Timing

Question 1

Why might a taxpayer/government care when income is recognized?

Answer 1

1. Time value of money

2. Tax rates fluctuate b/c a. laws change and b. you may change brackets.

Question 2

What happened in Helvering v. Bruun? How do we reconcile it with Macomber?

Answer 2

The landlord realized the gain when the lease expired, not when he sold the land. That’s when he was theoretically better off: could lease it for more (even though the realities of 1933 made this a little hollow). Macomber is limited to its facts; no one really likes it.

The landlord leased out land and a building on it for a 99-year term. The tenant removed the existing building and erected a new one. The lease was terminated due to the tenant’s default, and it was determined that, as of the cancellation date, the fair market value of the new building exceeded that of the old one by more than $ 50,000. The Commissioner determined that this amount represented realization of a gain subject to income tax in the year of the lease cancellation. This determination was reversed by the Board of Tax Appeals, whose judgment was affirmed by the court of appeals. The Supreme Court reversed, rejecting the landlord’s contention that the new building was an improvement that became indistinguishably blended with the realty and therefore no gain could be realized until the realty was sold. Rather, the court held that realization of a gain did not have to be in cash derived from the sale of an asset but rather could include profit realized from the completion of a transaction. Here, as the result of a business transaction, the landlord received back his land with a building on it that increased its value, and gain was thus realized.

Question 3

What are some reasons we wait until sale for recognition (for cash method taxpayers)?

Answer 3

1. Liquidity - may not have the cash to pay the tax liability
2. Valuation issue - not a problem for stock, but for a house it’s harder
3. Open transaction - the transaction is ongoing, want to be able to control when you have losses and gains, because some years you might have more or less income

Question 4

Irene purchased a house for $100K. She pays for the house in cash. The first 5 years, it appreciates in value. The next 5 years, it depreciates in value. Did a realization event occur in any of these years?

In year 12, when the house is worth $120K, Irene borrows $120K from the bank on a nonrecourse basis (using her house as security for the debt). Has there been a realization event in year 12?

Answer 4

No

Yes, it is realized all that year (but Woodsom says different)

Question 5

What is section 109 and its relation to Bruun?

Answer 5

109: Gross income does not include income (other than rent) derived by a lessor or real property on the termination of a lease, representing the value or such property attributable to buildings erected or other improvements made by the lessee.

109 voids Bruun, because the improvements made by the lessee would not be income, unless those improvements constituted rent.

Question 6

Ivan own Google stock, which he purchased for $50. It is now worth $100. Ivan swaps it for a $100 painting. Is there realized gain? If so, how much? See 1001(a) and Treas. Reg. 1.1001-1(a).

Answer 6

Yes, since 1001(a) infers (with help from 1000-1a - on pg. 621) that it differs materially in kind or extent, then gain is recognized. A painting is materially different from stock. So, the gain is $50.

Question 7

What happened in Woodsom? When would the taxpayer get taxed then?

Answer 7

Taxpayer bought house for 300k, years passed, she then took out a nonrecourse loan for 400k. The income from that loan was deemed not to be taxable. She would be taxed when she defaults, on the gain of 1k.

Question 8

In nonrecourse loans, what would the taxpayer do if the value of the property goes up past loan amount? goes down?

Answer 8

pay the loan

give up the house

Question 9

What are some problems with the realization doctrine?

Answer 9

1. Horizontal equity - wages taxed, but property increase isn’t
2. Vertical equity - richer taxpayers have more capital assets, taking advantage of the realization requirement
3. Efficiency - taxpayer distortion; bias towards holding assets that can take advantage of realization requirement
4. Administrability - have to police border between realization and not

Question 10

What happened in Cottage Savings Association v. Commissioner?

Answer 10

Petitioner exchanged participation interests in various mortgages with another lender pursuant to Federal Home Loan Bank Board Memorandum R-49 in order to realize tax-deductible losses sustained as a result of holding long-term, low-interest loans when interest rates surged. The IRS disallowed these deductions. Although the tax court allowed them, the appellate court reversed. On certiorari, the court held that because the mortgages had different mortgagors, and because they were secured by different properties, the loans were materially different with legally distinct entitlements. Thus petitioner was realized a loss under 26 U.S.C.S. § 1001(a) as a result of the exchange of participation interests. Since the transaction was completed and bona fide, the court held that the loss was actually sustained for the purposes of 26 U.S.C.S. § 165(a). Thus, the court reversed the order of the appellate court, and remanded the case.

Question 11

What is the take-away from Cottage Savings?

Answer 11

In the middle of the two extreme cases of like kind and very different in kind.

As long as the items exchanged have legally distinct entitlements, they are materially different, and so trigger realization (in this case a loss).

Question 12

What was the “alternative rule” to that in Woodsom?

Answer 12

That you should realize the gain when the nonrecourse loan is taken out.

Question 13

Why is CODI different from gain from a property sale? What section is important in this answer?

Answer 13

1. CODI is ordinary income, not capital

2. Some CODI is excludable, under 108

Question 14

What was Eisner v. Macomber about?

Answer 14

They had stock that they split up; realization did not occur because not net better off.

Plaintiff stockholder received certificates for additional shares issued by the corporation as stock dividends. Defendant United States treated those shares as income, and plaintiff paid a tax under protest on the same. The Court held that by treating the dividends as income, defendant failed to appraise correctly the force of the term “income” as used in U.S. Const. amend. XVI, as the mere issue of a stock dividend made plaintiff no richer than before.

Question 15

T trades in a light truck used in her business for a heavy truck to be used for the same purpose. The old light truck is worth $150 and has an adjusted basis to T of $100. The new heavy truck is worth $400. To even up the exchange, T also gives cash worth $250. What are the tax consequences of the exchange to T? What is her basis for the new truck?

Answer 15

Split up into two transactions:

T gives 250 in cash for 250 of truck - no tax
T gives truck for 150 of truck - $50 of realized gain, but it’s not recognized because it’s under 1031(a) because it’s for same purpose which is ITB, and basis is the original 100 plus the 250 spent, so 350 of basis for later.

So basis is old basis + cash spent + gain recognized - loss recognized (but since there will never be gain or loss in these situations, these last two don’t exist).

Question 16

What situations are there exchanges of items that are not materially different?

Answer 16

Exchange of same type of stock (same companies)

Exchange of 200 bushels of hay, but not specified which one

Question 17

What is the difference between the sources of law in recognition and realization?

Answer 17

the recognition rules are statutory and the realization rules are case law

Question 18

What are all the realization cases? (4)

Answer 18

1. Eisner v. Macomber
2. Helvering v. Bruun
3. Cottage Savings v. Commissioner
4. Woodsom

Question 19

What about the cotton dealers and car dealers hypos? Were there legally distinct entitlements?

Answer 19

Yes, there were different owners, and there were specific things being exchanged, and it wasn’t stock for the same company

Question 20

What are some arguments for the nonrecognition rules?

Answer 20

(a) Liquidity: Gain should not be recognized if the transaction does not generate cash with which to pay the tax.
(b) Valuation: Gain or loss should not be recognized if the transaction is one in which the gain or loss is or might be difficult to measure - that is, in which there is or might be a serious problem of valuation.
(c) Fairness: Gain or loss should not be recognized if the nature of the taxpayer’s investment does not significantly change (as does in people just holding on to investments).
(d) Efficiency: Gain should not be recognized in order to avoid discouraging mobility of capital (that is, the movement of investments from less valuable to more valuable uses). “Capital lock in effect”

Question 21

How does section 1031 work? What does the property exchanged have to be? (4) What happens to the boot?

Answer 21

Everything that is exchanged has to:

1. Either be an investment or used for trade/business
2. The two properties are of like-kind (all real estate is like kind, but not all other property is like kind; no personal property is like kind to real estate)
3. Neither property is stock
4. Neither property is cash (immediately or within the 45-180 day 1031(a)(3) exception)

When there is boot, 1031(a) doesn’t apply, but 1031(b) does apply, and the lesser of the realized gain and boot becomes the recognized gain.

Question 22

Are any real estate for real estate exchanges not recognized under 1031?

Answer 22

Yes, all investment or trade/business real estate exchanges are not recognized, but you can’t trade non-investment or non-business/trade real estate without recognizing.

Question 23

T trades in a light truck used in her business for a heavy truck to be used for the same purpose. The old light truck is worth $150 and has an adjusted basis to T of $100. The new heavy truck is worth $400. To even up the exchange, T also gives cash worth $250. X, the other party to the exchange in the preceding problem, has an adjusted basis of $50 for the truck transferred to T in the exchange. What are the tax consequences of the exchange to X? What’s X’s basis in the light truck going forward? What if the basis for the heavy truck were $500?

Answer 23

Realization event, because they have distinct legal entitlements. Because not sole kind, then 1031(a) doesn’t apply, so look to 1031(b). The amount realized is 250 in cash + 150 = 400. The basis was 50. So realized gain is 350. Lesser of the boot and the realized gain is the recognized gain. 250 is the lesser, so 250 is the recognized gain.

Basis is old basis - cash received + gain recognized - lost recognized.

50 - 250 + 250 (see above) - 0 = 50.

Loss would be 100 (400 - 500), but you can’t recognize the loss (it’s an asymmetrical rule - 1031(b))

Question 24

T is anxious to exchange his farm worth $75 for an apartment building of similar value owned by Y. T seeks nonrecognition treatment under § 1031. Y is interested in selling his property, but only for cash. X wants to purchase T’s property for cash, but T would prefer an exchange with Y.

a. Since no one can figure out a better way to do it, T sells his farm to X for cash, and then uses the proceeds to purchase Y’s property. What tax consequences?
b. As T’s counsel, what alternative sequence of transactions might you suggest to accommodate all the parties involved, while providing T with a more favorable tax result?
c. T exchanges his property for X’s promise to deliver an apartment building acceptable to T within one year. If X is unable to locate an acceptable property within the one year period, X will pay T $75 plus interest from the date of the original exchange. What tax consequences?
d. Suppose T wishes to acquire a specific apartment building before T finds someone interested in acquiring his farm. Would a § 1031 transaction be feasible under these circumstances?

Answer 24

a. X recognizes any gain or loss he has, and then has that amount in basis.

b.
1: T swaps properties with Y (doesn’t want farm), who then sells it to X for cash.
2: Have X buy the Y’s apartment, then swap the apartment for the farm.
In both options, X has farm, Y has cash, and T has apartment.
For T: 1031, since like-kind exchanging.
For Y: not 1031, but he will recognize same gain later anyway.

c. Then he’ll recognize any gain or loss at that point. Or if X finds a property within 45 days, and gives up within 180 days, then no recognition (1031(a)(3))
d. Sure, under 1031(a)(3), same as above

Question 25

Why are stocks and cash not under 1031? i.e. Why do exchanges of these result in recognition of gains (if there is realization)?

Answer 25

Because people would just keep exchanging stock without every being taxed.

Question 26

Long ago A bought shares of stock of Texaco for $10,000. He swaps them
for shares of stock of Exxon worth $60,000. Is the swap a taxable event?

Answer 26

Yes, it’s a realization even because of legally distinct entitlements, and 1031 doesn’t apply b/c it’s stock, so there is a taxable event.

Question 27

Long ago Bbought X Farm for $10,000 and has held it as an investment. He swaps X Farm for Y Farm, worth $60,000. Is the swap a taxable event?

Answer 27

No, there is realization, but 1031 is satisfied: ITB Real estate for ITB Real estate.

Question 28

Long ago C bought M Farm for $10,000 and has held it as an investment. She sells it for $60,000 and uses the proceeds to buy N Farm the next week. Is the sale a taxable event?

Answer 28

Yes, there can’t do cash, has to be an exchange for property.

Question 29

Long ago D bought S Farm for $10,000 and has used it in his farming business. He swaps it for a fleet of tractors worth $60,000 that he will also use in his farming business. Is the sale a taxable event?

Answer 29

Yes, can’t exchange real estate for personal property; never like kind.

Question 30

What the three things that can change an exchangor’s basis in 1031 transactions? Do each of these decrease or increase basis? What section of 1031?

Answer 30

1. Receiving cash - which decreases basis
2. Recognizes gain - which increases basis
3. Recognizes loss - which decreases basis

old basis - cash received + gain recognized - loss recognized

1031(d)

Question 31

Why is 1031(b) a lesser of rule?

Answer 31

Sometimes, there will be no realized gain even though there is an amount realized, for example when the amount realized is the same as the basis. So we don’t want there to be recognized gain when there is no realized gain. And on the flipside, we want to encourage people to make these kind of exchanges (with boot).

Question 32

What happens to the basis in like-kind exchanges of 1031?

Answer 32

Generally, there will be a “substituted” basis (see § 7701 (a)(42)) that is, the basis for the property received will be the same as the basis of the property relinquished.

Question 33

What happened in US v. Davis?

Answer 33

Pursuant to a separation agreement, petitioner taxpayer transferred one-half of his stock in a company to his ex-wife and orally agreed to pay her attorney for services concerning tax matters. The court of claims determined there was taxable gain on the transfer, but the gain realized could not be calculated because of the impossibility of evaluating the fair market value of the wife’s marital rights. The court of claims also concluded the fees paid by petitioner taxpayer to the ex-wife’s attorney were not deductible. On certiorari review, the United States Supreme Court concluded that petitioner taxpayer did have a taxable gain on the transfer, and its value was based upon the value of the stock on the date he transferred it to his former wife. The Court also agreed that the former wife’s attorney fees were not deductible because the attorney’s advice was directed to the former wife’s tax situation, not petitioner taxpayer.

Question 34

What about transfers incident to marriage and divorce? What section is this? What happens to the basis?

Answer 34

They are not recognized, under section 1041. Transferee gets the transferor’s basis.

Question 35

Is there a difference between alimony and 1041 payments?

Answer 35

Yes, alimony is under section 71 and is recognized; cash transfers setup by a divorce instrument are alimony. Alimony is deductible by the payor and included in the income of the payee; other transfers incident to divorce are not deductible by the payor or included in the income of the payee.

Question 36

Henry and Wilma, when they were married, jointly owned a house with a fair market value of $400,000 and a basis of $100,000. Pursuant to their recent divorce, Henry took title to the house and executed a promissory note for $200,000 payable to Wilma and secured by the house.

(a) What amount of gain, if any, is recognized by Wilma? What is Wilma’s basis for the note?
(b) What is Henry’s basis for the house?
(c) What would your answer to the above questions be in the absence of § 1041?

Answer 36

(a) None, 50k. He owns 200k of house.
(b) None, 50k. She owns 200k of house.
(c) Henry wouldn’t recognize any. Wilma would recognize 150k. Then basis going ahead for Henry in the house would be 250 (50 from before plus 200 from note).

Question 37

What was Farid-Es-Sultaneh v. Commissioner? What are the lessons?

Answer 37

Ante-nuptial is not applicable to 1041 (because before marriage)

• Free market basis (what was paid for it) for the receipt of property (under Davis) - Princess got 800k basis in 800k stock
  
  • Whenever 1041 doesn’t apply, Davis applies

Petitioner executed a pre-nuptial agreement with her extremely wealthy, soon to be, new husband. The pre-nuptial agreement stipulated that petitioner was to receive a certain amount of shares in a corporation that was to be an ante-nuptial settlement in the event the parties divorced. Petitioner released all dower and other marital rights, including the right to her support. The parties ultimately did divorce. The Tax Commissioner determined that stocks petitioner obtained pursuant to a pre-nuptial agreement were taxable for capital gains. The Tax Court upheld that decision. Petitioner sought review. The court reversed holding that income tax provisions were not to be construed as though they were in pari materia with either the estate tax law or the gift tax statutes. Petitioner gave fair consideration in relinquishing her marital rights, which were worth far more than the stock.

Question 38

What’s the main difference between 1041 and 1031?

Answer 38

1031 cares about what the property is, not about the counterparty

1041 cares about the counterparty, but not what kind of property (unless it’s cash)

Question 39

Is the alimony deduction above or below the line?

Answer 39

above the line

Question 40

Are child support payments included?

Answer 40

No, nor are they deductible

Question 41

Max and Winifred were divorced last year. The d ivorce decree has no provision for spousal support. Max, who has never been steadily employed, has not been able to hold a j ob for several months and asks Winifred, who is a successful personal injury lawyer, to help him out. Max threatens to go to court to seek spousal support. To avoid a hassle, and out of some lingering concern for Max, Winifred agrees orally to pay him $2,000 per month as spousal support. Will Winifred be allowed a deduction for the payments? Must Max report the payments as income?

Answer 41

Not alimony, because not incident to a divorce instrument; would probably be a “property settlement,” so excludable and not deductible

Question 42

Max and Winifred were divorced last year. The d ivorce decree has no provision for spousal support. Max, who has never been steadily employed, has not been able to hold a j ob for several months and asks Winifred, who is a successful personal injury lawyer, to help him out. Max threatens to go to court to seek spousal support. To avoid a hassle, and out of some lingering concern for Max, Winifred agrees orally to pay him $2,000 per month as spousal support. Wanda has a father, Fred, who lives wi th Manuel and Wanda and is dependent on them, and that the agreement provides that if Wanda dies during the four-year period in which payments are required, the payments will be made to Fred. Moreover, during the four years, Manuel is required to pay for an insurance policy on Wanda’s life, with Fred as beneficiary. What are the tax consequences to Manuel, Wanda, and Fred?

Answer 42

Are these payments alimony, if Fred (the father of Wanda) gets the payments if Wanda dies? No, 71(b)(1)(D): No payments after the death of the spouse

How to fix it so it’s alimony? Pay her a little more, to compensate for the risk that she dies. Do it in cash, have Fred use this money to pay for the life insurance

Question 43

Suppose Mike and Wilma have a son, Carlos, who is two years old. Mike is a successful lawyer. Wilma was also a successful lawyer, but quit practice when Carlos was born, with the understanding that she would care for him until he reached age 12 and then would return to work. Mike and Wilma have decided to end their marriage and have agreed that Mike will pay Wilma $40,000 a year for ten years, but with the obligation to terminate if Carlos should die sooner. What will be the tax consequences to Mike and Wilma?

Answer 43

Not alimony according to 71(c)(2)(A) since it’s contingent upon things happening to the child. So excludable and not deductible.

Question 44

Suppose that the marriage of Nancy and John is dissolved by a judicial decree that requires that Nancy pay John spousal support (alimony) of $IO,OOO per year. When the payment becomes due in the first year” after the decree is entered, Nancy offers to transfer to John, in settlement of her obligation to pay the spousal support, shares of stock of IBM with a fair market value of $10,000 and a basis in her hands of $I,OOO. Suppose thatJohn would be legally entitled to insist on payment in cash and that no other form of payment had been contemplated at the time of the dissolution. If J ohn accepts the IBM stock in satisfaction of Nancy’s obligation, what are the tax consequences to him and to Nancy? What if the same events occur in the second year following the dissolution of the marriage? Regs. § 1.I041-1T, A-7 provides that “[al transfer of property is treated as related to the cessation of the marriage if the transfer is pursuant to a divorce or separation instrument … and the transfer occurs not more than 6 years after the dale o n which such marriage ceases.” What do John and Nancy each prefer and why?

Answer 44

No, not cash, so not in 71(a)

If not in cash, is there a gain taxable to the transferor; 1041 apply? 1041(c)(1): yes, because it’s within the first year, so no gain

If in second year, then look at 1041(c)(2), “related to the cessation of the marriage”; facts and circumstances

Does John want the gain to be recognized as alimony? No, would prefer Davis, because then would not recognize gain, would get FMV basis (10k), not Nancy’s basis; If 1041, John would take Nancy’s basis (1k).

Does Nancy want 1041 or Davis?
1041, because g = 0
Not Davis, because g = 9k

Question 45

What is OID or Original Issue Discount? What is the question it’s concerned with? What question does OID’s answer present?

Answer 45

The term for unstated interest on debt, determined at the time the debt is issued.

How to tax interest as its accrued for investments that don’t pay out for a while and have no stated interest rate? One answer could be to tax the investment in the year it’s paid out, probably at capital gain rates. The OID answer is to treat the money as interest income (ordinary income) that is allotted per year as interest.

How to allocated the interest over the period of time between issue and redemption? You could charge a flat amount every year. Or, as OID does, you could use the “constant-yield-to-maturity method” or the economic accrual method”÷

Question 46

What is the formula for OID? (it’s common sense)

Answer 46

the stated redemption price at maturity - the issue price of the debt instrument (what was paid)

Question 47

What is the formula for each OID inclusion? Under what section?

Answer 47

the yield-to-maturity * adjusted issue price

Section 1272(a)(1) and (3)

Question 48

What is the “adjusted issue price”? What section is this under?

Answer 48

the issue price of the bond + any unstated interest that has already accrued on the bond but not been paid to the bondholder.

1272(4)

Question 49

Why do we apply OID rules to cash method taxpayers?

Answer 49

Because, otherwise, on the other side of the equation with corporate taxpayers, who are accrual method tax payers, would not be able to deduct until the time of redemption. To keep it symmetrical, we have to become accrual tax payers for this kind of income.

Question 50

What is the AFR or applicable federal rate?

Answer 50

If no interest is stated on the debt instrument issued in exchange for property, the payments to be made on the debt instrument are discounted to present value using the applicable federal rate (AFR). §1274(b), which is set by the Treasury every month.

Question 51

Rohini purchased a bond from Z corporation for $500. It is a zero coupon bond that will pay her $800 in 4 years. How much interest is there in the instrument? Describe the general manner in which this interest would be taxed to Rohini. Describe the general manner in which the interest would be deductible to Z corporation.

Answer 51

300 in OID

YTM = (SRP/IP)^(1/n) - 1
= (800/500)^(1/4)-1 = (8/5)^1/4 - 1 = 12.4%

• Yr 1 = 500 = Int. 500*12.4% = 62.34
• Yr 2 = 562.34 = 562.34*12.4% = 70.4
• Yr 3 = 632.46 = … 78.86
• Yr 4 = 711.31 = … 88.69

Z would deduct interest payments as they are made, and Rohini would claim them as income

Question 52

What was Burnet v. Logan?

Answer 52

Respondent’s mother had entered into a contract in which she sold her shares to a purchaser for cash and a fraction of the annual proceeds the purchaser thereafter made from ore extracted from the mine. From her mother’s estate, respondent obtained the right to one-half of her mother’s interest in the annual proceeds of the contract. The trial court concluded that the income tax deficiencies with respect to proceeds respondent had received from the contract were proper, but the lower appellate court reversed. On certiorari review, the United States Supreme Court concluded that it was impossible to determine with certainty the market value of the agreement. Respondent had obtained the right to share in the indefinite proceeds of a contract. The Court explained that in order to determine gain or loss, and the amount of gain, if any, it had to withdraw from gross proceeds an amount sufficient to restore the capital value that existed at the commencement of the period under consideration. Respondent could not deduct from gross receipts a supposed loss represented by an outstanding note. Conversely, a promise to pay indeterminate sums of money was not necessarily taxable income.

Question 53

What doctrine does Burnet v. Logan stand for? What does that doctrine say? What “approach” does it use?

Answer 53

Burnet v. Logan is said to stand for the “open transaction” concept or doctrine - the notion that where the total value of the consideration to be received by a tax payer is sufficiently uncertain (not “equivalent to cash” because of “no ascertainable fair market value”) gain is not recognized until the payments actually received exceed basis. In other words, she was allowed to use the “basis first” rule.

Question 54

What is the “closed transaction” approach?

Answer 54

To determine the present value of the expected payments and treat this sum as if it were cash received on the date of the sale. Gain or loss is then determined by comparing this amount with basis.

Question 55

What is the “installment method” approach?

Answer 55

To use an open transaction approach but to allocate some portion of basis to each expected payment received, so that some portion of the gain or loss is recognized as each payment is received.

Question 56

What is the formula for Yield to Maturity?

Answer 56

YTM = (SRP/IP)^(1/n) - 1

e.g., (121/100)^(1/2) - 1 = 1.1 - 1 = .1 = 10%

Question 57

Is OID taxed like capital income or ordinary income?

Answer 57

ordinary income, because it’s just interest income

Question 58

What section deals with the installment method?

Answer 58

Section 453

Question 59

What is an installment sale?

Answer 59

a disposition of property where at least 1 payment is to be received after the close of the taxable year in which the disposition occurs.

Question 60

What is the principal congressional objective in allowing the installment method?

Answer 60

to provide relief from the harshness of an obligation to pay taxes when the taxpayer has not received cash with which to pay those taxes

Question 61

What is the basic approach of the installment method?

Answer 61

First, the rules relating to unstated interest (§483) or OID (original issue discount) are applied. The installment method applies to what remains.

Question 62

What is the ratio we use to determine what amount of each payment should be the gain recognized in that payment?

Note: 1-(this ratio) = basis used for each payment

Answer 62

Ratio = Gain/AR

Question 63

What is the important exception to the installment method? What section is this under?

Answer 63

453(f)(4): Basically, you have to recognize gain immediately if the property involved is readily tradeable.

This is because installment method is for easing the burden of having to pay taxes without money from the thing you’re paying taxes on. Here you can get the money.

Question 64

Susie has a 100k basis in Blackacre. She sells Blackacre in exchange for a note (which is not readily tradable) that will pay her $1 million at the end of 10 years. The applicable federal rate is 10% compounded annually. Describe the tax consequences of this transaction.

Answer 64

The first thing that has to be figured out is the issue price (the present value of the 1 million). Can do this with present/future value formula or YTM formula.

FV = PV(1+r)^n
1mil = PV*(1+.1)^10
PV = 1mil/1.1^10 

YTM = (SRP/IP)^(1/n) - 1
.1 = (1^6/IP)^(1/10) - 1
1.1^10 = 1mil/IP
1mil/(1.1^10) = 1mil/2.5937424601 = 385,523.268
= 386k says Oh

Split into two pieces:

1. property from Susie for 386k to Susie
2. 386k from Susie for 1 million in 10 years to Susie

1.
gain = 386k - 100k = 286k, which is taxed in the year of payment (year 10)

2. 614k of OID, which she recognizes over 10 years, at 10%

So year one = 38,600 (386k+38,600)
year two = .1*(386k+38,600) = ?
etc. etc.

Question 65

Why is the installment sale method good for taxpayers as opposed to closed transaction? (2)

Answer 65

1. TMV - more taxes sooner
2. Pay more in one year might bump you into a higher tax bracket, meaning you pay more taxes overall than you would if you had spread it out

Question 66

What do the treasury regulations say about when income is constructively received?

Answer 66

“Income although not actually reduced to a taxpayer’s possession is constructively received by him in the taxable year during which it is credited to his account, set
apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given.” Treas. Reg. § 1.451-2(a).

Amounts to which the taxpayer has a legal claim

Question 67

What was Amend v. Commissioner? What’s the take-away?

Answer 67

If the contract is a bonafide arm’s-length transaction, constructive receipt can be contracted around.

The farmer entered into a contract to sell his wheat to a purchaser in August 1944, but was not paid until January 1945. The farmer used the cash basis method of accounting and paid tax on the payment from the purchaser as part of his gross income in 1945, the year that he actually received it. The commissioner determined that the farmer had the unqualified right to receive his money for the wheat in 1944; that all he had to do to receive his money was to ask for it; and that, therefore, the doctrine of constructive receipt applied. The court held that the contract between the farmer and the purchaser was a bona fide arm’s-length transaction and that the farmer did not have the right to demand the money for his wheat until January 1945; therefore the doctrine of constructive receipt did not apply. The farmer returned as a part of his gross income the checks which he actually received in payment for his wheat and complied with the income tax laws governing a taxpayer who keeps his accounts and makes his returns on the cash basis.

Question 68

What was Pulsifer v. Commissioner?

Answer 68

Defines “economic benefit doctrine”: Under the economic-benefit theory, an individual on the cash receipts and disbursements method of accounting is currently taxable on the economic and financial benefit derived from the absolute right to income in the form of a fund which has been irrevocably set aside for him in trust and is beyond the reach of the payor’s [creditors].

In 1969, the three minors were partial winners, along with their father, of an Irish sweepstake. Pursuant to Irish law, the minors’ winnings were to be held in trust until the three minors reached 21 or until an application on their behalf was made by an appropriate party to the Irish court for release of the funds. The court affirmed the commissioner’s determination that the minors’ winnings were taxable as income in 1969. The three minors had had an absolute, nonforfeitable right to their winnings on deposit with the Irish court. The money had been irrevocably set aside for their sole benefit. All that was needed to receive the money was for their legal representative to apply for the funds, which he forthwith did.

Question 69

An employer puts money in a bank account for Riley in Year 1, but the money cannot be withdrawn until Year 2. Does Riley have income in Year 1?

Answer 69

Under constructive receipt doctrine: no; no legal right to it in year 1
Under economic benefit doctrine: yes

Question 70

What question does the economic benefit doctrine ask?

Answer 70

have the funds been put aside? Do the payee’s creditors have any right to the amount set aside?
Only time stands between you and the money

EB requires you to take on a certain amount of risk to take a deferral. If you don’t take risk, then EB applies, and income is realized.

Question 71

Leila signs a contract with an employer in Year 1, which is notarized. In this contract, the employer promises to pay Leila for her Year 1 services on Jan. 1 of Year 2. Leila is a cash-basis taxpayer. Does she have income in Year 1?

Answer 71

Constructive receipt doctrine: No, no legal right until year 2
Economic benefit doctrine: No, time isn’t the only thing between Leila and the money. Someone might become insolvent. Money hasn’t been “put away.”

So, includes in income when she receives it (year 2).

Question 72

What was Minor v. US?

Answer 72

Constructive receipt? No answer
Economic benefit? No: so no realization

Plaintiff participated in a voluntary plan wherein he was paid a designated percentage of the ordinary fee with the balance going into a deferred compensation fund. When he only included the small percentage actually received on his federal income tax returns as gross income, the Internal Revenue Service determined that the entire amount was includible in plaintiff’s gross income because an economic benefit had been conferred. At trial, plaintiff successfully contended that plan participants had no right, title, or interest in the trust agreement or any asset held by the trust, and that his right to receive payments in the future was contingent and did not vest any interest in him. On appeal, the court concluded that the plan was unfunded, unsecured, and subject to risk of forfeiture. Therefore, plaintiff’s benefits were not property under 26 U.S.C.S. § 83 and 26 C.F.R. § 1.83-3.

Question 73

Why do divorced couples work together on alimony?

Answer 73

Because if one is in a higher tax bracket than the other, then alimony can be a preferred way to give money. Essentially, you give more money for less.

Question 74

What is the accrual method of accounting?

Answer 74

Income is included as it’s earned.

Question 75

What is the constructive receipt doctrine?

Answer 75

If you have legal right to the money; you’re the only thing standing in the way. Amend says: you can contract out of it. Not going to look to what you could have contracted for.

If you can get the money now, then we’re going to tax you on it.

Question 76

Why is deferral using economic benefit not a problem in the employer-employee context? When is it a problem?

Answer 76

404(a)(5): employer can’t take deduction unless employee takes the amount into income

IRS will indifferent when they are in the same tax bracket

IRS will care when the employee is in a higher bracket, e.g., with a nonprofit. Nonprofit doesn’t care when it gets a deduction; tries to defer employees’ tax liability and be able to pay them marginally less.

Question 77

Suppose you represent a superstar college football player who was selected first in the National Football League dra ft, by a newly established team (an “expansion” team). The team has offered to pay your client a signing bonus of $1 million , payable at the end of five years. This is in addition to salary and performance bonuses and is no t contingent on any aspect of performance other than signing the contract. You are satisfied with the amount of the signing bonus, but are concerned about the financial ability of the team to continue to pay the $1 million at the end of the five years, since it will presumably operate at a loss for at least five years and the losses may turn out to be greater than expected. The team is operated as a corporation. All the shares of stock of the corporation are held by a real estate tycoon who is active in management of the team and who is extremely anxious that your client sign. Your client is anxious not to pay tax on money that he has not received and wants to avoid any substa ntia l risk of not being paid. What is your advice about each of the following possible ways of structuring the deal?

(a) The corporation buys an annuity policy from an insurance company. The policy names the player as the annuitant and provides for payment of $1 million to the player at the end of five years. The corporation pays $600,000 for the policy. It is nonassignable and the payment cannot be accelerated.
(b) The corporation contributes $600,000 to a trust. The trustee is directed to invest the $600,000 in U.S. Treasury bonds. The interest that will be earned on these bonds (and on the interest received) over the next five years will total $400,000. The trustee is directed at the end of the five years to pay the $1 million to the player. The corporation retains no interest in the trust.
(c) The facts are the same as in (b) except that at the end of the five years the $1 million is to be paid to the corporation to provide funds that it can use to meet its own contractual obligation to the player.
(d) The corporation signs an unconditional agreement to pay $1 million to the player at the end of five years. The real estate tycoon who owns all the shares of the corporation signs a guarantee of its obligation.

Answer 77

(a) CR? No, can’t get it now
EB? Yes, only time, so 600k is realized on signing

(b) CR? No
EB? Yes
Different from Minor: player is the beneficiary (not the company as in Minor, which could go out of business)

(c) CR? No
EB? No
Like Minor: paid to the corporation, so not protected from the corporation’s creditors
Realization when he receives it (in year five)

(d) CR? No
EB? No
Like Minor: could go after the tycoon
Realization when he receives it (in year five)

So football player wants (c) or (d) for tax reasons, but he might prefer (b), then (a), then (d), then (c). So, B or D? B has less risk, so probably better. If deferral really matters, then go D. EB requires you to take on a certain amount of risk to take a deferral.

Question 78

What are qualified deferral systems? What is the benefit to employees?

Answer 78

When the business takes the deduction now, but the employee takes the income later. That way, business saves money now, and can pay employee more money later, than it would otherwise.

Question 79

What are some reasons for issuing employee stock options? (2)

Answer 79

To provide compensation that will induce the recipient to agree to work for the issuing company.
Receiving a stock option may improve an employee’s incentive to see the company prosper.

Question 80

What is an employee stock option? How is it different from an ordinary option?

Answer 80

it is granted in consideration of services to the employer, with the option entitling the employee to buy a specified number of shares of the employer’s common stock at a specified price during or at the end of some defined period of time (usually two to fiver years after date of the grant).

Ordinary options are just “side bets” by shareholders and others on the movement of the corporation’s stock price. Employee stock options can lead to the issuance of new stock at a price that is favorable to the option holder, thus potentially diluting the old stock.

Question 81

Mary has a stock option to buy a share of Google stock in Year 5 for $8. Under what circumstances would she exercise her stock option in Year 5?

Answer 81

If in Year 5, the FMV of the Google stock is more than $8, then Mary would exercise the option. Otherwise, there’s no additional incentive to buy the option.

Question 82

Google is Harold’s employer. In Year 1, Google gives Harold a stock option (at no cost to Harold). The option allows Harold to buy a share of Google stock in Year 5 for $8. At the time the option is given to Harold in Year 1, Google stock is selling at $20 / share. Harold exercises the option in Year 5. At the time he exercises the option, Google stock is selling at $25 / share. Harold later sells the stock in Year 10 for $35 / share. Value of option at year one is $13. How much income is there?

What tax treatment applies in each of the following scenarios:

(1) the option is a nonstatutory stock option that does not have a readily ascertainable fair market value at grant and the stock subject to the option is transferable at the time the option is exercised?
(2) the option is an incentive stock option?

Answer 82

$27: 35-8

(1) No inclusion in year one, because -RA (no readily ascertainable FMV). If there were inclusion, 13 of OI (assumed issue price) on year one - Google gets $13 deduction, and 14 in year 10 as CI (basis is now 21 = 13 + 8; so, gain = 35-21 = 14).

If -RA, year 5, stock is property. 25-8 = 17 of OI, employer gets that deduction. And when stock is sold for 35 in year 10, has basis of 25 (17+8), so CI of 10, no deduction for business.

If RA, -T, RF, then no inclusion in year one.
If RA and (T or -RF), then inclusion in year one.
If -RA, then no inclusion in year one.

(2) Not an ISO, because issue price is less than FMV (8

Question 83

What are three options of when to tax stock options? Which is the best theoretical option?

Use this hypo: For example: Gordon is a high-level executive in the Sodor Train Corporation (STC). In Year 1, STC gives Gordon an option to buy one share of STC stock in Year 5 for an exercise price of $8. At the time of issuance, STC stock is selling for $20 per share. In Year 5, Gordon exercises the option, using it to buy for the $8 option price a share of STC stock, now selling at $25 per share. In Year 10, Gordon sells the share for $35. For convenience: worth of option in year one: $8.

Answer 83

1. Income upon receipt of the option: income of $12 (note, not $20), basis of $20 (12+8) in stock; $15 of CI in year 10 (35-20).
2. Income upon exercise of the option: 17 (25-8), with a basis of 25 (paid 8 and recognized 17); 10 of CI gain in year 10
3. Gain recognized upon sale of stock: has basis of 8, and 27 of CI gain in year 10

Not option 1: have to guess value of option; might forfeit the option before exercise; might not exercise because FMV at exercise time is lower than exercise price.
Not option 3: too taxpayer favored; get to defer paying taxes; company never gets a deduction

Since options are rarely readily ascertainable, usually option 2 happens, where OI comes in at the exercise (FMV1 - EP), and CI comes in at sale of stock (FMV2 - (OI + EP)).

Question 84

What does section 83 say? Is that income taxed at capital gain or OI rates?

Answer 84

If RA, -T, RF, then no inclusion.
If RA and (T or -RF), then inclusion.
If -RA, then no inclusion. (really hard to be RA) Instead, income when stock is bought for exercise price.

RA - readily ascertainable FMV

Under §83(a), the employee must include income from the transfer in the first year in which the transferred property vests, which means that it is either transferable or no longer subject to a substantial risk of forfeiture.

Rights in the transferred property are subject to a substantial risk of forfeiture if the person’s rights in the property are conditioned on the future performance of substantial services by the employee. §83(c)(1).

Rights in property are transferable only if the employee can transfer the property to someone else who would not be subject to a substantial risk of forfeiture (which does not generally happen if the employee is subject to a substantial risk of forfeiture). §83(c)(2).

The amount included under §83(a) is (i) the value of the transferred property at the time that it vests less (ii) the amount (if any) that the employee paid for the property.

Since the amount included is compensation for services, it is taxed at ordinary income rates, not the special capital gain rates.

Question 85

What does exercising an option mean? What is an issue price? What is an option price? What is an exercise price? What is a strike price?

Answer 85

First you buy an option, then you can choose to exercise it or not (after which you no longer have an “option”).

The issue price is the amount the stock is worth (FMV) when you get the option to exercise it after some amount of time. Sometimes one buys an option (then it’s called an option price/strike price); others are given as compensation.

The exercise price is special price for the option holder after that amount of time.

For example: Gordon is a high-level executive in the Sodor Train Corporation (STC). In Year 1, STC gives Gordon an option to buy one share of STC stock in Year 5 for an exercise price of $8. At the time of issuance, STC stock is selling for $20 per share. In Year 5, Gordon exercises the option, using it to buy for the $8 option price a share of STC stock, now selling at $25 per share. In Year 10, Gordon sells the share for $35.

Question 86

What is section 422 about? Which approach does it use of the three? What are the restrictions? (4)

Answer 86

ISO’s (Incentive stock options)

The third option: Gain recognized upon sale of stock, basis in exercise price, CI gain of sale price - basis, with no deduction for business

1. However, the employee must have held the stock for at least two years after the grant of the option (year one) and one year after receiving the stock under the option (exercise time).
2. Also, the option price (issue price) must be no less than the FMV of the stock at the time the option is granted (year one).
3. Also, the option must be granted pursuant to a plan that stockholders of the granting corporation approve after receiving information about how many shares and which employees the plan covers.
4. Also, for each individual there is a 100k ceiling on the value of the stock as yet unexercised options constituting ISO’s can cover. The value of the stock is determined as of the time the option is granted (year one).

Question 87

What are two reasons to avoid 422 ISO options?

Answer 87

1. Preserving the corporate-level deduction (companies get to deduct)
2. Discomfort with various of its requirements (e.g., need to submit for shareholder approval option arrangements with senior management)

This makes them more popular than ISO’s

Question 88

When does an accrual method taxpayer include income? According to what?

Answer 88

1. 451-1:
2. All events test: when all the events have occurred which fix the right to receive such income
3. When the amount can be determined with reasonable accuracy

Question 89

When does an accrual method taxpayer take a deduction? According to what?

Answer 89

1. 461-1(a)(2)(i):
2. All events test: when all the events have occurred which fix the right to receive such income
3. When the amount can be determined with reasonable accuracy
4. Economic performance has occurred with respect to the liability (See 461(h))

Question 90

Why do companies provide options to buy stock instead of stock? (2)

Answer 90

1. Stock is something of value regardless of performance, whereas option doesn’t have value if stock doesn’t perform
2. Don’t have a lot of cash to pay their employees

Question 91

What are the three questions to be answered in options?

Answer 91

1. When is the employee taxed?
2. When does the employer get the deduction?
3. What type of income does the employee have?

Question 92

What am I going to look at when buying an option? (5)

Answer 92

1. Volatility - more volatility, less valuable option
2. Risk free rate of return - higher the rate, more valuable option
3. Strike/Exercise price - as value of this goes down, value of option goes up
4. Exercise date - as date increases, value of option goes up (more variation in the stock; greater chance that the FMV of the stock will be above the exercise price at some point)
5. Current FMV (issue price) - higher FMV, more valuable option

Question 93

Why is there no deduction allowed for the company in ISO’s?

Answer 93

It’s not ordinary income; it’s capital gains; employers can only take deductions on ordinary income

Question 94

What was Cramer v. Commissioner?

Answer 94

It’s about there being very few times where there will be a readily ascertainable FMV for compensatory options.

But taxpayers lost, and court upheld as a reasonable interpretation of the statute.

Appellee tax commissioner assessed deficiencies and penalties against appellant taxpayers’ 1982 federal income tax payment when appellant failed to include option sale proceeds in their 1982 gross income pursuant to I.R.C. § 83. Appellant argued that the options had a readily ascertainable fair market value and that under I.R.C. § 83(b) they included the value in their gross income in the year the options were transferred to appellant, whereas appellee argued that the options did not have an ascertainable value and, as such, I.R.C. § 83(e)(3) precluded the application of § 83 until appellant’s sale of the options in 1982. The lower court upheld appellee’s decision and the court affirmed the lower court’s order. The court held that pursuant to Treas. Reg. § 1.83-7(b)(2) appellant’s options did not have a readily ascertainable fair market value at the time of transfer because the options were subject to a substantial risk of forfeiture as their exercise depended upon the original recipient remaining employed with the company, their transferability was subject to the risk, and a five-year vesting schedule rendered the options not exercisable immediately in full upon grant.

Question 95

Where do you look to see if an option has a readily ascertainable FMV?

Answer 95

Reg. § 1.83-7(b) on pg. 560

Very hard to meet, i.e., very hard to be RA

Question 96

What is the expected cost of not paying your taxes?

Answer 96

Expected cost: (Chance of getting caught (audit rate) * Cost of getting caught) + ((100-audit rate)% * Amount in tax you pay if you don’t comply - likely 0) = 600

Question 97

What was Georgia School-Book Depository, Inc. v. Commissioner?

Answer 97

All events test: satisfied; collection isn’t part of all events test
Amounts determined with reasonable accuracy: satisfied (knows what he wants to be paid)

Delay in the receipt of cash in the absence of doubt about ultimate payment is not enough to prevent accrual of income. Collectibility has nothing to do with accruability unless the obligor is insolvent.

Petitioner, which was on an accrual basis, was a book broker, acting as a depository and distributor of school books. It represented various publishers in sales made by them of school books to the State of Georgia and was paid by them a percentage commission calculated on the sale prices obtained by the publishers. The state was obligated to pay for the school books only out of a “Free Textbook Fund” created and renewed from an excise tax on beer. During the taxable years this fund was not large enough to pay in full for the books purchased by the state. Held, the commissions payable to petitioner on account of school books sold to the State of Georgia were properly accruable to it in the years in which the sales were made.

Question 98

What was AAA v. US?

Answer 98

The Supreme Court affirmed a decision of a court of claims denying an action for refund of federal income taxes because it had properly found that petitioner, a national automobile club, had failed to apply members’ prepaid dues as taxable income in the calendar year of their actual receipt. The Supreme Court found that the accounting method employed by petitioner was in accord with generally accepted commercial accounting principles and practices, but could be rejected by the Commissioner of Internal Revenue in the exercise of his discretion under 26 U.S.C.S. § 41. In particular, petitioner’s practice of accounting for expected future service expenses in advance could have been found purely artificial by the Commissioner. Furthermore, Congress had specifically authorized petitioner’s desired method of accounting only in the instance of prepaid subscription income and had refused to enlarge 26 U.S.C.S. § 455 to include prepaid membership dues.

Question 99

What is economic performance according to 461(h)? (for the purposes of accrual deductions)

Answer 99

461(h)(2)

A-B: basically when the service happens or when the property is given/received

Question 100

What are three exceptions to the accrual method rules?

Answer 100

1. Georgia Book: so long as the payor is solvent and no legal obstacles to getting the funds (time isn’t a legal obstacle), accrual taxpayer will have to include. Have to have a reasonable expectancy of nonpayment to not include. Insolvency is such a reason. Also,
2. AAA: Prepaid income for services in another year is accrued in year of prepaid income. Deductions only occur as the expenses are made according to economic performance.
   (3. Westpac Pacific Food: Cash paid in advance by a wholesaler to a retailer, in exchange for a volume commitment, is includable when volume is transferred, not after transaction.)

Question 101

Would a collection agency pay accrual method?

Answer 101

Probably not, because there is a reasonable expectancy of nonpayment, because the obligor is insolvent.

Question 102

Applying the economic performance test under § 461(h), when should AAA be able to deduct the expenses it incurs in providing customers with roadside assistance?

Answer 102

When it actually provides assistance to them, so there will be asymmetry between the income inclusions and business expense deductions.

Question 103

Imagine a newspaper business in which subscribers must pay for their annual 2012 newspaper subscription in December 2011. Under AAA, when must the newspaper include the income from such subscriptions? Under 461(h), when may the newspaper deduct the expenses associated with providing the newspapers in 2012? Is there any relief provision the newspaper can rely upon to change this result?

Answer 103

In 2011, when they receive the prepaid subscription fees

in 2012, when it actually delivers the newspapers

No, can try to structure it in a few ways

1. Like a loan/declining balance
2. Opt-out provision
3. Pro rata amount; some at beginning, some when it happens

Question 104

Teresa’s landlord makes her pay one additional month’s rent upfront, when her lease begins. If she pays all her rent over the term of the lease and keeps the premises in good order, the landlord will give the one month’s rent back to Teresa at the end of the term, with interest. When, if ever, must the landlord include this one month’s rent in income?

Answer 104

It’s like a loan, with interest, so no inclusion and deductibility

Question 105

How would AAA structure its payment to be get it’s deductions up front?

Answer 105

1. Like a loan/declining balance
2. Opt-out provision
3. Pro rata amount; some at beginning, some when it happens