Scott Shane Federal Income Tax Outline

Federal Income Tax Outline Gross Income (Deductions) Taxable Income Apply Tax Rates Tax (Credits) Net Liability I. Scope of Gross Income A. General Definitions 1. § 61: broadly defined GI is all income from whatever source derived, unless there is a specific exclusion in the Code. 2. 3 Part Glenshaw Glass Test: a. Net accession to wealth b. Clearly realized i. Realized: triggering event causing receipt of economic benefit. ii. GR: all realized income and gains are recognized (reported on tax return), unless there is a specific section that says you do not. c. Taxpayer has complete dominion B. Receipt of Economic Benefit/Accession to Wealth 1. Some GR’s: a. GI need not be cash: § 1.61-21(d)(1): The receipt of property instead of cash in exchange for services is income to the FMV of the property i. E.g.: paid in stock is income b/c the realization is the receipt of the stock. ii. E.g.: Income can be a prize in cash or property – Game Shows b. Indirect GI Rule: Income doesn‟t have to be received directly, as long as it is paid on your behalf such that you derive an economic benefit. i. E.g.: If a 3rd Party pays taxes on the individual‟s behalf, it is considered income to the individual b/c derive financial economic benefit (he was obligated to pay taxes). c. Borrowing: is not income b/c it does not increase your wealth (no accession of wealth). It creates a corresponding obligation to pay it back. d. Illegally gained Money: no distinction is made for GI purposes b/n illegal and legal activities, so it is income. 2. Treasure Trove a. The Regulations define as income [Reg. §1.61-14(a)] Treasure Trove, to the extent of its value in US currency, constitutes gross income for the taxable year in which it is reduced to undisputed possession (not just when it is found). b. Distinct item v. Bargain Purchase/Appreciation i. Buying the piano and find something else inside the piano. The item inside is a distinct item, and thus is income. ii. However, if you buy a piano and later find out that it is a Steinway, there is no gross income until it is realized, which requires a triggering event. There is no GI when items just appreciate in value. C. Income Without Receipt of Cash or Property 1. Corporations a. Economic Benefit from the corporation, regardless of whether the corporation is owned by the taxpayer, is income. i. E.g.: If you live in a house owned by another (even a corporation you own) rent free, it is income. Benefit you are receiving is free rent. Since the owner is a separate entity and the rent can be measured, then it is deemed as income. (a) But, No income if you live in your own house. ii. E.g.: If employee consumes veggies of corporation he works for, then that would constitute income to the employee. (a) But, if you consume your own goods (grow your own food) it is NOT income when you pick it or eat it yourself, but it is income if you sell it or trade it. 2. Barter a. Key Rule: Benefit through barter/exchange of services, even without exchange of cash, is income equal to FMV for both parties. b. Barter is assumed to be of equal value. i. Reg. §1.61-2(d): Compensation paid in property is taxable as much as its FMV. 3. GR: No income if you do your own work (do your own taxes as a tax atty). Problems: What is income when Vegy grows vegetables in her crop?  Vegy harvests her crop – No  Vegy and her family consume $100 worth of vegetables – No  Vegy sells vegetables for $100 – Yes  Vegy exchanges $100 worth of vegetables for $100 worth of Tuna - Yes  Vegy sells in Grocery store in exchange for rent paid by Grocer to landlord – Yes, for rental value of space in store GROSS INCOME: SOME SPECIFIC EXCLUSIONS I. Exclusions for Gifts & Inheritances Received A. Rules of Inclusion and Exclusion 1. Tax GR § 61: Gross Income includes all income unless there is some specific code section that excludes it. 2. Income is interpreted broadly, while exclusions are interpreted narrowly 3. Gift Exclusion GR: a. § 102(a): GI of donee/recipient does NOT include the value of property acquired by gift, bequest, devise or inheritance. No matter who it is from or the amount. b. § 102(b): Income from a gift is NOT an exclusion. (gift of stock and dividend). c. § 102(c): ER/EE gifts: Subsection (a) shall not exclude from GI any amount transferred by or for an employer to, or for the benefit of, an employee. 4. Differentiate between exclusions from gross income and deductions available. B. Gifts 1. What is a Gift for Income Tax purposes? a. Definition/Test of a Gift: Look to the TR‟s intent to determine if a transfer is made out of emotions of detached and disinterested generosity (Comm’r v. Duberstein). i. Not a gift if anticipating a benefit. ii. Family member transfer v. Business Setting: Harder to have gifts if in a business setting (tips – for service and not detached generosity) 2. Employee Gifts (prima facie: not gifts) a. § 102(c)(1)] An EE shall not exclude transfers from an ER from GI (not a gift). b. [Reg. §1.102-1(f)(2)] – EE/ER gifts can be excluded from GI if the purpose of the transfer can be substantially attributed to the familial relationship of the parties and not to the circumstances of their employment. i. To be an exception from GI, EE must show that the transfer was not made in recognition of the EE‟s employment. (bifurcate) c. Any gift that is given company wide is not a gift. C. Bequests, Devises, and Inheritances 1. § 102(a): “Property acquired by gift, bequest, devise, or inheritance” is exempted from federal taxation and is not included in GI. 2. What is an inheritance? a. GR: Inheritance is excluded from GI, whether by devise or by settlement (cash or property; testate or intestate). 3. Examples: a. Father leaves $ in will = devise so excludable b. D gets $ intestate b/c F has no will = excludable from GI c. D gets $ for “long and devoted service to him”: inheritance so excluded from GI. NO written agreement. No obligation on the part of the F. d. Wolder: $ not an inheritance, but rather compensation for services rendered pursuant to written agreement…must include in GI. II. Exclusions for Employee Fringe Benefits & Certain Employee Provided Meals & Lodging A. General 1. Fringe Benefits: things you receive as an EE (thus not gifts). The tax law on fringe benefits is completely statutory. 2. Government is willing to exclude these benefits from gross income because: a. They are relatively small b. They would be cumbersome to account for Certain Fringe Benefits: § 132 – all 8 are excluded from GI a. No additional cost service b. Qualified employee discount c. Working condition fringe d. De minimus fringe e. Qualified transportation fringe f. Qualified moving expense reimbursement g. Qualified retirement planning services h. On premise athletic facility/gym B. [IRC §132] Certain Fringe Benefits 1. [IRC §132(a)]: Enumerated exclusions from gross income are: IRC §132(b) No-additional-cost service [THINK OF EXCESS CAPACITY – AIRLINE EE] i. The term “no additional cost service” means any service provided by an ER to an EE for use by such EE is not income if meet 2 tests/requirements: 1. Line of Business Test: the service the EE is receiving must be the type of service offered to customers within the line of business within which you work; and a. Doesn‟t apply if EE is working for a conglomerate (company w/ multiple lines of business) and the benefit is not in the EE‟s line of business, but b. [Reg. §1.132-4(a)(1)(iii)] EE may work in multiple lines of business and exclude fringe benefits from every line she works. 2. No substantial additional cost test: The ER does not incur substantial additional cost in providing such services to the EE. a. [Reg. §1.132-2(a)(5)(i)] Revenue forgone is an additional cost i. E.g.: Bumping a passenger off a flight for an employee = additional cost ii. E.g.: Marriott EE staying in an empty room = not additional cost). b. [Reg. §1.132-2(a)(5)(ii)] If service is fundamentally labor intensive for that particular person, it is not excludable i. E.g.: Lawyer having his estate plan done by the firm he works for during down-time = additional cost. ii. Who are employees? §132(h) – Spouses, dependant children, widower, disabled employees, retired employed (in airline context, parents) are all considered the employee so they get the fringe benefits. 1. If you are not considered an employee and a spouse using your fringe benefits, then it is income to you. iii. Discrimination §132(j): Must NOT discriminate b/n types of EEs. 1. Limiting benefit to highly compensated or Executive EEs = D 2. Limiting benefit to full-time EE‟s NOT D. 3. Note: If fringe benefit is discriminatory on an unRx basis, the entire value of the free service received would be included in income. IRC §132(c) Qualified employee discount [THINK OF RETAIL COURTESY DISCOUNTS], i. Allows ER‟s to allow EE‟s to buy products/services at a discount, w/o the discount being included in EE‟s GI. ii. Discount does not apply for the sale of real property. iii. 2 Requirements: (1) Line of Business Test, and (2) Restrictions on amount of discount iv. Must meet the Line of Business Test: big conglomerate beware. v. Restrictions on maximum amount of discount available: (a) Services (i) May not exceed 20% of the price at which the services are offered to customers (anything more is income). (ii) Insurance is a service. (b) Property (i) May not exceed the employer‟s “gross profit percentage” [(aggregate sales price - cost)  (aggregate sales price)] (ii) Nuance: If a customer is bumped, then there may be no [IRC §132(b)] fringe benefit; but there may be an [IRC §132(c)] fringe benefit up to the maximum amount. vi. Discrimination §132(j): Must not discriminate b/n types of employees. IRC §132(d) Working condition fringe benefit, i. Something an ER provides for EE which, if you bought it, would be a deductible business expense. ii. If the EE could have deducted the benefit (pursuant to [IRC §162] & [IRC §167]), then the EE can exclude the benefit from GI. (a) Bar dues, magazines, etc… iii. Discrimination §132(j): Can be discriminatory. IRC §132(e) De minimis fringe benefit (Think coffee and donuts  LOW VALUE) i. De minimiss: Any property or service whose FMV is so small that it makes accounting unRx or administratively impracticable 1. Rule: Must be in service or property, not cash ii. [Reg. §1.132-6(e)] (a) Included: E.g. cocktail parties, group meals, traditional holiday/birthday gifts @ low fair market value, use of copy machine, etc. (b) Excluded: E.g. season tickets, club membership, use of employer-owned facilities, etc. iii. On-Premises Eating Facilities (b) Treatment of certain eating facilities shall be treated as fringe when: (1) Facility owned and operated by ER is located on or near the business premises; and (2) Meals provided during workday; and (3) EE pays direct operating costs of such facility (raw ingredients). (c) EE pays less than true value of the meal, but the extra value of meal received is excludable from GI as a de minimis fringe benefit. (d) i.e. Atty dining room. (1) All Attys pay something for it, but they don‟t pay full price. (2) Costs should cover the costs of operating the facility (Interpreted to only require the cost of food) (3) Discrimination: most of these are only for lawyers, which is ok to keep out secretary and support staff. iv. Discrimination §132(j): Can not discriminate in favor of highly compensated EE‟s or “Partner‟s Only”, but can Rx discriminate to “Atty‟s only” dining room. IRC §132(f) Qualified transportation fringe benefit i. Qualified Parking provided to an EE on or near the business premises of the ER is excluded up to $175 per month, adjusted for inflation (a) FY 2004 = $195 (b) FY 2005 = $200 (c) Note: Value of the parking spot is the value of a similar spot in the area ii. Discrimination §132(j): Can be discriminatory. IRC §132(g) Qualified moving expense reimbursement i. Any amount received by an EE from an ER as a payment for expenses which would be deductible as moving expenses if directly paid or incurred by the EE (then reimbursed), is excludable from GI. ii. Discrimination §132(j): Can be discriminatory. IRC §132(a)(7) Qualified Retirement Planning Services i. GR: The term 'qualified retirement planning services' means any retirement planning advice or information provided to an employee and his spouse by an employer with a qualified employer plan and is excludable from GI. ii. Discrimination §132(j): Must not discriminate b/n types of employees. IRC §132(j)(4) On premises gym/athletic facilities i. Athletic facilities are excluded from GI of EE as a fringe benefit when they are: i. Located on premises ii. Operated by employer iii. Substantially all use is by EE‟s. Cannot include outside people. 2. [IRC §132(j)(1)] Non-Discrimination a. Some services must be provided on a nondiscriminatory basis b. Can‟t discriminate in favor of highly compensated employees c. Applies to: i. No-Additional-Cost Service ii. Qualified Employee Discount iii. De Minimis: On-Premises Eating Facilities iv. Qualified Retirement Planning Services [IRC §132(m)] d. Consequences of Discrimination Rule: if you discriminate when it is illegal to do so, 100% of the benefit value is income to the EE. C. Exclusions for Meals and Lodging 1. § 119: Meals or Lodging furnished to EE, his spouse or his dependents, for the convenience of the ER is not included in GI as long as i. Meals – 2 conditions are: (a) Meals must be furnished on the ER‟s premises (b) Must be for the (objective) convenience of the ER (there has to be an underlying reason of why you need to be there) (i) Groceries = meals. ii. Lodging – 3 conditions are: (a) Lodging must be on the business premises of the ER; (i) Adjacent or across the stree ok, but a block away is too far. (b) EE must be required to accept such lodging as a condition of his employment. (ii) Nature of work? (c) Lodging is furnished for the convenience of the employer. (iii) Just b/c the ER and EE agree to a clause in the K requiring EE to live on premises does not mean it is for ER‟s convenience. “Substance v. Form” and IRS will say in substance it was not a real reason why you needed to be there and the fact that you agreed to it does not make it so. 2. What if ER = EE? a. It is ok for the ER and EE to be the same b/c it is the corporation that is providing the benefit!! 3. What if ER transferred residence to EE in fee simple a. It is no longer the ER‟s business premises, so FMV of the house would be income. III. Exclusions for Certain Prizes / Awards & Scholarships A. Prizes & Awards 1. § 74(a): Gross income generally includes amounts received as prizes and awards. 2. § 74(b): Gross income does not include prizes & awards for religious, charitable, scientific, educational, artistic, literary, or civic achievement if: a. Recipient was selected without any action on his part (did not enter - Nobel); and b. Prize is transferred by payer to a qualified charity 3. § 74(c): Exception for certain employee achievement awards a. Must relate to length of service or safety B. Exclusions for Scholarships & Fellowships 1. § 117: If do not meet exception, then amount of scholarship is a clear net accession to wealth and must be declared as GI. This statute excludes from GI amounts received as a “qualified scholarship”. 2. Qualified Scholarship: any amount received by a degree candidate at an educational organization (assumed). a. What is excludable? [IRC §117(b)(2)] Amount received for: i. Tuition; ii. Enrollment fees; iii. Books; iv. Supplies and equipment b. Not excluded from Gross Income: i. Personal living expenses ii. Meals and lodging iii. Travel and research iv. § 117(c): Payment for teaching, research or other services by the student required as a condition for receiving the otherwise excludable amount. 3. These are not considered disinterested and detached gifts. IV. PROPERTY: Real or Personal A. 3 Questions to ask when analyzing gains/losses while dealing in the sale or disposition of real or personal property. 1. Do you have a realized gain/loss? (how much: AR-AB) 2. If yes, ask “is the realized gain/loss recognized?” a. Rule: All realized gains are recognized, unless there is a specific exception. If recognized, then must be declared as GI. b. There are some. (e.g. Gain from the sale of a personal residence (§121), transfer of assets b/t spouses or former spouses (§1041)) 3. If yes to both, do the realized & recognized gain/loss receive any special tax treatment? (eg. capital gains/losses) B. § 1001: Realized Gain/Loss 1. Amount Realized = $ Received from Sale or Disposition + FMV of Property/Services (other than $) received 2. Basis/AB: The basis of an item of property is the purchase price/cost to acquire property. a. Note: it does not matter how acquire property TERMS (options, ER gives you property, sell options) Amount Realized = AR b. Adjustments to Basis: §§ 1011-12, 1016 Adjusted Basis = AB i. Capitalized costs v. Expenses Gain = AR - AB (a) A substantial improvement/capital expenditure that is permanent in nature can be added to basis to get AB b/c are additional costs. (i) I.e. clearing land, patio, (b) Mere maintenance isn’t added to basis  painting (c) If you do home improvement work yourself, you cannot add the value of your labor to the costs to increase your basis  you are worried about cost only, not value!!! ii. In terms of adjustments to basis, a taxpayer wants an improvement to be considered a capital expenditure as opposed to a mere expense in order to increase the basis, thus decrease GI. 3. Gain = (AR - AB) a. Rule: Increase in value is not gain. It requires realization (triggering event) to qualify as a gain. C. Property Acquired by Gift 1. § 1015(a)-(c): Basis of property acquired by gifts and transfers in trust. a. GR – Carry-Over-Basis: When a DE receives property as a gift, the basis is the DR‟s adjusted basis. i. What if DR is dead and there are no records of DR‟s basis? The DE‟s basis is 0. b. Special Loss Rule - If at the time the gift is made the FMV is less then the DR‟s basis and the DE sells for a loss, then the DE‟s basis is the FMV at the time of the gift. i. Trap! Reg. §1.1015-1(a)(2): If using „carry-over‟ gives a loss and „FMV‟ gives a gain, then there is no loss or gain. (a) AB=10k, FMV=8k, AR=9k 2. § 1015(d): Gift Tax paid Adjustment: Increasing basis a. Idea: DE gets advantage in computing basis b/c gift tax paid on transfer. The cost paid to transfer should be reflected in DE‟s basis. Basis can be adjusted upwards for gift taxes paid by the donor. b. Computing Adjusted Basis: 2 date specific rules i. Overall Rule: No matter when the gift was made, if at the time of the gift the FMV of the property is less than or equal to the DR‟s AB there will be no gift tax paid adjustment!! ii. General Rule #1: for Gifts before 1977 (a) You add the gift tax paid to the AB to get the gift tax adjusted basis, as long as that number does not exceed the FMV at the time the gift was made. If it would exceed FMV, then your AB is the FMV. This rule only applies to gifts made before 1977. (i) If at the time of the gift, the FMV was equal to or less than the Donor‟s AB, then the Donee gets no gift tax paid adjustment. iii. General Rule #2: for Gifts after 1976 (a) Equation for Gift Tax Paid Adjustment: x = Gift Tax Paid Adjustment (i) Add X to AB (b) Net Appreciation (in donor‟s hands) = FMV @ time of gift – Donor‟s AB POST 1976 EQUATION X Net Appreciation (in donor‟s hands) = Amount of Gift Tax Paid Total Amount of Gift (FMV of Gift) D. Property Acquired b/n Spouses or Incident to Divorce: § 1041 1. GR for TR Non-recognition: No gain or loss shall be recognized by the transferor (will 2. 3. 4. 5. not be reported) on a transfer (can be sale or gift) of property from an individual to (or in trust for the benefit): a. a spouse or, b. a former spouse, but only if the transfer is incident to the divorce. A transfer of property is incident to the divorce if such transfer: a. occurs within 1 year after the date on which the marriage ceases; or b. is related to why the marriage ended. Note: the TR will have a realized gain or loss in the transfer of property b/c there is a triggering event, but it is just not recognized. Basis for TE spouse receiving property: Always use carry over basis – basis of TR! a. No special-loss rule b. No gift-tax paid adjustment c. So, when the TE spouse then resells the property, you use the carry over basis to compute the recognized gain or loss. Husband/Wife getting divorce example of 2 stocks of same value where one had greatly appreciated. You want to advice your client to take the stock with less appreciation b/c using the carry-over basis you have less of a gain. E. Property Acquired From a Decedent (AB) 1. When you get property from a decedent it is a net accession to wealth, but it is not income… 2. Stepped-Up Basis for property acquired from the decedent a. Rule §1014: Property acquired from a DCT receives a basis equal to its FMV on the date of death i. Property appreciates during decedent‟s lifetime: (a) Property receives a “stepped-up” basis with no income tax cost to anyone. ii. Property depreciates during decedent‟s lifetime: (a) Property receives a “stepped down” basis without deductible loss. iii. Note: If dad gives it to son right before dies, then it is a carry-over basis gift, but if had given in will then use FMV. b. § 1014(e): If property is given and then gotten back w/in 1 year, by reason of death, then no stepped-up basis is used. Instead the basis is the AB of the property in the hands of the decedent immediately before death to prevent collusion. i. Example: Son buys property for $20K; gives to mom when property is worth $100K; mom dies within 1 year of gift and devises property to son; property goes back to son but, son‟s basis is still $20K (no stepped-up basis pursuant to 1014). c. § 1014(f): New tax law that repeals Estate Tax will eradicate the “step-up” in basis and replace it with a “carry-over” basis for property acquired from a decedent after January 1, 2010. d. § 1014(b)(6): Double Step-Up/Down for Community Property J’s i. Community Property owned by SS is deemed to have come from the DCT b/c no right of survivorship and deceased spouse can devise to anyone they want. Therefore, SS‟s basis is the FMV at time of death (gets stepped-up basis), and the basis of the deceased spouse‟s property is its FMV. ii. Joint Tenancy has right of survivorship, so only the DCT‟s interest in the jointly held property gets the step-up upon death. iii. CA has a new state of title – CP with right of survivorship: Example  Husband and Wife buy property in 1980 for $200K; Combined AB (cost) = $200K together (AB = $100K/each). Property held in Joint Tenancy (each own ½ undivided interest in property). Property increases in FMV to $800K. Husband dies. What result? In JT, the spouse automatically gets it b/c of Rt of survivorship. His ½ goes to the wife. Her adjusted basis is $100K (her ½) + $400K (his stepped-up half at FMV) = $500K is AB and so if sell house SS has a Realized Gain = (800-500) = $300K.  Husband and Wife buy property in 1980 for $200K; AB = $200K together ($100K/each). Property is held as Community Property. Property increases to $800K. Husband dies & wills his part to the spouse. What is her basis? $400K (husband‟s ½) + $400K (wife‟s ½ = FMV at time of death [look at §1014(b)(6)]) = $800K [BOTH HALVES GET STEPPED-UP  CODE PRETENDS THAT FOR CP, W/ RESPECT TO SS‟S ½ SHARE, THAT SS GOT IT AT HUSBAND‟S DEATH] SO when she sells it for $800k, she has no gain.  F. Amount Realized (AR): when you sell property 1. GR § 1001: AR = $ Received + FMV of any Property (other than money) Received a. The entire amount of a realized gain or loss is required to be recognized, unless a specific provision provides otherwise. 2. Services rendered in exchange for cash: a. AR = FMV of the „money’s worth’ of the services. 3. Property is purchased or sold subject to or assuming a mortgage? a. AB: always your cost/purchase price. b. Seller‟s Equity in home = FMV – Loans c. Mortgage Terms i. Recourse vs. Non-recourse Loans (a) Recourse (personally liable on house) or (b) Non-recourse (the lender can take the house back but, cannot come after you personally) Assuming vs. Taking Subject to the Loan (a) Assume Loan: Buyer becomes liable on the loan (b) Take subject to the loan: Original borrower still on the loan and lender thinks original buyer is the owner. Although not taking personal liability, since the property is still security on the loan, the buyer must continue to pay down the lown. (c) Does not matter for tax purposes.  Buyer will pay equity only, not the full FMV b/c they have to pay the loan. d. AB/AR i. Buyer’s AB = Cash + Loan Amount (a) When purchasing property, no matter how you pay for it (cash and / or mortgage), that amount is the AB. ii. Seller’s AR = $ Received + any liabilities = Sale Price (a) If property is encumbered by a liability and the buyer either assumes the liability or takes the property subject to the liability, the amount of the liability is included in the seller's AR (Crane). (i) [Reg. §1.1001-2:(a)(2)] Discharge of Indebtedness: The amount on a sale or other disposition of property that secures a recourse liability does not include amounts that are (or would be realized and recognized) income from the discharge of indebtedness. ii. (b) Upside Down = Purchase when the FMV of the property is less than the mortgage (negative equity situation). AR will still be the full amount of mortgage b/c buyer is still assuming or taking subject to the liability. (i) If someone purchases property and takes subject to a loan, that entire loan is part of the amount realized even if it exceeds the FMV. (Tufts). G. Part Sale – Part Gift [treated as a sale at a bargain-price] 1. Hypo: Gift me a watch worth $1k  then no income b/c AR by gift is not income. DE‟s basis is a carry-over basis. But if sell for $200, then part sale and part gift. 2. Red Flag: property being transferred for less than FMV. 3. Transferor [Reg. §1.1001-1(e)] a. Transferor has Gain if Consideration Paid by transferee is more than transferor‟s Adjusted Basis: Gain when AR  AB b. No loss can be sustained c. Gift Amount = FMV – Consideration Paid (AR) 4. Transferee [Reg. §1.1015-4(a)] a. GR: Transferee‟s basis is the greater of the Consideration Paid or the TR‟s Carry-Over basis [AB] b. Factor in any gift-tax-paid adjustment, if applicable Exa mple s Tran sfero r give s watc h wort h $100 0 to trans feree in exch ange for $300 . Tran sfero r paid $200 for the watc h.  T r a n s f e r o r ‟ s G a i n = $ 3 0 0 ( A R ) $ 2 0 0 ( A B ) = $ 1 0 0  T R ‟ s g i f t = $ 1 0 0 0 3 0 0 = $ 7 0 0  T r a n s f e r e e ‟ s A B = $ 3 0 0 Tran sfero r give s watc h wort h $100 0 to trans feree in exch ange for $300 . Tran sfero r paid $400 for the watc h.  T r a n s f e r o r h a s n o g a i n  T r a n s f e r e e ‟ s A B = $ 4 0 0 Mom bought property for 100k (AB = 20 cash and 80 loan= 100). FMV increased to 300k and she took out a 2nd loan on the equity for 100k. Total loan is 180k. Mom gives property to son subject to the mortgage.  Value of Gift = $120 in Seller‟s equity  What is the son‟s basis on Sale and Mom‟s AR? Since loans go with the property, Mom receives the elimination of her Loan amount. This amount is deemed to be the amount son paid as consideration to mom = 180k (the value of the loan) = AR.  Mom‟s Gain: 180K (AR) – 100K (AB) = 80K Gain. Son‟s AB (treated like a sale) = 180k (what he paid: he took subject to the loan). Mortgagor gives property to spouse = no gain or loss recognized under §1041, and spouse gets transferor‟s carryover basis  Husband gets carry-over basis of $100k. Paying off mortgage has no effect. Mortgagor‟s AB of land if the 100k mortgage is used to improve the land?  AB is affected because improvements adjust AB upward. Increase in basis for capital improvements.  New AB = 200k. (original AB = 100 + loan used to improve = 100 = 200 new AB) Mortgagor‟s AB if the 100k was used to purchase stock?  Borrowed money wasn‟t used for the house, so no affect to the AB. AB = 100k (initial cost paid for the land). V. Exclusions for Life Insurance Proceeds payable by reason of death A. GR: §101(a)(1) 1. If you are the beneficiary of a LIP, it is a clear net accession to wealth to you. 2. GR: GI does not include amounts received under a LIP, if such amounts are paid by reason of the death of the insured. a. No limit to amount or relationship. 3. §101(c): Interest  Any amounts made as interest, from insurance proceeds, will be included in GI b/c only the face value of the policy is excluded. B. Exception to the GR: § 101(a)(2): Transfer for Valuable Consideration 1. Exception to the GR: [Reg. §1.101-1(a)(2)] If you buy the LIP from another and pay valuable consideration and collect the proceeds of insurance plan, you can exclude only the consideration paid and any later premium payments you make after purchasing the policy. 2. Exceptions to the Exception: When whole amount is excluded [IRC §101(a)(2)(A)] Carry-Over Basis Exception If the Transferee has a carry-over basis, then the exception to the exception of the GR applies and TE gets to exclude the whole amount, not merely the consideration paid. (a) Eg. Transfer between husband & wife - whole amount can be excluded. § 1041 says TE basis is a carry-over basis and no gain or loss is recognized for the TR. Since TE uses a carry-over basis, then the whole amount can be excluded. (b) E.g.: Insured sells the policy to her Kid for its 60k FMV and on insured‟s death, the 100k proceeds are paid to Kid. Since no carry-over basis, the Kid can only exclude 60k, the amount paid (40k is income to kid). Mom‟s AR  60k. AB= 40k (what she paid); Mom‟s gain = 60k-40k=20k gain. ii. In a part-gift, part-sale situation, this exception to the exception to the GR only applies when the carry-over basis is greater than the consideration paid. (a) If the consideration > carry-over basis then only the consideration can be excluded, not the whole thing. Plus any premium pmts made. b. § 101(a)(2)(B): Transfer to a SH: The full exclusion of 101(a) applies if such transfer is to a Shareholder. i. If such transfer is to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a SH or officer. ii. Transfer of policy from shareholder to corporation – the corporation can exclude the total amount of the policy and not merely the consideration paid. C. § 101(d): Payments of life-insurance proceeds at a date later than death 1. GR: These payments are excluded from GI. 2. Example: Rather than receiving the full $100k value today, you accept pmts of $25k over 10 years. Only $100k can be excluded. So, each year $10k can be excluded and the additional $15k will be treated as interest income. This prorating continues even if you live past your 10 year life expectancy. But if you die early, like after 1 year, you lose any additional exclusions left on the table, the $75k. D. § 101(g): If you sell early it will still be treated as by reason of death if: 1. Amount received under life insurance is on the life of a terminally or chronically ill individual where death is imminent. a. i. VI. Income from Discharge of Indebtedness (and possible exclusion of discharged debt from GI) A. Hypo: If have a debt b/c someone loaned you money, it is not income b/c no net accession to wealth. But if part of that debt is discharged and you are relieved of your liability to repay then income is realized. Taxpayer will try and argue that it was a gratuitous/gift discharge and that the debt was forgiven out of detached and disinterested generosity b/c gifts are excluded from GI. But if not a gift then it is income. B. GR: § 61(a)(12): a taxpayer has recognized income if a loan owed to another is cancelled, in whole or in part. And § 108: GI includes income from the discharge of indebtedness. C. Contested Liability Doctrine [must have a liquidated debt that you know the value of] 1. GR: If a taxpayer, in good faith, disputes the amount of a debt, and then settles on the amount of debt, it is only if part or all of that new settlement amount of the debt is discharged, does the taxpayer recognize income. When you have a disputed debt, then it is unliquidated and in order to have GI, debts must be liquidated (uncontested). a. There has to be a true disagreement on amount of debt (i.e. legality of debt). D. Exception to the GR Including Income from Discharge of Indebtedness 1. § 108(a): GI does not include any amount which would be includible in GI by reason of the discharge of the indebtedness if: a. The debt is discharged in bankruptcy [Title 11]; b. The discharge of the debt occurs when the taxpayer is insolvent (FMV of assets < Liabilities). i. §108(a)(3): The amount excluded by reason of insolvency is limited to the amount of the insolvency. If insolvent by $30k, and debt discharged is $40k…then only can exclude from GI $30k, so $10k is still income from discharge of indebtedness. E. Cross-Over Questions: Owe K $10k 1. S paid w/ a painting worth $8k which you paid $5k for: a. $2k income to S from discharge of indebtedness. b. $3k realized gain to S b/c AB-AR of 5-2=3. (Ask is it recognized?). c. Total income = 3+2=5k 2. S paid w/ Services worth $10k a. The debt has been paid in full, but the $10k is income to S b/c compensation for services rendered is a realized gain. 3. S paid with Services worth $8k. a. 2k is taxable income to S from discharge of indebtedness. b. 8k is income to S b/c he was paid for services rendered. 4. S‟s employer pays K $7k and K forgives $3k of debt. a. $3k is income to S for discharge of indebtedness. b. $7k is income to S b/c it was an indirect benefit (you had to pay) from ER (not a gift). F. Recourse/Non-recourse loans and discharge of indebtedness 1. AB of 100k and 180k loans and FMV 170k: Bank discharges Debt a. Recourse Loan: Since seller would have been liable for the $10k, that 10k is income from discharge of indebtedness. Also, seller had a gain on the sale of property (170-100) of 70k. Total gain of 80k. b. Non-recourse loan: Bank is taking the property with the loans, so the AR is 180k, meaning seller has income from the sale of property of 80k and no income from the discharge of indebtedness. VII. Receipt of Damages and Related Receipts A. Concept: Taxpayer has incurred an injury & we are going to give her a break and not tax her on what she receives in damages. 1. Parts of compensation: lost wages/business profits, pain/suffering, actual damages. Although wages would have been income, IRS has lost the fight. All are excludable. B. § 104: Compensation for injuries or sickness 1. GI does NOT include; a. § 104(a)(2): amounts of damages (other than punitive) received (by suit or agreement or settlement) for personal physical injuries or physical sickness; i. Emotional distress is not treated as a physical injury or physical sickness (a) If the basis for the injury is NIED/IIED (emotional), it is not a physical injury, so any recovery counts as gross income (b) If the basis for the c/a is physical, then the emotional distress resulting is excludable. But if witness physical injury and suffer emotional distress, any award is not excludable except those allotted for specific medical expenses. ii. LIBEL, defamation, SLANDER not physical either. 2. Tax advice: when filing lawsuit, emotional distress from the c/a list. 3. Damage must be tort-like (sexual harassment – nor tort-like). 4. Interest: When taxpayer receives the PV of an award for a personal injury in a lump sum and invests it, any interest earned on the amount invested is taxable. C. § 104(c): Punitive damages are NOT excludable from Gross Income. 1. Exception: a. They are awarded in a wrongful death action and, b. If there is a long-standing state statute, which only provides for punitive damages. D. Hypo: Win case and get awarded $1m, but $400k is for atty fees. What is income, the full 1m or just the net amount of 600k. Supreme Court says the full 1m is income.. 1. This is only for non-physical suits b/c otherwise the whole 1m would be excludable.