UNITED STATES TAX CALCULATORS

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1 INTRODUCTION TEXT FINANCIAL CALCULATIONS FOR LAWYERS LECTURES INDEX GLOSSARY PRESENT VALUE OF A SUM FUTURE VALUE OF A SUM SINKING FUND AMORTIZATION WITH CHART PRESENT VALUE OF AN ANNUITY FUTURE VALUE OF AN ANNUITY INTEREST CONVERSION AMORTIZATION SIMPLE CALCULATOR YIELD CALCULATOR NAVIGATION INSTRUCTIONS SOLVING FOR INTEREST RATE FINANCIAL CALCULATIONS FOR LAWYERS UNITED STATES This set of calculators is not available with the one-hour version of the FINANCIAL CALCULATIONS FOR LAWYERS Course. It is, instead, part of the expanded course. Many though certainly far less than a majority - of United States Internal Revenue Code Sections are purely mechanical. Essentially, they involve algebraic formulae. As such, one may create a calculator which will compute the section consequences. Arguably, Congress is ill-advised to write algebraic formulae in a traditional English statutory manner. Doing so can be very cumbersome as well as confusing. Arguably, such formulae should appear in mathematical terms, with mathematical symbols. Better still, perhaps Congress should simply enact calculators for some I.R.C. provisions, thereby obviating the need for English words other than definitions. Alas, because that is unlikely to come to pass, we offer some TAX CALCULATORS. They still require the user to understand defined terms, but that is always true of algebra. The CALCULATORS should aid a student in understanding how the particular statutory provisions work. They should not, however, substitute for an understanding of the Code. The following calculators are available. Copies of the relevant statutes are also available: ORIGINAL ISSUE DISCOUNT (OID) COMPUTATIONS and Section Steven J. Willis All Rights Reserved. 1

2 Under sections , taxpayers holding OID instruments must accrue (and then include) deferred interest on the obligation. They may then add the accrued amount to their basis of the debt instrument. Similarly section 163(h) allows issuers of OID instruments to accrue interest deductions consistent with section 1272 computations. When triggered, sections 163(h) and 1272 apply both to cash method and to accrual method taxpayers. The section 1272 interest allocation uses a constant yield to maturity (CYM) as the basis of the default six-month periodic interest allocations. It then uses a modified straight-line "stair step" method for daily allocations within the relevant six months. The stair step straight-line allocation overstates interest for three months and then understates it in the same amount for three months. Congress apparently adopted such a method believing it to be simpler than a more consistent CYM daily allocation. Arguably, that was unwise; however, the resulting complications are not severe and the resulting inaccuracies are not significant. Essentially, the OID CALCULATOR is a modified version of a SINKING FUND or Reverse AMORTIZATION CALCULATOR. FRONT-LOADED ALIMONY COMPUTATIONS and Section 71. For federal tax purposes, taxpayers must include alimony received and may deduct alimony paid. Section 71 defines alimony for federal tax purposes. Since 1982, it has not relied on state law definitions of alimony. Under the federal definition, taxpayers may "elect out" of the provisions and thereby denominate as non-alimony that which would otherwise qualify as alimony. Otherwise, alimony involves amounts paid in cash to a spouse or former spouse pursuant to a Court Order or other written agreement. Child support which also has a specific federal definition for tax purposes is not alimony. To qualify as alimony, periodic payments must cease on the death of the recipient spouse (other than for past-due alimony). Under the federal definition, amounts paid in cash to a former spouse to satisfy an obligation to equitably distribute property or to satisfy a community property allocation may indeed qualify as alimony. To so qualify, the recipient must waive the right to any payments which may accrue following her death; however, that risk is often less significant than it might otherwise appear. For one thing, she would be dead, so why would she care? Second, in many cases, the unpaid amounts which remain with her ex-husband will flow in time to their children. Also, she may purchase life insurance on herself which will equal the waived payments. The ultimate result can be very favorable to taxpayers in some cases. Such cases involve one high-bracket taxpayer and one low-bracket taxpayer not an Steven J. Willis All Rights Reserved. 2

3 unrealistic possibility. If that is the case, the parties may legally disguise property distribution payments as deductible (and includible) alimony payments. Thereby, they would arbitrage the bracket differential. For example, if the payor were in a 50% bracket (do not forget about state taxes) and the recipient in a 20% bracket, Uncle Sam would effectively contribute a 30% savings, which the parties could then share as part of the marital settlement negotiations. Congress clearly made this possible under the statute. However, Congress also included a statutory catch for those who attempt the above arbitrage. Under section 71(f), in the third post separation year, the alimony payor must include the amount of alimony "front-loaded" alimony into the first and second post-separation years. The recipient may deduct the same amount. DEPRECIATION COMPUTATIONS and Section 168. Tax depreciation is purely mechanical, albeit a bit convoluted. It requires knowledge of an arbitrarily assigned life, an arbitrary convention, and several depreciation "methods." Some additional math plays a part, but the computations are not difficult they are just tedious. The DEPRECIATION CALCULATORS perform the tedious work. Students must still understand the definitions and the economic impact of the deductions. PRE-PAID RENT ALLOCATIONS and Section 467(f). Absent the application of sub-section 467(f), recipients of pre-paid rent must include the amount received in the year of receipt. This is always true of cash method taxpayers who include income items upon receipt. It is almost always true of accrual method taxpayers who must generally include income items as of the earliest of the date they are due, paid, or earned. See, Schlude v. Commissioner, 372 U.S. 128 (1963). Similarly, absent the application of sub-section 467(f), payors of pre-paid rent must capitalize the amount paid under section 263 and then may amortize it on a straight-line basis over the appropriate term. Sub-section 467(f) if operative would place both taxpayers (the payor and the payee) on the accrual method for purposes of the rent deduction or rent income. It would also impute the appropriate interest income and deduction, using a statutorily defined interest rate and a constant yield to maturity computation method. Essentially, the sub-section treats pre-paid rent as a loan repaid - both interest and principal - with the use of property. Steven J. Willis All Rights Reserved. 3

4 The resulting computations which involve a modified SINKING FUND CALCULATOR appear as an upward-sloping curve. In contrast, more traditional amortization of intangibles appears as a straight line with zero slope. Accelerated Depreciation as computed in the DEPRECIATION CALCULATOR appears as a downward-sloping curve. Because the sub-section 467(f) allocation method rests on the economic reality of the transaction (subject to the statutorily defined interest rate), it is economically neutral: it neither subsidizes nor penalizes pre-paid rent situations. Other cost allocation methods such as accelerated depreciation with its downward curve and intangible amortization with its zero sloped line subsidize or penalize their inherent transactions, depending on the viewpoint of the party. Unfortunately for taxpayers, the Treasury has yet to issue regulations implementing section 467(f). Without such operative regulations, the section is arguably inapplicable. Enacted in 1986, the sub-section has been nonoperative for over two decades. DEFERRED RENT ALLOCATIONS and Section 467(a). Absent the application of sub-section 467(a), accrual method recipients of deferred rent must include the amounts in the years earned, but without any consideration of an interest component. In contrast, cash method taxpayers would include such income items upon receipt; hence, they would defer recognition. Similarly, absent the application of sub-section 467(a), accrual method payors of deferred rent deduct the amount accrued under section 461(h), but without any consideration of unstated interest. Cash method payors would deduct nothing until the year of payment. Sub-section 467(a) places both taxpayers (the payor and the payee) on the accrual method for purposes of the rent deduction or rent income. It also imputes the appropriate interest income and deduction, using a statutorily defined interest rate and a constant yield to maturity computation method. Essentially, the sub-section treats deferred rent as a loan - both for interest and principal The principal of the loan is the annual rental amount; then, the subsection imputes interest on the deferral. The resulting computations which involve a modified AMORTIZATION CALCULATOR appear as an upward-sloping curve. In contrast, more traditional amortization of intangibles appears as a straight line with zero slope. Accelerated Depreciation as computed in the DEPRECIATION CALCULATOR appears as a downward-sloping curve. Steven J. Willis All Rights Reserved. 4

5 Because the sub-section 467(a) allocation method rests on the economic reality of the transaction (subject to the statutorily defined interest rate), it is economically neutral: it neither subsidizes nor penalizes deferred rent situations. Other cost allocation methods such as accelerated depreciation with its downward curve and intangible amortization with its zero sloped line subsidize or penalize their inherent transactions, depending on the viewpoint of the party. STRIPPED COUPON BONDS and Section One of the most famous United States tax cases involved stripped coupon bonds: Helvering v. Horst, 311 U.S. 112 (1940). The decision helped create the ASSIGNMENT OF INCOME DOCTRINE, particularly in its application to income from property. Under the doctrine, when a taxpayer stripped the coupons from a bond and gave them to another, the taxpayer/donor remained liable for reporting the income resulting from redemption of the coupons. Section 1286 does not change the Assignment of Income Doctrine; however, it changes the measurement of the income attributable to stripped coupons. It also moots the specific holding of Horst with regard to coupon bonds. It says nothing, however, about the application of Horst to assignments of income from property other than coupon bonds. Another famous tax case is Commissioner v. P.G. Lake, Inc., 356 U.S. 260 (1958). Lake involved the ACCELERATION OF INCOME DOCTRINE a tax doctrine related to but distinguishable from the ASSIGNMENT OF INCOME DOCTRINE discussed in Horst. Lake applies to a taxpayer who sells an income right from property and who retains ownership of the underlying property. Under Lake, the owner/seller taxpayer must currently recognize ordinary equal to the sale proceeds unreduced by any basis. The taxpayer must allocate the property's entire basis to the retained interest and none to the income interest. Section 1286 changes the Lake result as it applies to stripped coupons from a coupon bond. It says nothing, however, about stripped income rights from any other type of property. Section 1286 requires a taxpayer who strips coupons from a bond to apportion his basis, by relative fair market values, to the various component parts of the bond. As a result, each coupon would receive a basis, as would the underlying bond itself, which represents the principal invested. The STRIPPED COUPON BOND CALCULATOR uses both a PRESENT VALUE OF A SUM CALCULATOR and a modified AMORTIZATION CALCULATOR to apportion the bond's basis. ACQUISITION PREMIUM ALLOCATIONS and Section Steven J. Willis All Rights Reserved. 5

6 Acquisition Premium is the opposite of Market Discount. Both result because of market interest rate changes with regard to a particular instrument. If interest rates fall, an instrument with a fixed rate will rise in price, resulting in an Acquisition Premium on sale. If, instead, interest rates rise, an instrument with a fixed rate will fall in price, resulting in Market Discount on sale. Section 1272(a)(7) provides one method for allocating Acquisition Premium over the taxpayer's remaining ownership period in the instrument. This method divides the premium by the un-accrued original issue discount. It then subtracts that portion of future OID accruals. The method is relatively simple to use and does not require a re-computation of interest allocations: the OID computations would already appear with the instrument, as computed by the issuer. Treasury Regulation section provides an alternate method of dealing with Acquisition Premium. Essentially, it re-applies the OID Calculator as if the instrument were re-issued. As such, it correctly allocates the premium based on a constant yield to maturity assumption. In contrast, the arguably simpler arithmetic Code method understates the holder's income in the early years following a premium purchase and then overstates income in the later years. In 1982, when Section 1272 first appeared in its present form, the Code section method was clearly simpler to use because it involved simple arithmetic rather than algebra, which the regulation method requires. The regulation method is more accurate, but not sufficiently so to justify the added complication in The widespread use of Financial Calculators and the ease of creating an OID CALCULATOR and an AP CALCULATOR may justify a statutory amendment forcing use of the algebraic regulation method. Until such an amendment occurs, however, most taxpayers will use the Code method because it defers income: in most cases income deferral is desirable. MARKET DISCOUNT INTEREST ALLOCATIONS and Sections Market Discount is the opposite of Acquisition Premium. Both result because of market interest rate changes with regard to a particular instrument. If interest rates rise, an instrument with a fixed rate will fall in price, resulting in Market Discount on sale. If, instead, interest rates fall, an instrument with a fixed rate will rise in price, resulting in an Acquisition Premium on sale. LIKE-KIND EXCHANGE GAIN/LOSS/BASIS COMPUTATIONS and Section HOTCH-POT AND FIRE-POT COMPUTATIONS and Section Steven J. Willis All Rights Reserved. 6

7 ANTI-SCHLUDE CALCULATOR for Pre-paid Services Deferral. DEPRECIABLE PERSONAL PROPERTY GAIN CHARACTERIZATION CALCULATOR and Section CAPITAL GAINS AND LOSS CARRYOVER CALCULATOR and Sections Steven J. Willis All Rights Reserved. 7