average Versus Marginal Tax Rates
One of the most controversial features of any tax system is the extent to which it redistributes
income or otherwise requires some people to pay more than others.
A progressive income tax is one with average rates that rise as income rises. Under a
progressive rate structure the tax on a person with a high income is not just a greater amount
than the tax on a person with a lower income; it is a greater proportion of income.
A regressive income tax is one where average tax rates decline with income.
Overall, the U.S. federal tax system (including all taxes, not just income taxes) generally
features progressive tax rates, though the degree of progression varies depending on the tax.
WE have graduated rate structures (Hess thinks the consensus is shifting from graduated
rate structures to proportional).
Within the individual income tax, progression is accomplished primarily by a schedule of rates
with increasing marginal tax rates – that is with increases in rates that apply only to
increments in income.
E. The Taxable Unit and the Marriage Penalty
A “taxable unit” means that individual, or group of individuals, who is, or are, treated as a tax
paying unit in the same sense that they must aggregate their income for purposes of
calculating the tax payable. Married people permitted to file joint return – most favorable;
heads of household, unmarried individuals, married people filing separate returns – least
favorable
“Marriage penalty” – added tax paid by two people who have roughly the same earnings and
who marry one another. “Secondary worker” person whose income is lower and whose
commitment to working is less than the primary worker
Married single-earner couples are better off than they would be under a system with one
schedule for all, since they have the advantage of the most favorable rate.
PROBLEMS – p. 118
1. Suppose A purchases stock for $1000 and gives the stock to his son, B, at a time when the FMV
of the stock is $2,500.
c. Ernesto hasUnder §102(a),
stock with B does
a basis not have
of $20K and aanyFMV gross income
of $80K, pluswhen
$80KBingets the stock
a savings
from A. account
a. How much gain does
i. Wrong B recognize
answer is to justifgive
he sells the stock
the $80K out for $3,500?
of the savings When you have
account. If he income
gives
with a gift her you the
have to pay
cash, tax on
no gain andit. no
Under
loss.Section 1015, his basis is his father’s basis!
i. ii.
AR -What$3500; if heABgives
- $1000; Gainstock
Ana the $2500 and she sells it. Similar to Part A. If they are
b. How muchever gaingoing
does Btorecognize
sell the stockif heinsells
thethe
nearstock for it
future, $1,500?
is better to sell now.
i. iii.
AB -ANSWER
$1500; AB - $1000;
depends onGain
whether$500Ernesto plans to sell the stock in the near
2. Suppose C purchases futurestock for $2000
or not. and gives
If he does, give itstock to daughter,
to Ana. If he does D, not,atgive
a timeherwhen the FMV of
the cash.
the stock
d. isErnesto
$1000. has What amount
stock withof gain or
a basis of loss
$20K(ifandany) is recognized
a FMV by Dstock
of $80K, plus on a sale
withfor the of
a basis
following amounts?
$120K and a FMV of $80K.
a. $2,500 i. If a client asked you which one to sell tax consequence aside, you should say
i. AR -that $2500; AB $2000;
is beyond your Gain $500
competence.
b. $500 ii. If the loss stock is the best thing to sell (like it will only go lower), suggest that
i. If C Ernesto
sells, $500 = AB
sells the$2000
stock. – AR ($500) = $1500 loss (deduction from gross
income)
iii. If the gain stock is going to be sold, Ana needs to sell it.
ii. iv.
If DItsells,
has $1000
to be one (AB) or -the
$500 (AR) = $500 loss (deduction from gross income)
other.
(Look
v. Sellatthe §1015(a)
stock that – FMV is less than
is decreasing inbasis
valuewhenand usethethe
giftproceeds
was madetoand fund wethe
are
determining
tuition; same loss).situation
Gets reallythatoddwe when
wouldsaledo inis between
(b); or sellFMV
the and basis. stock
decreasing
c. $1,500 because he would anyway since it is a loser; only Ernesto could use the loss.
i. There Thenis no tax consequence.
maybe he should keep that money and give the increasing stock to Ana
1. AR (1500)
because she will – AB
be (2000)
taxed at–acan’tlower dorate;
that this
(negative
assumes gain)
that he wants to sell
2.
both;AB (1000) – AR (1500) – you can’t have a negative loss
3. During e.
theThenextfacts
fourareyears,
the Ernesto’s
same as indaughter,
(a) except Ana will
that require
Ernesto is $80,000
88 yearsfor oldcollege tuition
and is poor and
health.
expenses. In each of theto
i. Basis following
donee issettings,
the FMVadvise him to
at the date of the
the best means death
decedent’s of transferring
– Section wealth
1014.
to the daughter soBasis that she may go to college. Ernesto is in the maximum
is cost unless another section applies, and another section when the marginal tax bracket
and Ana has no income. donor is dead – 1014. Step up in basis is section 1014(a) – Basis – FMV at
a. Ernesto has a single
date asset, death.
of donor’s stock with a basissell
Ana would of $20,000
it for just and a FMV
about whatof $80,000
the FMV would be.
i. GiveCongress
it to Ana–and if youlet live
her long
sell it,enough
put thetomoney
have all in assets
the bank to payin
increase the tuition
value, youeach
will
year. forego the capital gains tax when you die. (Means Ana is not taxed on the
ii. OR give$60Kher about
if she $20K
is the of stock each
beneficiary). yeartax
Estate toissell
notand payon
based forincome
tuition tax
– Yr 1: AR -
$20,000, AB - $5000 (1/4 of 20 bc 20 is ¼ of 80), Gain $15,000. Ana’s tax liability
principles.
would be less than Ernestos’ because she is in a different tax bracket (less income
is taxed because she has a lower total income).
b. Ernesto has a single asset, stock with a basis of $120K and a FMV of $80,000
i. Don’t assume any gift at all. Let’s just say Ernesto sells the stock. Loss Equation.
AB ($120K) – AR ($80K) = loss ($40K)
1. It reduces his gross income (Ernesto’s). §165(a) – I can take $40K off my
gross income this year. Let’s say he has GI of $150K. Take $40K away. He
will only have taxable income of $110,000.
ii. If Ana had sold the stock, things would be very different. Computed under
§1015(a). $80K (AB) - $80K (AR) = $0 (no loss here). If the family wants to use
the investment loss, it has to be Ernesto’s, not Ana’s.
limited to items of income from the performance of services or to items of ordinary
income. It does not include gain on assets owned by the decedent and not subject to
any contract for sale at the date of death; if it did, there would be nothing left of the
1014 stepped-up basis at death.
D. Recovery of Capital
Income includes interest, rents, dividends, and other returns on one’s capital or cost or
investment. It also includes gains from the sale (or other disposition) of that capital. It doesn’t
include returns or recoveries of one’s capital. Sect 72(e)
1. Sale of Easements
Inaja Land Co. v. Commissioner
Taxpayer paid $61K for 1236 acres of land. City constructed a tunnel which increased
flow of water; water was polluted and cause erosion. City paid the taxpayer $49K
because they said it was return/recovery of their capital. Capital recoveries in excess
of cost do constitute taxable income. No portion of payment in question should be
considered as income, but full amount must be treated as a return of capital and
applied in reduction of petitioner’s cost basis. (Congress has neither codified this result
nor rejected it; has been accepted as the rule).
o Return to basis = recovery of capital (the terms are used interchangeably)
o $61K (basis) – 49K (return of capital – paid for flood) = 12K new AB
o TEST – unable to determine basis and no change in title.
o This would NOT apply to a sale of a portion of property. Sales are GI regardless
of whether you can find exact value of the portion of property).
o Basis is never reduced below zero.
Problem 3 (p. 121)
o Inaja Land sells the entire property for $25K. What tax consequences?
Sale §1001(a)
AR ($25K) – AB ($12K) = gain ($13K)
Suppose that in 1939 the city paid Inaja Land $65K instead of $49K
(net). What tax result in the year and in a later year when the entire
property was sold for $25K?
Can’t have a negative basis. Old basis was $61K and amount
received was $65K. There is a gain of $4K. Basis in the land is
zero.
Recovery of Capital Doctrine – the government tries to make this apply as infrequently
as possible. Don’t like to defer
Most common examples – flooding and extracted minerals.
E. Transactions Involving Loans and Loan Discharge – Basic Rules: Misconceived Discharge
Theory (p. 159-65; 174-78)
Sec. 61(a)(12) – Gross Income from cancelation of indebtedness
Class Hypo: Clients are going to buy a piece of real estate. Clients go to bank and borrow 125K. On
the day they get the check from the bank and sign the note, do they have Gross Income? No, at the
time they receive the money, they receive an equal liability. They then use the money to buy
property which is secured by a mortgage. Clients both lose their jobs. What happens if the clients
don’t pay the loans back? What if bank forgives part of the loan?
Loan - $125K
Forgive - $25K
Owe - $100K
25K is GI and taxable now under section 61(a)(12). Clients are richer by the amount that they won’t
have to pay back.
1. Loan Proceeds Are Not Income
Rule – Loan proceeds are not included in GI and loan repayments are not deductible. Rule
applies to both recourse (loans on which borrower is personally liable) and non-recourse
loans (lender’s only recourse in case of default is against property pledged as security for the
loan).
Rationale – Loan proceeds don’t improve one’s economic condition because they are offset
by corresponding liability; loan doesn’t increase net worth
Relation to Accounting Method – the rule applies to both cash method and to accrual method
taxpayers.
2. True Discharge of Indebtedness
A person can have income from the discharge of indebtedness.
For tax purposes, one should separate the loan transaction from the transaction in which
proceeds of the loan were used. Tax consequences for the use of the funds should be
accounted for independently, according to the requirements of annual accounting. See 165(c)
(3)
The leading case on discharge of indebtedness (Kirby) distinguished, instead of rejecting
outright, an earlier case (Kerbaugh-Empire) that mistakenly applied a transactional approach,
trying the treatment of the loan discharge to a loss on the use of the proceeds.
United States v. Kirby Lumber Co. (1931) – Kirby issued bonds for $12 million for which it received
par value. Later in the same year it purchased $1 million (face amount) of same bonds at a price of
$862,000 (difference of $138K). Issue – whether this difference is a taxable gain or income of Kirby
for the year? Debentures – 1 million. Repayment – 862K (paid 86 cents/dollar to get the million
worth of bonds back). When interest rates go up, value of bonds go down. This is like the bank
forgiving 138K. Kirby is richer by 138K. Gross income includes gains and profits and income derived
from any source whatever. Treasury Reg – If the corporation purchases and retires any of such
bonds at a price less than the issuing price or face value, the excess of the issuing price or face
value over the purchase price is gain or income for the taxable year.
Hypo: Clients above didn’t borrow from the bank, they borrowed from an aunt; didn’t lose
jobs. Aunt later says, I forgive the $25K debt. Discharge of indebtedness? Yes. Gross
income? Probably not, because this would probably be considered a gift. When 61 and 102
may apply, 102 usually trumps. (If anything says something other than section 61, then the
other section usually controls.) We have to determine the intent of donor.
3. Relief Provision
There are a number of exceptions to 61(a)(12)
Insolvent Debtors. Section 108(a)-(b); Insolvent – liabilities exceed assets. 108 is not a
blanket statement – several conditions must be met.
Solvent Farmers. Relief provided for insolvent debtors also available to solvent farmers for
“qualified farm indebtedness” (debt incurred in operation of a farm by a person who, during
the 3 preceding taxable years, derived more than 50% of annual gross receipts from farming.
See 108(g).
Adjustment of purchase money debt. Section 108(e)(5) provides that the reduction of debt
incurred to purchase property and owed to the seller is treated as a reduction in sale price,
rather than income to the purchaser.
Student loan forgiveness. Section 108(f)(2) excludes from income any
cancellation/repayment of a student loan, provided the cancellation or repayment is
contingent upon work for a charitable/educational institution.
Section 108 is an exclusion of Gross Income. No Gross Income if your liabilities are
discharged, but 108(a)(3) says you must be insolvent before and after the discharge; but
108(b)(1) reduce attributes from the amount of the discharge debt (b)(2)(E). 2 exceptions.
108(b)(2)(E) – deals with basis reduction
Example – assets = $1,000,000. Liabilities = $1,500,000. One creditor discharges $200,000 of debt.
Was the debtor insolvent before and after? Yes (liabilities exceeded assets by $500K before and
$300K after). He still has excess debt. This discharge is NOT GI. At the time of this example, the
asset has an adjusted basis of $800,000. You must reduce the basis of some asset by the amount
of the discharge – 108(b)(2)(E).
Basis is calculated under Section 1017
Basis was $800,000. Take away $200,000 discharge of indebtedness. Basis is $600,000. 1001(a) is
still going to apply when the asset is ultimately sold. The number for AB is now $600,000 rather than
$800,000. Gain is $200K more than it would have been. We have deferred tax consequences until
the taxpayer sells the asset.
Sections after §101 trump earlier sections. There are exceptions.
4. Misconceived Discharge Theory
Sometimes gifts are given in exchange for the donee paying the gift tax owed by the donor. If
the amount of gift tax paid by the donee exceeds the adjusted basis of the gift; the donor will
be taxed on that amount
Example: The client owns property that she wanted to sell/get rid of. Basis - $50K. FMV –
1,000,000. If it’s not a sale, it is a gift. If it is a gift, there is a gift tax. Assume the gift tax is
$200K. What are the options?
o Sell a piece of the property worth $200,000. AR = $200K; AB = about 10K bc 200k is
1/5 of a million and 200k is 1/5 of a million. If she does this she will have 190K in taxes
– gain is GI
If she did this she would ultimately have less gift tax if she gave the rest away
(now a FMV of 800K). She could use the procceds of the sale to pay the gift
tax.
The debt follows the farm, so the owner doesn’t have to pay it back. She is not
being discharged of a debt because the debt is not disappearing, it is just
transferring. She is being relieved of a debt.
Relief of a debt is plugged in to amount realized.
o She could mortgage the farm. Worth 1 million, she takes out a loan, secured by a
mortgage for 200K. She can use this loan to pay the gift tax if she gives farm to her
grandchildren. What is the basis of property after she takes out the loan? 1 million – no
change. She does not have gross income in the amount of the mortgage. Transfer of
the farm is subject to the mortage.
Net value of redemption - $800K; grandchildren will have to pay mortgage back
Does grandma have an income tax consequence when she makes the gift?
This is partly a gift and partly a sale. She won’t have to pay the mortgage back.
She still has money from the mortgage, until she pays the gift tax. Debt of the
mortgage has shifted. Is she richer bc she is no longer primarily liable for the
debt? Yes, she has $200K cash. She still has a realization under 1001(a).
AR 200,000-AB 50,000 = 150,000 gain
Diedrich v. Commissioner
Petitioners made gifts of stock to their children which were subjects to the condition that
donees pay the gift tax. Donor’s basis in the transferred stock was $51,073; the gift tax paid
by the donees was $62,992. If you fulfill someone else’s obligation to a third party, the
original obligator has income because they are made richer. If donee pays the tax, the donor
realizes an immediate economic benefit. A donor who makes a gift of property on condition
that the donee pay the resulting gift tax realizes taxable income to the extent that the gift
taxes paid by donee exceed donor’s AB in the property.
Estate of Weedon v. Commissioner – the donor remains personally liable for the gift tax until
it is paid
What if the adjusted basis in example above was $300,000?
There is a section that says if a transaction is part sale and part gift, no loss can be
recognized
What would the grandchildren’s basis be if grandmas can’t recognize the loss? 300,000 – the
grandchildren have a straight donee basis. Grandma still has the last 200K but she has
recognized a los so she has no gains to pay the tax on.
1.0001-1(e)(1) – no loss recognized on the part sale, part gift
What if $1 million was borrowed against the farm with a fair market value of $1 million?
So far there are no consequences; the $1 million is the loan
What does the $1 million do to the basis in the farm? Nothing
Your basis is always your cost. Basis in the loan is $1 million is because that is what you
have to pay back
What if your client didn’t own the farm but borrowed a million to buy it?
Basis in farm would be $1 million – not because she got 1 million loan, but because that’s
what she paid
Your basis is in whatever asset you buy with the loan proceeds
The correct way to compute annual depreciation is to compare the present value of anticipated cash
flows at the beginning of the taxable year with the present value of such cash flow at the end of that
year.
G. Review of Chapter 2
This problem does not have a single numerical right answer
Need to know when you don’t have enough information – do more legal research – call my
client and figure out X, Y and Z
Do this problem on an annual basis
Write down any issues you see in the problem and in any order they come in your mind.
Issues 1)Tax consequence of the inheritance? Income? Which value is basis? 325k? or
250K? 2) Tax consequence of replacing the roof? 3) $40K loan he received and paid back 4)
deduction for depreciation? Is the building depreciable? Section 167. Did he take the
deduction? (call client). 5) is the roof depreciable? Did he take deduction? (call client)
Tax consequences of receiving building – income? Basis?
o Answer – tax consequences of receiving building. It is income? NO (section 102(a)).
Would it be gross income otherwise – glenshaw glass case. Basis? FMV at the time of
the grandfather’s death – 1014(a). (ignore material in section 1022).
Tax consequences of receiving loan proceeds?
o Answer – Generally not taxable. No gross income here because client has to pay back
the loan. There is no section in the Code for this. Under Glenshaw glass, you are
richer when you have income. A loan is making you richer.
Tax consequences of repairing roof? Deduct? Add to basis? (how much?)
o Answer for this comes from chapter 6. Most likely answer is that roof is added to basis
and then depreciated. Deduct? That depends. If you could deduct it, you wouldn’t add
it to basis. It is very likely though it is deductible. It is subject to deprecation. Can you
keep the roof as a separate asset? That depends too. Today, you would probably view
it as a separate asset. It would have its own depreciation schedule.)
o How much? What is the basis for the roof? $50K (what the roof cost). Basis = cost
(section 1012). The basis of an asset is its cost regardless of the source of the funds
(Tufts and Crane).
o Roof is depreciable under 167(a). 167(c) – basis for depreciation is 50K cost. Look at
schedule in Chapter 6. Let’s say it is 10 years. If you depreciate this evenly over 10
years – you have a $5K depreciation deduction. So, built in year 4. And reduce basis –
1016(a)(2)
Is building depreciable?
o 167(a). $325k depreciation (6 or 7k a year).
o Is roof depreciable? Yes. Adjust basis §1016(a)(2)
Has client depreciated the building before?
o Ask client.
What are the tax consequences of repaying the loan?
o Scope here is different because did repay the loan. What happens when you pay it
back? No – repayment of untaxed income.
(Interest – did when paid. §163).
Tax consequences of sale of building. §1001(a) AR-AB = gain. $400K (amount received) – AB
(first thing we have to figure out how much depreciation did the client take on the building and
then on the roof) (we know original basis was $325K and took some depreciation on the building
and roof). You would subtract the AB building + AB roof from $400k. The excess would be gain.
At least a $25k gain, but definitely more than that (400K - $375K + AB building and roof).
What about getting rent from different renters? §61(a)(5). You don’t add or subtract this from
the building’s basis because you aren’t changing anything to the building.
Decision Tree
Do you have a realization? (materially different)
o If yes, do we have to recognize the transactions this year? Recognition. Can we defer it to
next year?
If recognition yes, you pay the tax this year. NO deferral.
If recognition no, you don’t pay the tax this year. Deferral.
Can’t have non-recognition unless you put a section number next to the word NO. Like §1031.
o How can something be materially different and be of like kind? The tolerance for like-
kindness is greater.
o Statute is written for real-estate (larger, less liquid).
o She may give us an exception (like merchants trading inventory).
1. X and Y would like to exchange property (purely a real estate for real estate exchange) so 1031
applies, as long as the two people are holding the property for the purposes listed in 1031(a).
The gain from dealing in property is realized because the two properties are materially
different, but not recognized because the properties are of like kind. 1031(d) – the basis shall
be the same as that of the property exchanged (X and Y’s basis in the new property is the same
basis in the old property).
2. What is Whiteacre was worth $30K? X transfers Balckacre and exchanges $5K in exchange for
Whiteacre. If there is any cash involved at all, then it is recognized if it is a gain (but it would
still be a like kind exchange). Y is the client with the tax liability on $5000. 1031(b). Basis – X’s
basis in Whiteacre when he receives it is $15,000 (his original basis of 10,000 plus what he
additionally paid for Whiteacre; old basis plus cash; 1012 and 1031). Y’s basis in Blackacre is
figured according to 1031(d). 17,000 – 5,000 (money) = 12,000 + 5,000 (gain recognized) =
17,000 new basis. DO NOT ASSUME THAT Y’s NEW BASIS will always equal the old basis!
1031(c) - $5000 in a loss won’t require recognition of loss (forbids recognition of loss0. We
won’t have hypo where non-like property is anything other than cash.
3. Whiteacre still worth $30K, but Y’s basis is $27,000 instead of $17,000. Nothing has changed on
X’s side. X is still transferring Blackacre plus $5,000. Y’s gain recognized is limited to $3,000
according to 1031(b). What Y pays tax on is the lesser of the previous unrealized gain or the
cash.
a. Y’s basis = 27,000 - $5,000 (money) = 22,000 + 3,000 (gain recognized) = 25,000 AB in
Blackacre
4. X – Blackacre – fmv $25K; AB 10K. Y – Whiteacre – fmv 25K; AB 28K. 1031 isn’t elective;
1031(c) no loss ever recognized on like kind exchange (if you want to recognize loss, don’t do
like kind exchange). After exchange, Y will own Blackacre with a $28K basis in it; X will own
Whiteacre with a $10K basis in it
5. X side is the same; Y – Whiteacre – fmv $30K, AB – 33K. Y will receive $5K cash and Blackacre in
the exchange. Y’s basis in Blackacre would be $28K. 1031(c) says there is still no loss
recognized.
X has a 10K basis in Whiteacre. Basis = 33k -5k =28k –0k (no gain or loss recognized) = 28K
(1031(d)). (Y has a new unrealized loss that is equal to his old unrealized loss – 3k).
D. Transfer Incident to Marriage and Divorce – Introduction; Property Settlements (p. 310-20)
1. Introduction
Transfers incident to marriage and divorce raise income and deduction issues. There are
complex rules distinguishing between alimony and other types of transfers that are not
deductible by the payor and not taxable to the payee.
Property settlements – section 1041
2. Property Settlements
a. Transfer Incident to a Divorce or Separation Agreement
United States v. Davis
Marital discharge – fmv of 83K. Basis in stock – 75K. Husband (davis) has a gain of 8k
(83AR – 75 AB = 8 gain). Congress came up with 1041 for this type of situation. A) no
gain or loss shall be recognized … if the transfer is incident to the divorce. B) property
shall be treated as acquired by the transferee by gift and the basis of the transferee in the
property shall be the AB of the transferor. Don’t pay attention to (b)(1); just (b)(2)! Donee
gets donor’s basis no matter how high/low it is compared to the FMV. Donee recognizes
the gain or loss. Mrs. Davis’ basis would be 75K. (Means Mr. Davis would not pay the tax
when the property is transferred but Mrs. Davis would pay tax when she sells.) 1041
Overrules Davis.
HYPO – A owes B money on a loan made several years ago. B says he will discharge the
loan; instead of requiring you to pay me cash, I will take the boat you have in your
backyard. Boat has a fmv of 25K; value of the loan was 25K. This is property satisfying a
debt rather than cash. Does A have GI? Loans don’t generate GI when you receive them
or when you pay them off. Whether A has GI depends on what his basis is in the boat. If
A’s basis in the boat is 15K he has GI in the amount of 10K and it’s taxable. Why? 25K
AR – 15K AB = 10K gain. 25K is the value of the discharge. Variation on Davis.
Congress altered result in Davis and simplified law by adopting 1041 – provides that no
gain/loss shall be recognized on transfers of property between spouses or incident to
divorce
o 1041 works together with the alimony rule – 71(b)(1)
o Alimony is deductible by the payor and included in the income of the payee
o Results are that transfer of property, other than cash, incident to divorce;
Does not result in the recognition of gain and
Doesn’t give rise to deduction by transferor or income to transferee
b. Antenuptial Settlements
Farid-Es-Sultaneh v. Commissioner
F argues $10 is her 1012 cost (basis) because they had a bilateral agreement – stock for
property rights. F’s inchoate interest in the property of her husband greatly exceeded the
value of stock transferred to her. She performed the contract under the terms of which
stock was transferred to her and held shares not as donee but as purchaser for fair
consideration – basis $10, gain $9/share. Antenuptial means before marriage
1041 not enacted at the time of the case. 1041 says spouse or former spouse – but
usually getting married is a condition precedent to a transfer as part of a prenuptial
agreement. If you provide in prenuptial agreement that the transfer is to take place before
marriage, 1041 doesn’t apply. If the marriage is the precondition to the transfer, 1041
applies. Once they are spouses/former spouses, 1041 will apply.
§71(c)(1) – in general, subsection (a) shall not apply to that part of any payment which the terms of the
divorce or separation instrument fix as a sum which is payable for the support of children of the payor
spouse. This is a behavior modification statute.
This is not as strange as it looks because elsewhere parents are allowed a deduction for each
child he/she supports. §§ 151, 152 – personal exemptions for dependents. $3500/child/yr. This
is a flat amount. It doesn’t matter if you are spending more. Congress wanted to be consistent
here – married couples with kids deduct the same amount as separated couples with kids.
If you are paying child support, you get a deduction under §§ 151 and 152
Let’s say you write a separation agreement where the payor spouse has to pay $3000 a month
until may, 2020 (the youngest child reaches 18). This sentence will be considered child support.
Problem 4 (p. 324) – Mike and Wilma have a son, Carlos, who is two years old. Mike is a successful
lawyer. Wilma was also a successful lawyer, but quit practice when Carlos was born. Mike and Wilma
have decided to divorce. Mike agreed to pay Wilma $40,000 a year for ten years or until Carlos dies.
Will this $40,000 be considered alimony? No. It is considered child support and falls under §71(c). Not
deductible. If Mike wants the deduction, he has to cut out the part “for 10 years or until Carlos dies.” If it
just said $40K a year, it is alimony not child support. Hess would add “until Wilma dies.” One situation
where Hess doesn’t know is if it said “Wilma gets $40K a year for 10 years or until she dies.” A situation
which would work would be “10 years or whenever she goes back to work.”
o The only thing that matters is the divorce decree. So, if you represent the payee spouse, it
is in your client’s interest to have the payor spouse to pay it as alimony.
Question 5 – p. 324
Nancy and John get divorced. Nancy is required to pay John spousal support (alimony) of $10K a
year. When the payment becomes due she doesn’t have cash so she gives it in stock. She is not
allowed to do this under §71(b)(1)… has to be cash. So, when she gave the stock, she wasn’t
technically paying alimony. No deduction under §71(b)(1). It would fall under §1041(a)(2) – no
gain or loss shall be recognized on a transfer of property from an individual to a former spouse,
but only if the transfer is incident to the divorce. Under §1041(c), incident to divorce is related to
the cessation of the marriage.
We’ve said that Nancy gets no deduction.
John doesn’t pay income tax on it because it didn’t fall under §71(b)
It is a transfer between former spouses. No tax today and no deduction to anybody day. John gets
a $1000 basis in the stock. In the future, he will pay tax on the difference between the value of
the stock and the $1000 basis.
If Nancy wants to take the $1000 deduction, tell her to sell the stock. She’ll have to pay tax on the
gain though before she pays John.
d. The Tax Incentive
e. A Final Question
4. Child Support Obligations in Default
Child support is not deductible by the payor and is not taxed to the payee (usually the
custodial parent)
Diez-Arguelles v. Commissioner – non-business bad debts are deductible only to the extent the
taxpayer’s basis in the debts under section 166. Taxpayer here had no basis in the debts (basis of
$0). Arrangements in child support payment were not deductible.
Section 71(a) provides that alimony/separate maintenance shall be included in wife’s GI.
215(a) allows corresponding deduction to husband for payments includable by the wife.
Section 682 extends the statutory scheme to trust arrangements by excluding from the
husband’s income, and including in wife’s income, amounts received from an alimony trust.
Husband is treated as a conduit for GI that legally belongs to wife under the divorce decree.
Section 62(a)(10) provides that alimony payments made by a husband shall be deducted
from his GI in computing his AGI: deduction is permitted even if husband does not elect to
itemize his personal expenses, i.e., just as if payments were excluded from his income to
begin with
Theoretical Issues (p. 328)
a. Charlie Carpenter last year earned $35K. This year he earned $20K and built a house to rent to
others. He used $30K of savings to buy land and materials. FMV of the house was $45K.
a. Yr 1 - $35K GI comp. for svcs.
b. Yr 2 - $20K GI comp. for svcs. [$15K self-performed services – no tax – we like self-
sufficient people] $30K spent on materials and land is his basis in the house. The fact that
the house is worth $45K does nothing because there is NO REALIZATION.
b. Tom Trucker earned $35K driving a truck. He took $30K of savings from earlier years and $15K
of this year’s earnings and bought a house for $45K.
a. This yr – GI - $35K. AB house = $45K.
c. Ann Accountant earned $35K last year. This year she earned $20K and went to law school.
a. Last yr – GI $35K
b. This yr – GI $20K. She can’t take a tax deduction for the labor she is putting into law
school. It is a personal expense.
d. Perry Player – future earnings expected to be $30 million. Until he earns income, he doesn’t have
any. Has a basis of $0K.
F. Review of Chapter 3
Example – football player in Miami comes to Knoxville to pursue real estate career during off
season. Courts have said coming to Knoxville in pursuit of a trade or business. If football player is at
home in Miami, he can deduct cost of traveling from Miami to Knoxville, apt and meals in Knoxville,
cost of parking car in Knoxville. All expenses of the secondary place of business are deductible.
Common example – visiting professor –all the expenses of visiting are deductible. Travel expenses
include:
Travel expense include – transportation, meals, lodging
“sleep or rest rule” – you can’t take a deduction for meals and lodging unless you are away
from home long enough to require sleep or rest
you can’t take a deduction for meals if you come back in one day. Theory – eating is a
personal expense that would be incurred anyway
If you don’t have a home to be away from, you are not traveling away from home, so you have no
deductions. Common example – truck drivers. *Reimbursed expenses not deductible by person
reimbursed – EVER!
6. Hantzis v. Commissioner – where a taxpayer resides and works at a single location, he is
home. “While away from home” requirement has to be construed in light of the requirement
that the expense be the result of business exigencies. The ultimate allowance or
disallowance of a deduction is a function of the court’s assessment of the reason for the
taxpayer’s maintenance of two homes:
a. If reason is personal, home is place of employment and deduction denied
b. If reason is business exigencies, home is residence and deduction allowed
H’s trade or business didn’t require her to maintain a home in Boston or NY. For the
purpose of 162(a)(2), NY was her principal place of business so she was not away from
home. She had no principal place of business in Boston (husband did).
This present two questions:
1. if she clerked for firm in Boston while in school at Harvard, would she have principal
place of business in Boston to be able to take deductions for traveling away from home
to work in NY? Probably
2. question of 2 career family: 2 people both gainfully employed , working ear round in
different cities. Hess thinks this will be legislated soon – amend to section 162 that will
allow deduction for these expenses
7. 162(a) – limits temporary jobs to those lasting a year or less. A person who takes a
temporary job is allowed to deduct travel/living costs – Peruifoy v. Commissioner
8. Moving expenses – section 217 allows deduction for moving expenses of a taxpayer who
takes a new job, if the new job would add at least 50 miles to his commute and in the year
following the move, taxpayer work sat least 39 weeks at the new job. Deductions under 217
aren’t subject to the 2% threshold found in 67(b)(6)
Bielfeldt v. Comm’r – B seeks to overturn a decision by Tax Court denying him the right to offset
trading losses he incurred against all but $3,000 a year in ordinary income. (B trades stock in his
own home. Sounds like someone who is engaged in passive investment. He would not want to be
engaged in passive investments because he wants to deduct more than 3,000/year – losses on
assets that ordinarily would be capital assets. He wants them to be inventory so that they can be
ordinary losses?). The standard distinction between dealer and trader:
* dealer – income is based on services he provides in the chain of distribution of goods he buys and
resells. Only broker-dealers can have inventory in stocks and bonds (they are not just selling on
their own behalf) – generally accepted as the RULE.
* trader – income based on fluctuations in market value of the securities or other assets that he
transacts in
IRS treats dealer gains and losses as ordinary income. B’s argument would turn a speculator into a
dealer for purposes of IRC> B was a speculator – his activities are in most cases outright
speculation of interest rate movements. Affirmed.
Inventory – section 1221(a)(1) – property SOLD (or held primarily for sale) to customers in the
ordinary course of trade/business; rule: should generate ordinary income and ordinary loss. Purpose
of exempting this asset from capital gain is horizontal equity. Characterization of all property is
capital (you have to show that it’s NOT capital to get separate treatement).
PROPERTY USED in a trade or business – equipment, etc. – section 1221(a)(2); 1231 – hotchpot
(in the middle of inventory and passive investments)
Passive investments – 1221(a) – general rule – these items should generate capital gain and capital
loss. A capital expenditure is rarely a capital asset – it is usually a 1231 asset because it’s
depreciable property or land.
Malat v. Riddell – Supreme Court defined what primarily meant – principally or of first
importance. In mixed motives cases (not inventory because not primarily for sale), the default
rule applies – default rule is capital
Assuming taxpayer has only one use for the property, the next obstacle in determining
inventory is in a trade or business. Means the same thing in 1221 as in 162 – question of fact
(analysis requires several fact determinations). Look at level of busy-ness. AT some point
someone is busy enough that what started out as hobby can become business.
You have got to do the netting first. If you have more gains than losses, it is capital. If you
have more losses than gains, it is ordinary?
Tax consequence for 1231 asset depends on…
o The thrust of 1221(1) – non capital characterization of ordinary business profits. The
broad intent of this section is clear: ordinary business activities generate ordinary
income and loss
o Section 475 – requires securities dealers to mark any securities that are not properly
treated as inventory or held for investment
2. Primarily for Sale
Biedenharn Realty Co. v. United States – Taxpayer bought plantation as an investment. He
began to sell it all. Taxpayer reported 60% as ordinary income and 40% as capital gain
(pursuant to agreement with government). IRS claimed it was all ordinary income; taxpayer
claimed all capital gain. Winthrop factors:
o Frequency and substantially of sales
o Improvements
o Solicitation and advertising efforts
o Brokerage activities
o Additional taxpayer contentions
Court rejects proposition that prior intent is always irrelevant. Congress didn’t intend to automatically
disqualify from capital gains bona fide investors forced to abandon prior purposes for reasons
beyond their control. Taxpayer’s passivity is in the past; he has since undertaken role of real estate
protaginist. This is 1231 property – property moved from passive investment to property used in a
trade or business because taxpayer’s use for it changed. When property becomes residential – it’s
inventory – property held for sale to customers in trade/business – 1221(a)(1)
You have to know what the taxpayer is using the property for before you can characterize what type
of asset the taxpayer has.