Timing Issues for Income & Deductions P.648

Transcription

1 CH 6 Timing Issues for Income & Deductions P.648 1) Accounting period - taxes are due and collectible on an annual (i.e., yearly) basis. 2) Accounting overall method options (a) cash method and (b) accrual method Accounting method must clearly reflect income. See Subchapter E, Code 441 et. seq. Cf., accounting for (1) income tax purposes, & (2) financial reporting to owners. Objective for each accounting system? 12/1/2011 (c) William P. Streng 1

2 Integrity of the Taxable Year (or by Transaction?) Burnet v. Sanford & Brooks p.651 For the period taxpayer had reported gross income for receipts and offsetting expenses. The expenses exceeded income during this period. Work abandoned & suit filed to recover. In 1920 taxpayer received $192,578 ($176,272 for expenses and $16,306 accrued interest). Held: Inclusion of the entire amount received in 1920 gross income. 16 th Amendment not violated. 12/1/2011 (c) William P. Streng 2

3 Taxable Year Choices p (a) For individuals the annual accounting period is ordinarily the calendar year. Code 441(b). See the definition of fiscal year in Code 441(e) & the definition of week year - 441(f). The objective is to measure events within that period, notwithstanding that some transactions may continue beyond the current year. The "annual accounting principle is relevant here. 12/1/2011 (c) William P. Streng 3

4 Modifications the Tax Benefit Rule p.654 Dobson case (casebook, p. 657, note 4). Deduction in earlier year and recovery in a subsequent period. Earlier had sold stock at a loss and claimed a loss deduction. Earlier transactions were treated as closed and completed - but those losses did not reduce income. Subsequent recovery in a lawsuit for fraud. Held: for taxpayer, no gross income inclusion required, since no tax benefit was received earlier. 12/1/2011 (c) William P. Streng 4

5 Code 111 p.655 Tax Benefit Exclusion An exclusionary provision - recovery of a loss deducted in the earlier year is excluded from gross income to the extent the earlier deduction produced no income tax benefit. The inference from Code 111: those recovered amounts attributable to the prior year deductions must be included in income to the extent those deductions had value in reducing the prior year's tax liability. 12/1/2011 (c) William P. Streng 5

6 The Inconsistent Events Rule p. 656 Hillsboro and Bliss Dairy cases 1) Repayment to bank shareholders of taxes on shareholders previously paid by the bank corporation. No recognition required of the bank when refunds made to shareholders. 3) Distribution of previously expensed assets (cattle feed) in a corporate liquidation. Recovery was required to the corporation on the distribution. Dissent: file revised returns (if S/L no run) 12/1/2011 (c) William P. Streng 6

7 Charitable Contribution Deduction & Gift Returned See p. 664 re the Alice Phelan Sullivan case: 1) Property was transferred to charity 2) Charitable deduction was claimed for tax 3) Property was returned to donor 4) Inclusion in donor s gross income? Yes, to extent of lesser of (a) the earlier deduction or (b) the fair market value of the property. 12/1/2011 (c) William P. Streng 7

8 Claim of right doctrine p.664 & later deduction North American Oil Consolidated v. Burnet case. Consider: 1) Taxpayer receives earnings under a claim or right (and, therefore, earnings are to be included in taxpayer s gross income). 2) But, a deduction available if amount received must be subsequently repaid. 3) What if the income tax rates changed in the interim? See 1341 re claim of right doctrine Lewis case, p.664, where salary repaid in later year. 12/1/2011 (c) William P. Streng 8

9 US v. Skelly Oil Co. p.665 What is the Income? Refunds to customers for prior overcharges. 27 ½% percentage depletion for the prior claimed income. Actual taxable income was in a lesser amount (i.e., less % depletion). When restored to customers a deduction for: (a) the gross amount paid, or (b) the after % depletion amount? Held: Only a deduction for the after % depletion deduction of the prior included amount. 12/1/2011 (c) William P. Streng 9

10 Claim of right doctrine & 1341 p.668 Later year restoration of an amount earlier received under a claim or right permits a reduction of income tax liability in the year of repayment by the amount of the tax on the income in the year of inclusion. Must have earlier received the income under a claim or right. Cf., restoration of embezzlement income. Voluntary payments are not eligible for this treatment. Cf., Welch v. Helvering (debt payment) 12/1/2011 (c) William P. Streng 10

11 Repayment of Unreasonable Salaries p.669 Assume: Earlier receipt of a salary payment, but in an unreasonable amount i.e., non-deductible under Code 162(a). Repayment of the excess amount by the employee is paid pursuant to a reimbursement contract. Payor is entitled to a deduction (but per IRS - the 1341 claim of right relief is not available when the restoration of the amount paid subsequently occurs). 12/1/2011 (c) William P. Streng 11

12 Net Operating Loss Deduction 23 yr. averaging period? p.669 Code 172 provides (1) a carryback of loss for two years (file for a quickie refund ) and (2) a carryforward for 20 years. 172(b)(1)(A). 172(d) provides that carryover rules only apply to business losses. Nonbusiness deductions are disallowed to the extent in excess of nonbusiness income. Cf., e.g., gambling loss treatment Worker, Homeownership and Business Assistance Act ( ) allowed a possible five year carryback (expired ). 172(b)(1)(H). Why provided temporarily? 12/1/2011 (c) William P. Streng 12

13 Methods of Accounting p.672 Code 446(a) - income is computed on the basis of the taxpayer s books. And, 451 & 461. Options (under 446(c)) are: 1) cash method 2) accrual method (required for taxpayers with inventory, etc.) (not personal service corp) 3) other specific methods e.g., 453 re installment sales method Cf., the open transaction method (i.e., basis recovery first) for property dispositions (e.g., Inaja Land Co. case) 12/1/2011 (c) William P. Streng 13

14 Methods Compared on the Income Side p.674 Cash method: income side - no inclusion until the amount is collected (but cash equivalent, etc.). Accrual method (measuring economic results): income side - include in gross income at the face value of the promise received. Tax basis is (1) created in the promise and (2) is treated as recovered when the claim is later paid; if less than the tax basis amount is realized (including if the claim is sold for a discount), a tax loss is then incurred. 12/1/2011 (c) William P. Streng 14

15 Cash Method of Accounting Fundamental Rules P.674 Three separate rules are pertinent for applying the cash method of accounting rule: 1) Cash-equivalency doctrine (e.g., a check). 2) Constructive receipt doctrine (p. 675). 3) Economic benefits doctrine ( 461(h)). Who uses the cash method? Individuals, personal service corporations & small corporations. 12/1/2011 (c) William P. Streng 15

16 Constructive Receipt Doctrine Reg (a) A cash basis taxpayer cannot "turn one's back on income. Does taxpayer have power to receive? The constructive receipt doctrine requires that a taxpayer must include an item in gross income at the time the taxpayer has both (i) the right to the item and (ii) the power to obtain the possession of that item. Cf., the existence of a meaningful restriction, e.g., with bank Certificate of Deposit. This is an income, not a deduction issue. 12/1/2011 (c) William P. Streng 16

17 Constructive Receipt Doctrine p.675 Carter case employer delayed the payment of his wages until a subsequent year. Taxpayer argues for constructive receipt in an earlier year. (What effect of advice from IRS agent?) Held that (even though funds were authorized) he had no constructive receipt in the earlier year. Income was includible in gross income only when actually received in the subsequent year. Cf., (p.677) a controlling shareholder s right to rent payment from the (Fetzer) corporation? 12/1/2011 (c) William P. Streng 17

18 Delayed Payment as not Constructive Receipt p.678 No constructive receipt when agreeing to delay the receipt of the payment to be made particularly if the deferral agreement is made prior to the time the services are performed. Note the insurance salesperson contracts (p.678) to delay payments until after retirement as permitting deferral of gross income inclusion. But, note the IRS nonacquiescence in the Olmstead case (p. 678). Note (p. 678) possible use of escrow arrangement. Is escrow agent subject to taxpayer instructions? 12/1/2011 (c) William P. Streng 18

19 Cash Equivalent? Rev. Rul p.680 Barter club credits (a medium of exchange ) are includible in taxpayer s gross income when credited to the club member Income is received in the form of credit unit rights which can be immediately used to purchase barter club goods and services. How is compliance monitored by IRS? See 6045 re information returns from a barter exchange. What about virtual world credits (derived via Internet trading)? 12/1/2011 (c) William P. Streng 19

20 Cash Equivalency Doctrine Income Inclusion p.682 Checks are the equivalent of cash but, even if received after the close of business on New Year's Eve (when cash is not available)? Should a promise to pay be treated as the equivalent of cash? No (per Rev. Rul ), unless the promise to pay is represented by a promissory note. If a promissory note is received, it is a cash equivalent for recipient, assuming the note can be negotiated for cash. 12/1/2011 (c) William P. Streng 20

21 Cash Equivalency Doctrine Income Inclusion p.683 1) Post-dated check? Negotiable promissory note? 2) See the Cowden note analysis (p. 683) (receipt of a contract right to receive future cash) as being immediate income (to extent of fmv of the promise): What if the note is non-negotiable? What if the note is substantially discounted because of a significant risk of non-payment? The recipient treats the note as property, then including in gross income the fair market value (not the face value) of the promissory note. 12/1/2011 (c) William P. Streng 21

22 Payments & Deductions Rev Rul p.685 Reg (a)(1) deduction when paid Payment made by a check is treated as made on the date the check is placed in the U.S. mail. What about using private delivery service (e.g., Fedex)? In this ruling the check was issued by a financial institution & the payment was made on the date of check mailing. What about electronic payment transfers? 12/1/2011 (c) William P. Streng 22

23 Rev. Rul Credit Card Amount - Cash Equivalent? A credit card is used to contribute to charity. A deduction is available immediately - when the credit is committed (not when the bank issuing the credit card is paid). Cf., credit cards vs. promissory notes vs. checks. A credit card debt is an obligation to a third party. This is equivalent to the use of borrowed funds to complete the charitable contribution (& not the delivery of one s own promissory note). 12/1/2011 (c) William P. Streng 23

24 Payment by Delivering One s Own Promissory Note p.687 Can a cash basis taxpayer obtain a deduction when delivering its own promissory note? No, this is not a cash payment equivalent. An actual payment of the note (or the delivery of other property, including a promissory note issued by another person) must occur to enable income tax deduction. Don Williams case, p Deduction if borrowing funds, receiving the cash, and using the cash to pay the debt (including interest at the lending bank)? No, unless unrestricted control over the borrowed funds. 12/1/2011 (c) William P. Streng 24

25 Direct Asset Acquisition Cost - Prepaid Expense p.689 Boylston Market Assn. - Casualty insurance premiums were prepaid for three years. Held: The prepayment was a capital expense and straight line amortization of this intangible (as created on this payment) is required over the relevant three year insurance coverage period. Capitalization required because not difficult to allocate cost on a daily basis? Note the one year exception rule p. 690 (next slide) 12/1/2011 (c) William P. Streng 25

26 One-Year Exception to Prepayment Rule p.690 Consider a prepaid outlay covering only 12 months (a variant of Boylston situation). Is this an asset to be capitalized? Yes, if matching expenses against income. A 12 months rule (of convenience?) does permit an immediate deduction, but is this rule defensible? However: should part of expense be capitalized because attributable to following tax year? How deal with the interest element when reduced price upon repayment? 12/1/2011 (c) William P. Streng 26

27 Accrual Method Tax Accounting p.693 Code 446(c)(1) & (2) Cash method Accrual method Cash method - when cash is received or paid. or Accrual method - when the rights to receipts and the obligations to make payments become fixed, regardless of when the payments are made, i.e., all events have occurred for determining accrual with reasonable accuracy. 12/1/2011 (c) William P. Streng 27

28 Who Uses the Accrual Method? Taxpayers using GAAP use accrual method. Exception for small business with inventory. Code 448 prohibits certain taxpayers (e.g., C corporations) from using the cash method. For individuals, usually the cash method applies - the checkbook and the shoe box for receipts is the documentation method. Consistency is a prerequisite to clearly reflecting income. Reg (c)(2)(ii). 12/1/2011 (c) William P. Streng 28

29 Accrual of Income p Income accrues for tax purposes when: (i) all events have occurred that establish the right to receive the income, and (ii) the amount thereof can be determined with reasonable accuracy. I.e., an account receivable is created. Income items are accrued at their face value, not at their fair market value (an unfavorable result). 12/1/2011 (c) William P. Streng 29

30 Hallmark Cards p.694 Taxpayer shipped merchandise which was accepted by customers upon receipt. But, a different approach was implemented for Valentine s Day merchandise. Title passage was delayed until after January 1. Held: All events test was only satisfied when title passed, and only then are sales to be accrued. A change in contractual terms and not a change in accounting method. 12/1/2011 (c) William P. Streng 30

31 Time of Accrual of Sales of Goods Income p Reg (c)(1)(ii)(c) alternative income inclusion methods include: 1) When the goods are shipped 2) When the product is delivered or accepted 3) When title passes to the buyer 4) When billed to the buyer 12/1/2011 (c) William P. Streng 31

32 Advance Payments for Unearned Items p.700 When include in gross income the amounts actually received but not yet (economically) earned? Westpac Pacific Food, p.700 (after three Sup. Ct. decisions on the issue) Cash payment in advance in exchange for a volume commitment, i.e., advance trad e discounts. Amount treated as a liability. Tax Court held inclusion required. 9 th Cir. reversed & no income inclusion required when cash was received. 12/1/2011 (c) William P. Streng 32

33 Indianapolis Power &Light Co. Security Deposit p.705 Are deposits made by customers to assure payments for future utility services advance payments for services and, therefore, immediate gross income? No: 28 judges/justices; yes - 0. An express obligation to repay existed. Should the income tax treatment of customer deposits be consistent with GAAP? What distinction exists between (i) a loan and (ii) an advance payment for services (which constitutes immediate gross income)? 12/1/2011 (c) William P. Streng 33

34 Artnell case p.706 Deferral Permitted Re: baseball clubs and advance ticket sales. Taxpayer knows exactly when the games will be played (and when income earned). But, what about weather postponements? What about the Houston Astro s Minute Maid Field where baseball is played outside (but inside, if necessary)? 12/1/2011 (c) William P. Streng 34

35 Rev. Proc & Reg p.706 Payments received for services to be performed subsequently. Permits deferral for prepayment for services, intellectual property, memberships, etc. Why a Revenue Procedure? Reg permits advance payments for goods sold to customers to be deferred until year the goods are shipped. 12/1/2011 (c) William P. Streng 35

36 Accrual of Deductions p.708 The all-events test Reg (a)(2) specifies the time for an accrual method taxpayer to accrue and deduct expense items: i) all events have occurred to fix the liability; ii) the amount of the liability can be determined with reasonable accuracy; and, iii) economic performance has occurred with respect to the specific liability. 461(h). 12/1/2011 (c) William P. Streng 36

37 The All Events Test - General Dynamics p.708 Accrual basis taxpayer provides medical benefits to employees. Question whether the taxpayer can deduct an estimate of an obligation to pay for medical care if claims not made as of close of the year. Supreme Court holds no current deduction available for reserve account amounts. A liability that is contingent may not be deducted--it is only an estimate of liability. 12/1/2011 (c) William P. Streng 37

38 U.S. vs. General Dynamics - Dissenting Opinion p.712 Emphasis on consistency between tax and financial accounting. Reliance on the Hughes Properties progressive jackpot case permitting expense accrual for anticipated payments. The potential of nonpayment of the liability does not prevent accrual of the expense. Is the non-filing of a claim highly improbable? 12/1/2011 (c) William P. Streng 38

39 Ford Motor Company p.716 Accruing current deductions for amount to be paid in the future under structured tort settlements. Tax Court holds method of accounting for structured settlements does not clearly reflect income a question of fact. Affirmed. Subsequent enactment of 461(h) limiting the deduction. 12/1/2011 (c) William P. Streng 39

40 The Installment Sales Method p.732 A deferred obligation is property 1001(b). Cash method: Include the FMV of the obligation in the amount realized (less tax basis equals current gain) in property transactions. Possible future collection gain? Yes. Accrual method taxpayer: Include the face amount of the future payment obligation in gross income and, subsequently, no collection gain will be included (since not realized), but possible loss. But what about cash/liquidity to pay the tax? 12/1/2011 (c) William P. Streng 40

41 Choices for the Taxation of Installment Sales 453 1) Current inclusion of all gain (prior slide). 2) Entire recovery of tax basis first. Note: Burnet v. Logan decision (p. 733). 3) Report gain on a pro-rata basis as principal payments are received. Financially correct? Liquidity concerns. Cf., taxation of annuity. 4) Amortize on a level basis (i.e., constant interest rate and a declining principal balance). Cf., tax treatment of financial instruments. 12/1/2011 (c) William P. Streng 41

42 Scope of the Installment Method p.733 Installment method concept - exchanging property for a note in a tax deferred exchange. The default method applies of installment treatment, unless electing out of 453. The note payments trigger proportionate income recognition as the cash is received, i.e., gain is prorated to the principal payments. Code 453(b)(1) - at least one payment is to be received after the close of the sale year. Not applicable for loss sales (see 1001). 12/1/2011 (c) William P. Streng 42

43 Limitations on the Installment Sales Method 1) sales of inventory - 453(b)(2)(B). 2) dealer dispositions - 453(b)(2)(A). 3) certain sales to related parties (e.g., upon a disposition by a related purchaser) - 453(e); see discussion at p ) sales of personal property under revolving credit plans - 453(k)(1). 5) sales of publicly traded securities - 453(k)(2). 6) depreciation recapture for the item sold; 453(i). 7) a demand note is received - 453(f)(4). 12/1/2011 (c) William P. Streng 43

44 Installment Sale Mechanics p.733 Ratio for determining portion of the current payment includable as installment gain: Gross profit times current payment Contract Price equals current includable installment gain. The tax deferral benefit in this approach is that interest income is also received by the seller on the deferred tax amount. Capital gains eligibility is maintained. 12/1/2011 (c) William P. Streng 44

45 Mortgaged Property & Section 453 p.734 The assumption of mortgage debt is not treated as a payment under the installment note. But, entire basis is offset against the mortgage enabling deferral of gain to future cash payments. Exception applies for mortgage debt in excess of tax basis treated as a payment made in the year of sale. Cf., Tufts case (liability in excess of basis). 12/1/2011 (c) William P. Streng 45

46 Disposition of Installment Sale Obligations p.736 Possible acceleration of the recognition of installment gain amount occurs when disposition of installment note before its maturity. 453B. Gain is (a) the amount realized over (b) the tax basis in the installment obligation (or the fair market value of obligation, if not a sale or exchange). Tax basis is the face value less the unrecognized gain. continued 12/1/2011 (c) William P. Streng 46

47 Disposition of Installment Sale Obligations, cont. 1) No tax basis step-up if a transfer is made at death - 691(a)(4) provides for gain potential retention (gain accrued for accounting purposes) - note 1014(c) exception to tax basis step-up. 2) 453(e) acceleration of installment gain when: (a) sale of qualifying property to a related party, but (b) related party disposes of the property within two years of the installment sale. 12/1/2011 (c) William P. Streng 47

48 Limitations on installment sale gain tax deferral Code 453A (p.736): 1) Borrowing on the security of the installment note accelerates the gain recognition (above $150,000 for certain property). Code 453A(d). 2) The seller is to pay (below-market?) interest to the IRS on the deferred tax amount attributable to income tax owed on debt above $5 million. Code 453A(c). 12/1/2011 (c) William P. Streng 48

49 Open Transaction Method for Contingent Payments p.737 What if the amount of the future payments cannot be determined? E.g., where the payments are dependent upon a royalty (intangible property or mineral property). But 453 does apply to contingent payments where: (1) maximum selling price, or (2) maximum period for receiving payments. Alternative IRS position: proration of tax basis over a 15 year period. Alternative: the open transaction method. 12/1/2011 (c) William P. Streng 49

50 Possible Election out of the Installment Sale Method Taxpayer can elect out of the installment sale method. Code 453(d). Why? Tax reporting choices available then are: 1) Immediate inclusion (are loss carryforwards available?), or 2) Open transaction treatment. Note, the limited availability of open transaction treatment. E.g., Reg. 15A.453-1(d)(2)(ii)(A). 12/1/2011 (c) William P. Streng 50

51 Unstated or Imputed Interest p.737 What happens when a debt instrument is issued with no interest amount actually payable on the debt instrument? The value of the obligation is reduced in the market to reflect that no interest is being paid (or the interest percentage is less than the then applicable market interest rate being paid). Cf., a Series E U.S. savings bond. 12/1/2011 (c) William P. Streng 51

52 Original Issue Discount (OID) Obligation p.738 OID obligation defined: A debt obligation with the stated interest payment being for an amount less than the current market discount rate (often a zero interest rate). Value differential (i.e., the amount less than the face value) is included in the cash payment to be made upon maturity of the debt obligation. OID is a cost of borrowing money, i.e., as interest (or rent ), economically accruing. 12/1/2011 (c) William P. Streng 52

53 Original Interest Discount - Tax Elements p Current (i) income inclusion and (ii) deduction of the accruing interest component. Code 163(e) and requiring accrual basis treatment & also for cash basis taxpayers. The value increase is attributable to time lapse. 2. The amount received at maturity does not produce capital gain (but tax basis recovery). The tax character would be ordinary income (except where a prior tax basis is established). 12/1/2011 (c) William P. Streng 53

54 Original Interest Discount Exceptions to Accrual p.739 Section 1272 does not apply to: 1. U.S. savings bonds. 2. One year or less loans. 3. Loans between natural persons. 4. Tax exempt obligations. 5. De minimis loans ($10,000 or less) between natural persons. Note similar treatment for below market loans Section /1/2011 (c) William P. Streng 54

55 Possible Imputed Interest in Installment Sales p.740 Seller is both (i) seller and (ii) lender. Objective: Disguise interest income or expense as payment for the property. E.g., convert ordinary income into capital gain by reducing the interest amount (ordinary income) and increasing the sales price (capital gain, after basis recovery). 483 and 1274 may convert a portion of principal payments into imputed interest. 12/1/2011 (c) William P. Streng 55

56 Deferred Payment Sales 483 & 1274 p.740 1) Code interest is included on OID basis - stated principal over real principal. Not applicable to residence sales and farms less than $1million. Code 1274(c)(3). 2) Code imputed interest is included in income based on the taxpayer s normal accounting method (payment), not as OID. 3) Limit of 9% discount rate applicable to sales under $2.8 million. 1274A(a)&(b). 12/1/2011 (c) William P. Streng 56

57 Market Discount - Impact of a Discount Rate Change p.741 1) An increase in the market interest rate (discount rate) will decrease the value of an existing debt instrument for a term. 2) A decrease in the market interest rate (discount rate) will cause an increase in the value of a financial instrument paying a greater rate of interest. These are not realized gains or losses. The realization principle necessitates an event constituting a realization, not a mere decline (or increase) in asset value. 12/1/2011 (c) William P. Streng 57

58 Market Discount Tax Treatment p.741 The market rate of interest increases (e.g., from 5% to 6%) and, therefore, the value of an existing 5% financial instrument currently held declines in fair market value. The purchaser acquires this depreciated bond (prior to its maturity) at a price less than its face value. The value of that bond increases to par as the bond gets closer to maturity. continued 12/1/2011 (c) William P. Streng 58

59 Market Discount, cont. The value gap reflects the differential between (i) the actual interest rate on the instrument and (ii) the discount rate when the depreciated instrument is purchased. Code 1276 provides that gain realized on the sale or redemption of a market discount obligation is treated as (ratably accruing) interest income to the extent of taxpayer's share of market discount (the discount is not recognized on an accrual basis, i.e., no current inclusion). 12/1/2011 (c) William P. Streng 59

60 Example A Bond Purchase No OID X Corp issues a ten-year $100,000 face amount registered bond at 10% interest per annum. Purchased for $100,000. The issue price and the stated redemption price at maturity are equal. No OID. The cash method investor reports the annual interest payments as income when received. An accrual borrower (X Corp) deducts interest expense as economically accruing (including prorationing over split years). 12/1/2011 (c) William P. Streng 60

61 Example B OID, since a nonmarket interest rate applies 12% market rate and 10% actual rate - 10 year 100x bond purchase for $88,700. OID of $11,300. The 12% current interest yield on $88,700 equals $10,644 interest income for first year. OID is excess over year one payment of 10% stated interest (i.e., $10,000). $644 is OID income (for the 1 st year) as it accrues and $10,000 interest income is income when paid. The OID is current income & added to principal (& tax basis), with increasing OID in subsequent years. 12/1/2011 (c) William P. Streng 61

62 Example C - Bond purchased at premium (interest % high) The 100x bond has a premium of $21,000. Actual amount from investor is $121,000. Bond pays interest of $10,000 (10% of 100x) The real interest rate is only $8,470 ($121,000 times the 7% market rate). The bond premium is $1,530 ($10,000 less 8,470) - a return of principal, reducing the current income amount. Amount received at maturity? 100x only. 12/1/2011 (c) William P. Streng 62

63 Example D Market Discount Purchase of a bond for $90,000 exactly one-year after its original issue. The market discount is $10,000. The market discount is included in gross income when collected at maturity, not when it economically accrues. Code If a sale of this bond occurs before maturity, then ordinary gain (i.e., interest) is realized to extent of the prorated market discount. 12/1/2011 (c) William P. Streng 63

64 Below Market Loans p.742 A. The rent (interest) free use of money has current value, as provided by: 1) Employer - compensation to the employee and deduction to the employer. 2) Parent a gift to donee (e.g., child). 3) Corporation to shareholder dividend distribution treatment to shareholder. B. Plus: consider the ongoing loan/income tax components of the use of the money. 12/1/2011 (c) William P. Streng 64

65 Below-Market Loan Tax Treatment ) Original funds transfer (term loan): Loan to borrower & a note back to lender. Transaction treated as (a) compensation or (b) gift or (c) dividend to the borrower. 2) Deemed Interest Payment/Receipt: (a) Interest expense is deemed paid by the borrower and (b) interest income is deemed received by the lender. Cf., term loan vs. demand loan (including gift loan) status. 12/1/2011 (c) William P. Streng 65

66 Example: Interest Free Loan to the Employee Employer loans 100x interest-free to the employee payable in two years. 1) Income tax treatment when the loan is made: (a) income to the employee & (b) deduction to the employer. What amount of income?? When? 2) Income tax treatment upon the repayment of loan (or earlier?): (a) interest expense to the payor (deductible?), and (b) interest income to the employer. When accruing? 12/1/2011 (c) William P. Streng 66

67 Term Loan vs. Demand Loan a) Demand loans: When deemed transferred? Gift and demand loans - values are deemed transferred by the lender to the borrower on the last day of the calendar year. b) Term loans: measure the present value of all payments due v. the principal of the loan. The excess of the redemption price at maturity over the issue price (i.e., the present value of the loan) is OID. Code 7872(e)(2). Note the (current) gift tax effect when a gift term loan is made. 12/1/2011 (c) William P. Streng 67

68 Example A p.743 Employee Interest-free Loan Loan to CEO of $1 mil. for 10 years at 0% interest. Present value - $700x (3%+ AFR?) 7872(b) - difference between $1 mil. and 700x is forgone interest; the real principal amount of the loan is 700x, and the 300x difference is immediate compensation. Corp. can immediately deduct the 300x as compensation expense ( 162). Corp. to include 300x interest income as it accrues (OID rules). CEO maybe can deduct the 300k interest as interest expense. 12/1/2011 (c) William P. Streng 68

69 Example B Interest-free Loan to Shareholder Borrower is the sole shareholder of Corp. The 300x is included in the borrower s income as a dividend when the loan is made (and no deduction is available to corp., since dividends paid to a shareholder are not deductible to the payor). Assume E&P. Same income tax consequences for the parties with respect to accruing (i) interest income and (ii) interest expense deduction. 12/1/2011 (c) William P. Streng 69

70 Example C Family Member Loan Lender is the father/mother of the borrower. The 300x in forgone interest is excludible as a gift for income tax purposes under 102 (at the time loan is made). Donor/lender may be exposed to federal gift tax for this donative transfer. When? Remaining tax consequences (interest income to lender and possible interest expense deduction) are the same as prior problems. 12/1/2011 (c) William P. Streng 70

71 Deferred Compensation p.746 Compensation is earned but payment by the employer to employee occurs on a delayed basis. Choices for income deferral vehicles: (1) Nonqualified and (2) qualified deferred compensation arrangements. For nonqualified plans: (1) election to defer before the services are rendered and (2) no tax deduction until included in employee s income (i.e., symmetry). 12/1/2011 (c) William P. Streng 71

72 Rev. Rul p.747 1) Situation 1. An unsecured promise to pay not evidenced by a note is not the equivalent of cash. Unfunded/unsecured agreement to defer compensation does not trigger applicability of the constructive receipt doctrine. 2) Situation 4 (p.749): Amount paid into escrow causes immediate GI inclusion. 12/1/2011 (c) William P. Streng 72

73 Nonqualified Deferred Compensation p.751 Postpones GI inclusion where a substantial risk of forfeiture exists, e.g., conditioned upon the future performance of services. Code 409A. Immediate inclusion for taxation purposes if the risk of loss in the interim is illusory. Deduction correlated to GI inclusion. 12/1/2011 (c) William P. Streng 73

74 Qualified Pension/Profit Sharing Plans p.752 Qualified plan (DB or DC) if: (1) nondiscrimination favoring highly paid (but social security integration); (2) vesting; (3) funding; (4) limits on contributions. If qualified: (1) immediate deduction for plan contribution; (2) no GI to employee participant; (3) no GI inclusion to intermediary trust holding the funds. 12/1/2011 (c) William P. Streng 74

75 Individual Retirement Accounts p.755 Individual retirement accounts (IRAs) for individuals no having benefit of qualified plans or having lower income amounts. Smaller contribution (& deduction) amounts. Cf., Roth IRA no deduction (i.e., contribution from tax-paid funds) but no inclusion when subsequent distribution. Possible conversion of regular to Roth IRA. 12/1/2011 (c) William P. Streng 75

76 Cash or Deferred Arrangements p.757 Possible salary reduction (or 401(k) plan to enable employee to make a contribution to a deferred plan, rather than receiving as cash income, currently includible in GI. Similar plans (403(b)) for employees of tax-exempt organizations. 12/1/2011 (c) William P. Streng 76

77 Employee Stock Options - Employee can call p.758 Fundamental rule: A bargain purchase from an employer creates compensation income to an employee (including stock purchase). Example: As compensation for services an employer gave to an employee an option to purchase shares of the employer corporation at a price not less than the then fair market value of the stock. The option was subsequently exercised. 12/1/2011 (c) William P. Streng 77

78 LoBue case Nontransferable Option LoBue received a nontransferable stock option (for employer s stock) contingent upon continued employment. Options exercised when the stock valued above the option price. Tax Court determined no income resulted since intent to confer a proprietary interest. Held: Taxable gain to be measured as of the time the options were exercised and not at the time when granted. 12/1/2011 (c) William P. Streng 78

79 Code 83 p.759 Option Timing Rule Realization of compensation income occurs on the grant date if the option has a readily ascertainable value at that time. The option value is ordinary income on the grant date. The employee has tax basis in the option at its fair market value. No income received when option is exercised. Subsequent sale produces capital gain. 12/1/2011 (c) William P. Streng 79

80 Section 83, continued Exception: No Ready Value Code 83(e)(3) - no income is realized on receipt of option if the option does not have a readily ascertainable fair market value. Thereafter, ordinary income is realized when the option is exercised to the extent of the difference between the price paid and its fair market value. Code 83(a). 12/1/2011 (c) William P. Streng 80

81 Code 83(b) Election Employee - Investor Status Election to accelerate ordinary income inclusion but further post-election appreciation would be capital gain. Elect under Code 83(b) to include the value over the amount paid - with the value determined without regard to restrictions. No deduction is available if the Code 83(b) election is made and the property is thereafter forfeited. Code 83(b)(1). 12/1/2011 (c) William P. Streng 81

82 Incentive Stock Options p specifies requirements for ISOs Both grant and exercise are deemed to be nonrealization events for income tqax purposes. See 421(a)(1). Gain on the ultimate sale of the acquired stock is classified as capital gain. Employer has no 162 deduction. 12/1/2011 (c) William P. Streng 82

83 Inventory gain/loss tax calculation p.760 Tax basis is difficult to trace into each inventory item (but barcodes?). Therefore, must use an accounting or identification system that (1) seeks to establish the tax basis of those items remaining in closing inventory, and, therefore, (2) also determines the tax cost for those inventory items sold from inventory during the particular tax year. 12/1/2011 (c) William P. Streng 83

84 Cost of Goods Sold Determination p.760 Gross income from a business selling inventory is computed as follows: Gross receipts: Less: inventory cost (CGS, how determined?) Equals: gross income 12/1/2011 (c) William P. Streng 84

85 Determining the Cost of Goods Sold 1) Opening inventory 2) Plus: Additions to inventory during the course of the year (i.e., goods purchased or goods produced) 3) Less: Closing inventory 4) Equals: Cost of goods sold (CGS) Tax planning objective: minimize the closing inventory amount (increasing the CGS). 12/1/2011 (c) William P. Streng 85

86 Method for Identifying the Closing Inventory Items FIFO or LIFO ordering method to be used? FIFO - the remaining inventory consists of goods most recently added to inventory (the conveyor belt approach). LIFO - the remaining goods are those first into inventory (the bottom of the barrel system); goods sold during the year are those which were most recently acquired (the most expensive? Yes, if inflation.) 12/1/2011 (c) William P. Streng 86

87 Example p.761 Inventory Accounting 61(a)(2) gross income on the sale of inventory. Year 1 buy 100 widgets for $10=$1,000 Year 2 buy 100 widgets for $13=$1,300 & sell 120 for $15 each =$1,800 Year 2 GI: (a) FIFO $10 and $13= $1,260 cost (= $540 income); or, (b) LIFO $13 and $10 = $1,500 cost (= $300 income). 12/1/2011 (c) William P. Streng 87

88 Example Inventory Accounting, cont. The booking requirement. See Code 472(c) & (e)(2). If using LIFO for tax purposes, must also use LIFO inventory method for reporting to shareholders and creditors (i.e., for GAAP purposes). What is the purpose of this financial statement consistency requirement? 12/1/2011 (c) William P. Streng 88

89 Thor Power Tool Co. p.764 Taxpayer attempted to write down, i.e., deduct excess inventory under the lower of cost or market method, per Reg (c), but continued to hold the inventory. Taxpayer argued this conformed to best accounting practice. Sup. Ct. says IRS can disallow this write-down under the clear reflection of income standard. See Reg (a)(2). Tax accounting can give no quarter to uncertainty (from fn. 11, not included in edited version). 12/1/2011 (c) William P. Streng 89

90 12/1/2011 (c) William P. Streng 90