Chapter 3 p.195 Problems of Timing

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1 Chapter 3 p.195 Problems of Timing Possible relevance of timing considerations: (1) the acceleration or (2) the postponement of: either (a) income or (b) deductions. Important relevant factors: 1) Changes in tax rates (whether changes in statutory tax rates or individual circumstances); 2) Time value of money, i.e., the interest return benefit on deferred income tax payments. Query: What is the present value of the future payment? 10/22/2014 (c) William P. Streng 1

2 The Realization Doctrine p.196 See IRC 1001(a) concerning realization being required for FIT for an income event from a property disposition transaction. I.e, must more occur than only an economic increase in the value of the property owned? Cf., Haig-Simons definition of income (a realization event is not necessary). Does the 16 th Amendment require a realization event for gain recognition on property? No. 10/22/2014 (c) William P. Streng 2

3 Eisner v. Macomber p.197 Does the 16 th Amendment permit taxation of a stock dividend distributed by a corporation? Thus, a U.S. constitutional inquiry: Does the 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. 10/22/2014 (c) William P. Streng 3

4 Eisner v. Macomber, cont. Majority opinion - Reference to the 16 th Amendment: 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: 16 th Amendment precludes this taxation. Holmes dissent: This proposed taxation does not violate 16 th Amendment requirements. 10/22/2014 (c) William P. Streng 4

5 Unrealized Appreciation Included in GI? 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 /22/2014 (c) William P. Streng 5

6 Bruun p. 208 Lease Cancellation Tenant constructs (in 1929) a 50 year life building on owner s land. Lease for 99 years. Tenant defaults and lease is cancelled in 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). 10/22/2014 (c) William P. Streng 6

7 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 Postponed income except where the building is constructed in lieu of rent. 10/22/2014 (c) William P. Streng 7

8 Code 109 & 1019 Deferral Is Permitted Deferral of recognition of the gain realized at the lease termination is authorized. Tax basis for the improvements received is zero under 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. 10/22/2014 (c) William P. Streng 8

9 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. 10/22/2014 (c) William P. Streng 9

10 Cottage Savings Assn.- Loan Package Swap p.216 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. 10/22/2014 (c) William P. Streng 10

11 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., no inclusion in gross income when based merely on property appreciation in value even if an economic accretion to wealth. 10/22/2014 (c) William P. Streng 11

12 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 required time for reporting for financial accounting purposes (particularly when the financial 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 a tax refund). 10/22/2014 (c) William P. Streng 12

13 Debt Modification as a Disposition p.224 Is the modification of a debt obligation a tax realization event? Reg states that a significant modification of a debt instrument is an exchange for FIT purposes. Consider a change in debt instrument in (1) length of term, (2) interest rate, (3) another element (e.g., priority; recourse ). Exception from this realization treatment for a unilateral option or a change in an index rate where variable rate obligation exists. 10/22/2014 (c) William P. Streng 13

14 Nonrecognition Treatment p.227 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? 10/22/2014 (c) William P. Streng 14

15 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. Not all property is eligible. 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). 10/22/2014 (c) William P. Streng 15

16 PLR p.229 Private letter ruling request re 1031 tax free exchange eligibility for a swap of (1) a conservation easement in Property A for (2) a fee interest in real estate (also subject to a conservation easement). Treated as like kind real estate assuming each property held for productive use in a business or for investment. Test is based on the nature or character of the property. 10/22/2014 (c) William P. Streng 16

17 Identifying Like Kind Property P.232 Is like-kind treatment permitted for: 1) Different types of real estate? Cf., TICs; saleleasebacks (how long a lease?); oil and gas properties? 2) Auto/truck trade-ins? Low tax basis when prior tax depreciation; not for a personal auto. 3) Professional athlete contract swaps? 4) Partnership interest swaps? See limits in 1031(a)(2). Liquid securities and inventory are not eligible. Coins? Rare coins? 10/22/2014 (c) William P. Streng 17

18 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; 2) Decreased by the boot received; 3) Increased by the gain recognized on the exchange (lesser of realized gain or the boot; i.e., if no gain then no taxable boot). See 1031(d) providing the rules for a transferred tax basis for replacement property. 10/22/2014 (c) William P. Streng 18

19 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. Client s tax basis for the replacement property is 4x (to preserve the income tax potential on the 6x deferred gain). 1031(d). 10/22/2014 (c) William P. Streng 19

20 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. Client s tax basis for the replacement Property B (fmv 8x) is 4x (to preserve 4x deferred gain). Tax basis for 2x cash received is (obviously) 2x. 10/22/2014 (c) William P. Streng 20

21 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 the 7x cash amount) is realized and recognized. Tax basis for the replacement Property B is 3x (fmv). All gain has been recognized. Tax basis for 7x cash received is (obviously) 7x. 10/22/2014 (c) William P. Streng 21

22 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 as Prop. A). 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 upon disposition, unless subsequent appreciation of replacement property occurs). 10/22/2014 (c) William P. Streng 22

23 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 12x basis of the transferred property, as reduced by the 2x cash); the 2x potential loss is retained in the replacement property (10x basis & 8x fmv); 2x tax basis for the 2x cash received. 10/22/2014 (c) William P. Streng 23

24 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 (i.e., other property). Tax basis for the replacement Property B is 4x (& remaining 4x gain potential). Tax basis for the other property is 2x. 10/22/2014 (c) William P. Streng 24

25 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 for Client. 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). Transferor to Client may/may not have gain. 10/22/2014 (c) William P. Streng 25

26 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) exchange 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)? 10/22/2014 (c) William P. Streng 26

27 Like-Kind Exchange Deferred Property Receipt Starker exchange p 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(a)(3) 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? 10/22/2014 (c) William P. Streng 27

28 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 2 nd taxable year of gain) of a replacement property similar or related in service or use. Cf., the more expansive 1031 like kind property concept. 10/22/2014 (c) William P. Streng 28

29 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. 10/22/2014 (c) William P. Streng 29

30 Corporate Transaction Nonrecog. Rules p.238 Note 1001(c). Consider the formation of a corporation (i.e., a separate taxable entity): 1) Transfer occurs of appreciated assets into a corporation in exchange for stock of the corp. Is gain recognition required? No ) 1032 corp. does not recognize gain on issuance of its shares for shareholder s assets. 3) What about multiple individuals contributing various assets (e.g., traded shares) into a corporate investment fund? cont. 10/22/2014 (c) William P. Streng 30

31 Corporate Transaction Nonrecog. Rules cont. 4) What tax basis to the shareholder for the stock received? See 358 re substituted basis. 5) 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? 10/22/2014 (c) William P. Streng 31

32 Tax-free Corporate Reorganizations p.240 1) Change place of corp. organization from Texas to Delaware. Why? How? Taxable? Nonrecognition occurs and a substituted income tax basis applies for the replacement shares. 2) What if a merger occurs of A corp into existing B corp and the A shareholders receive some shares of B Corp.? Is gain recognition required of the A shareholders on this exchange? Not if exchange occurs in a tax-free reorganization. See 354 and /22/2014 (c) William P. Streng 32

33 Deemed Realization Constructive Sales P.241 Objectives: How to (1) raise cash, (2) protect against downside, & (3) delay tax realization? E.g., sale against the box sell borrowed shares (possible?) - assume 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) gain is to be recognized on a constructive sale of an appreciated financial position. Similar- futures or forward contracts. 10/22/2014 (c) William P. Streng 33

34 Deemed Realization Constructive Sales, cont. Alternative structures possibly triggering applicability of Code 1259: Example: Zero-cost collar transaction - Sell a call option exercisable at a price above current fair market value (i.e., option holder exercises if FMV above option price). - Buy a put option (same maturity) at price below current FMV. Exercise if price below put. Does this constitute a constructive sale (i.e., limited future risk)? Possible 1259 regs.? 10/22/2014 (c) William P. Streng 34

35 Original Issue Discount (OID) P.245 Example: Debt instrument provides for either (1) no current interest or (2) inadequate (i.e., below market) interest. Interest income must be accrued whether for (1) a cash basis or (2) an accrual basis taxpayer, i.e., treat as OID the unstated interest. OID is the difference between the (1) issue price and (2) the redemption price Tax policy objective: To avoid delay of interest income recognition while enabling a current interest expense deduction (for accrual basis). 10/22/2014 (c) William P. Streng 35

36 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? Tax basis recovery? See 1271(a). Note: All OID has previously been included in gross income. Prior income 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 OID rules: treat all this gain as capital gain when obligation matures & is paid by the borrower. 10/22/2014 (c) William P. Streng 36

37 OID Income Tax Treatment P.245 What is the income tax treatment to the holder of the debt instruments as the income accrues on the OID obligation? See Code 1272(a)(1) which requires current inclusion of annual OID in gross income. See certain exceptions in 1272(a)(2). Note: The current interest income accrual increases the tax basis to the holder of the OID instrument. 10/22/2014 (c) William P. Streng 37

38 Debt Obligation Issued for Property 1274 p.246 Sale of property occurs for a specified arm s length amount. Price is financed with debt owing to the seller. But, the debt instrument is determined to have a FMV less that the face of the promissory note. How is this determined? Query: Is the interest rate adequate? Compare the stated interest rate to the real economic rate (i.e., the AFR). continued 10/22/2014 (c) William P. Streng 38

39 Debt Obligation Issued for Property 1274, cont. What is the appropriate interest rate for this purpose, i.e., the applicable federal rate (AFR). How is rate determined? See 1274(d). 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 the OID is not actually received). This OID will be added to the income tax basis for the debt instrument. See Table, p /22/2014 (c) William P. Streng 39

40 Treatment of Deferred Rent Payments p provides for application of these OID concepts to deferred rent payments: (1) (Cash basis) lessor to include both (a) deferred rent and (b) interest on deferred rent in current income (as if an accrual basis taxpayer). (2) (Accrual basis) lessee can deduct a similar amount each year. Not applicable to total payments not exceeding $250, (d)(2). 10/22/2014 (c) William P. Streng 40

41 Market Discount & the 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 later 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 that this gain is ordinary income but not until debt proceeds are actually received. Prior sale? Same result. 10/22/2014 (c) William P. Streng 41

42 Exceptions to OID Current Inclusion Rules P.248 Sale for deferred payment(s) of (a) a principal residence or (b) farm for less than $1 million (e.g., for a principal amount without any interest) or (c) price less than $$250, (c)(3) specifies OID rules not applicable. However, see 483 provides for treatment of discount portion (1) as interest income (and not as capital gain), but (2) only when the payment is received. A recharacterization rule: not a timing (i.e., accrual) rule for cash basis seller. Cont. 10/22/2014 (c) William P. Streng 42

43 Exceptions to OID Current Inclusion Rules P.248 Example from the casebook (re 483): Sell residence for $1 million with entire amount due in five years. Seller s tax basis is $400,000. If the AFR is 10 percent: 1) At maturity Seller receives $1 million, consisting of (a) $620,921 for the house (220,921 capital gain protected under 121) and (b) $379,079 of interest income. 2) Buyer (a) pays $379,079 interest expense and (b) has tax basis for the house of $620, /22/2014 (c) William P. Streng 43

44 Open Transaction Rule 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 promise (i.e., contract) to be currently valued (at discounted cash flow) and treated as received then by the owner? IRS claims a closed transaction, with income 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. Cont. 10/22/2014 (c) William P. Streng 44

45 Open Transaction Rule Burnet v. Logan p.249 Facts: Tax basis for shares was $180,000. Received (a) $120,000 cash and (b) right to future payments based on royalties. IRS says right to royalties worth $100,000 (25 years at $9,000 per year, discounted to current value). Therefore, gain of $40,000 (220 less 180). Court says recover $180,000 tax basis first: the $120,000 cash plus early year payments of $60,000 until $180,000 total received. Then, capital gain (& no part as interest income). 10/22/2014 (c) William P. Streng 45

46 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 recovery until full basis is received. 2) 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). 10/22/2014 (c) William P. Streng 46

47 Open Transaction Treatment p.252 Is available only in rare and extraordinary circumstances. Reg (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? 1) Postpone any inclusion in gross income. 2) All proceeds are treated as capital (gains) while the transaction is open. No receipts are considered as being interest (ordinary) income. 10/22/2014 (c) William P. Streng 47

48 Installment Method 453, 453A, 453B p.254 Objective: coordinate income tax reporting with the taxpayer s actual receipt of cash. Assume 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. 10/22/2014 (c) William P. Streng 48

49 Second Disposition by Related Person p (e) re: (1) 1st disposition of property is to a related person, and, (2) 2 nd disposition is by the related person to another person before all installments are paid on the 1 st disposition. The 1 st disposition is treated as closed when the related person sells in the 2 nd disposition. E.g., 1 st sale on installment basis to related person and 2 nd sale for cash, related person can then hold cash pending installment payments with tax deferral to the 1 st seller. 10/22/2014 (c) William P. Streng 49

50 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 crossreference 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). Does DOMA preclude latter as a defined relationship? Then, a form over substance argument by IRS? 10/22/2014 (c) William P. Streng 50

51 Limitations on Installment Sales Eligibility p.255 See 453(b)(2) and (k). Installment sales treatment is not available for (1) inventory sales or (2) sales of publicly traded securities. See 453A an 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. 10/22/2014 (c) William P. Streng 51

52 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 is applicable where: (1) 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) 10/22/2014 (c) William P. Streng 52

53 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 amount to be paid. 2) Allocate income tax basis over the maximum payment period. 3) Allocate tax basis in equal annual amounts over a 15 year period. 10/22/2014 (c) William P. Streng 53

54 Constructive Receipt Doctrine p.256 Cash taxpayers include an item in income when actually or constructively received. See Reg (a) re constructive receipt, i.e., when set aside or otherwise made available. See Amend case, p 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. 10/22/2014 (c) William P. Streng 54

55 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 to apply for the funds. Economic benefit occurred in the earlier year. 10/22/2014 (c) William P. Streng 55

56 Non-Qualified Deferred Compensation p.263 See Rev. Rul identifying non-qualified compensation where 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). 10/22/2014 (c) William P. Streng 56

57 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. 10/22/2014 (c) William P. Streng 57

58 Deferred Compensation Tax Issues p 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) dollar limitations on plans of state agencies; the payor is not subject to income tax (b) Tax-exempt charities and public educational agencies have limitations A no employee deferral if an election exists to accelerate benefits - even though based on an external condition. 10/22/2014 (c) William P. Streng 58

59 Deferred Compensation Problems p.270 a) Nonassignable annuity policy naming employee as beneficiary - GI inclusion. b) Contribution to a trust for the employee, with interim investment and a deferred payout to the employee - GI inclusion. c) Contribution to a trust and at the end of the deferral period, paid to the employer. No GI. d) Corporation with unconditional agreement to pay, guaranteed by corporation owner. No GI only a promise to pay. 10/22/2014 (c) William P. Streng 59

60 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. stock). Defined benefit (DB) plan: employer agrees to pay fixed retirement benefits based, e.g., on (1) years of service, and (2) final pay amount. Defined contribution (DC) plan: an amount is contributed based on a formula (e.g., 5% of current compensation) and the amount paid at retirement is based on the investment return. continued 10/22/2014 (c) William P. Streng 60

61 Qualified Pension/Profit Sharing Plans p.270 Qualified retirement plan & income tax results: 1) Employer deduction for plan contributions. 2) No current GI to the employee-participant; GI inclusion upon later distributions 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. 10/22/2014 (c) William P. Streng 61

62 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 is permitted). 2) Vesting benefits become 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. 10/22/2014 (c) William P. Streng 62

63 Special Retirement Plan Structures p 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 is not providing benefits Roth IRA nondeductible contributions, but non-inclusion for accruals and distributions. Note: (1) Penalties for early withdrawals, & (2) Required minimum distributions at 70 ½. - 10/22/2014 (c) William P. Streng 63

64 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 for stock. 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, a benefit is derived for rendered services. See LoBue, p /22/2014 (c) William P. Streng 64

65 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) Employee increases tax basis for option/shares when income at option grant. 4) Employee has capital gain when subsequently selling shares at a price above his/her tax basis. 10/22/2014 (c) William P. Streng 65

66 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. 10/22/2014 (c) William P. Streng 66

67 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 (neither in year of grant nor 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). 10/22/2014 (c) William P. Streng 67

68 Current Stock Option Taxation Alternatives 1) Statutory stock options, i.e., incentive stock options (ISOs). 422 (next slide) Income tax treatment: Only capital gain treatment upon the eventual stock disposition. 2) Nonstatutory stock options, i.e., dependent upon tax accounting rules. But, see treatment under 83 concerning current income inclusion. 10/22/2014 (c) William P. Streng 68

69 Incentive Stock Option (ISO) Rules 422 P.278 Statutory structure permitting GI inclusion is 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 the employer loses immediate deduction but deferral of cap. gain for EE? 10/22/2014 (c) William P. Streng 69

70 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 issued if having a readily ascertainable FMV. No current GI inclusion when the option is nontransferable and a substantial risk of forfeiture inclusion when conditions lapse. GI inclusion when exercise for the difference between (1) exercise price and (2) stock value. 10/22/2014 (c) William P. Streng 70

71 Election to Accelerate Inclusion re NSO p (b) employee can elect current inclusion (even if a forfeiture risk) to the extent of FMV. GI inclusion is based on the value of stock (not options?) without restrictions. No income tax (loss) deduction by an employee who made a 83(b) election if forfeiture of the option subsequently occurs. But, 83(b) is not applicable if an option lacks a readily ascertainable fair market value. 83(e)(3). 10/22/2014 (c) William P. Streng 71

72 Cramer p (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 (b)(2) (& no ascertainable FMV & therefore ordinary income). Plus, serious penalties are applicable. 10/22/2014 (c) William P. Streng 72

73 Cramer p.283 & Penalties 6662 Accuracy related penalty on underpayments. Amount of 20 percent of the underpayment where penalty applies: 1) Negligence or disregard of rules. 2) Substantial understatement of income tax. 3) Substantial valuation misstatement. 4) Transaction lacking economic substance fraud penalty 75% of underpayment. 10/22/2014 (c) William P. Streng 73

74 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)? 10/22/2014 (c) William P. Streng 74

75 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? 10/22/2014 (c) William P. Streng 75

76 Code 1041 p 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 re no tax-free transfer of accrued interest income. Does the Davis case survive the enactment of 1041? 10/22/2014 (c) William P. Streng 76

77 Property Transfers Example H and W together own investment property: 1) W receives Property One 60x tax basis and 100x fair market value (appreciated). 2) H receives Property Two 140x 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 /22/2014 (c) William P. Streng 77

78 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. 10/22/2014 (c) William P. Streng 78

79 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 deduction ( 62(a)(10)). A federal definition of alimony applies to determine whether the payment constitutes gross income to the recipient. What impact of the Windsor/DOMA case? No deduction to the payor parent for child support payments made to the other ex-spouse. 10/22/2014 (c) William P. Streng 79

80 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 ) 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). 10/22/2014 (c) William P. Streng 80

81 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: Old Colony Trust Co. case. 10/22/2014 (c) William P. Streng 81

82 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? 10/22/2014 (c) William P. Streng 82

83 Theoretical Issues p 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? 10/22/2014 (c) William P. Streng 83

84 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. 10/22/2014 (c) William P. Streng 84

85 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 source of revenue for foreign countries. 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. 10/22/2014 (c) William P. Streng 85

86 Accrual Method Taxpayers p.312 Fundamentals of the accrual method of accounting (businesses: required for FIT- 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. 10/22/2014 (c) William P. Streng 86

87 Delay in the Receipt of Cash p.313 Georgia School Book Depository case p 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. 10/22/2014 (c) William P. Streng 87

88 Hallmark Cards case p. 316 (note) Hallmark cards shipped Valentine cards to retailers in December, but retailers did not want ownership on for personal property tax purposes. Hallmark retained legal title until Jan. 1 of each calendar year. Hallmark s income was permitted to be accrued in the subsequent year when title passed to the retailer and, then, all events had occurred to fix the right to the income. 10/22/2014 (c) William P. Streng 88

89 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? 10/22/2014 (c) William P. Streng 89

90 Subsequent Prepaid Income Cases p.321 Schlude (Sup. Ct., p.321): prepaid dance lessons; inclusion at time of receipt of payment. Artnell (7 th Cir.) deferral until games played. Boise Cascade (Ct. Cl.) inconsistent receipts. Must consistently report income when services are rendered (not requiring any earlier reporting if an advance receipt). 456 subsequently enacted: to enable membership organizations to spread prepaid dues over service period. 10/22/2014 (c) William P. Streng 90

91 Subsequent IRS Action IRS takes administrative action to enable limited deferral. p.321 1) Rev. Proc (re: services) reporting in the current or the subsequent year, if consistent with financial accounting (i.e., a booking requirement ). 2) Regs (sales of goods) & similar treatment as services rules for reporting advance payments for goods. Why Rev. Proc. vs. Treas. Reg. mechanism? 10/22/2014 (c) William P. Streng 91

92 Security Deposits v. Advance Payments p.323 Indianapolis Power & Light (28-0), p 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 apt. lease deposit amounts? 10/22/2014 (c) William P. Streng 92

93 Westpac Pacific Food p.324 Is advance trade discount paid (for a 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 (inventory cost affected). 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. 10/22/2014 (c) William P. Streng 93

94 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. Can not deduct an uncertain or contested liability. 10/22/2014 (c) William P. Streng 94

95 General Dynamics Corp. Sup.Ct. P.329 Deduction was claimed for medical expenses reimbursable to employees 1) when the expense was incurred, but 2) no current claim to the employer had been made as of the end of the tax year. Amount claimed was based on estimates of past experience. Sup. Ct.: All events test was not satisfied; some employees might not file a claim for reimbursement. 10/22/2014 (c) William P. Streng 95

96 The Economic Performance Test P (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 for services to be performed next year can not be deducted currently. 10/22/2014 (c) William P. Streng 96

97 10/22/2014 (c) William P. Streng 97