Part A: What is Income? Gross Income

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Prof. Batchelder

Tax Outline

Fall 2005

Part A: What is Income?

  1. Gross Income

    1. General Rule -§61: Gross income is income from whatever source derived.

      1. §§71-90: list of what is included in income

      2. §§101-149: list of what is NOT included in income

        1. These are NOT exclusive lists

    2. Above the Line Deductions - §62: this section provides a list of things which are deducted above the line to reach Adjusted Gross Income → these items may be deducted even if taxpayer elects to take standard deduction.

      1. Items eligible for Above the line deduction are:

        1. Trade and Business Deductions §162

        2. Losses from Sale/Exchange of Property §161 and following

        3. Deductions attributable to rents/royalties

        4. Certain Deductions of life tenants/income beneficiaries

        5. Pension, profit-sharing and annuity plans of self-employed individuals

        6. Retirement savings

        7. Alimony

        8. Moving Expenses

        9. Interest on Education Loans

        10. Higher Education Expenses

        11. Health Savings Accounts

        12. Costs involving Discrimination Suits

    3. Below the Line Deductions/Standard Deduction - §63: After calculating AGI, taxpayer then subtracts either the standardized deduction or itemized deductions. This is basically the default for deductions – if not enumerated in §62, and it is a deduction, then would be a below the line deduction under §63.

      1. NOTE: for below the line deductions then need to distinguish between miscellaneous and Non-miscellaneous. (see below, discussion of the relevance under §67)

      2. Miscellaneous: anything not listed as non-miscellaneous, such as unreimbursed business expenses, and investment expenses under §212

      3. Non-Miscellaneous (§67(b): generally includes things like interest, taxes, casualty and wagering losses, charitable donations, medical expenses, and several others.

    4. Calculating Federal Income Tax Liability

      1. Calculate gross income (§61)

      2. Subtract “above the line” deductions (enumerated in §62)

        1. The resulting figure (Gross income – Above the line deductions (which are the same as “Exclusions”)) is Adjusted Gross Income (§62)

      3. Subtract “below the line deductions.” Below the line deductions are the sum of personal exemptions (§§151 and 152) and either a standard deduction (§63) or itemized deductions (start with §§67)

        1. The resulting figure is known as taxable income (§63)

      4. Apply the tax rate schedules (from §1) to taxable income to determine tentative tax liability.

        1. KEY POINT: this is a progressive rate! So the MTR only applies to the last amount of income, does NOT apply to all income.

      5. Subtract from tentative tax liability any available tax credits. Keep in mind the important distinction between deductions and credits: Deductions reduce income, whereas credits directly reduce tax liability.

      6. The remaining amount is final tax liability.

    5. Cases:

      1. New Rule: Commissioner v. Glenshaw Glass Co.: Gross income includes all gains i.e. accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.

      2. Old Rule: Eisner v. Macomber defined income as derived from capital, labor or both combined.

  2. Form of Receipt/Compensation for Services

    1. Form of payment is irrelevant. Payment for services is included in income at FMV. (Old Colony Trust Co. v. Commissioner)

    2. §275 denies any deduction for federal income taxes.

      1. Result of §275: We have a tax inclusive rate → this means that the amount of taxes paid out for federal income taxes are included in income when determining amount of tax owed.

    3. This means that if employer wants to give employee a certain amount after taxes, must do this via grossing up.

    4. Grossing up: Income After Tax = Income Pretax – (Income Pretax x Tax Rate)

  3. Fringe Benefits

    1. Definition: benefits transferred to employee by employer. There is essentially a spectrum

      1. Benefits which are clearly work related → not included in GI (this would be things like pencils etc…)

      2. Benefits which are very unrelated to work → these may be seen as compensation

      3. Benefits which are somewhere in between → these are the difficult cases in terms of determining whether or not to include in GI.

    2. Meals and Lodging

      1. §119(a): meals and lodging provided to employee, his spouse, and his dependents, by or on behalf of employer and for the convenience of the employer may be excluded from employee’s income if

        1. in the case of meals → meals furnished on the business premises of the employer

        2. In the case of lodging → employee is required to accept such lodging on the business premises of his employer as a condition of employment.

      2. §Reg. §161-2(d)(1): if you get compensation for services you need to include it in income, whether it is cash or use of property. When you receive property for exchange of services, the amount of income you include is the FMV of what you received, not the value of the services.

        1. EXCEPTION: this regulation does NOT apply if employer has a “non-compensatory motive” for providing the property/services. In addition, the more closely the item/service is tied to the job, the less likely included in income. (Benaglia)

      3. Relevant Cases:

        1. Benaglia v. Commissioner: B required to take food/lodging on the business premises for the convenience of his employer. This was NOT included in his income.

        2. Commissioner v. Kowalski: §119 covers meals furnished by employer and not cash reimbursements for meals. This means that such cash reimbursements would have to be included in GI.

        3. United States v. Gotcher: even if employee receives some incidental benefit from expense-paid items such as meals, or lodging, the value of these will not be included in his gross income if the meals and lodging are primarily for the convenience of the employer. When this indirect economic gain by the employee is subordinate to an overall business purpose, the recipient is not taxed. This case is often cited for the principle that what matters is the primary purpose of the payor/employer.

    3. Spousal Expenses

      1. In United States v. Gotcher, Mrs. Gotcher’s expenses were included as income.

        1. §274(m)(3): travel expenses deductible for spouses/dependents only if

          1. spouse is an employee of the taxpayer

          2. there is a bonafide business purpose

          3. the expenses otherwise would have been deductible

        2. Reg. §1.132-2(t): even if employer cannot deduct spouse’s expenses, employee can exclude the reimbursement so long as the spouse’s presence had a bonafide business purpose. This creates a presumption:

          1. if dominant purpose of having spouse on trip is for business → excludable from GI

          2. if dominant purpose of having spouse on trip is personal travel → include in GI

    4. Work Related Fringe Benefits

      1. §132 provides for certain fringe benefits which are NOT included in gross income.

      2. Notes on the mechanics of §132

        1. §132(l): §132 DOES NOT APPLY to fringe benefits expressly described elsewhere (except for (e) which discusses de minimus fringe or (g) which discusses moving expense reimbursements). Thus, if you are dealing with something like meals, which is already covered under §119, the only way it could be covered under §132 would be if it could qualify as a de minimus fringe (§132(e))

        2. §132(j): the exclusions offered under §132(b) and (c) are only available to highly compensated employees if they are also offered to regular employees.

      3. Exploration of the Specific Provisions

        1. §132(b): No Additional Cost Services. EX: if a stewardess got a free standby flight this could fit under this provision because it is no additional cost service, and is in the employee’s line of business. Note, however, that if the employee works for Delta as a stewardess and Delta owns TimeWarner and the employee gets a discount on cable, this would NOT be excluded from income because it is not in the employee’s line of business.

        2. §132(c): Qualified Employee Discount

        3. §132(d): Working Condition Fringe. This section relates to any property/services provided to an employee of the employer to the extent that, if the employee paid for such property or services, such payment would be allowable as a deduction under either §162 or §167.

        4. §132(e): De minimis fringe. This section refers to any property/service whose value is so small as to make accounting for it unreasonable or administratively impracticable.

          1. §132(e)(2): refers to cafeterias which are onsite

          2. Regulation 1-132-6: says that occasional meals for overtime can be excluded out of income in particular situations. Can only be if

            1. it is reasonable

            2. it must not be done on a routine/regular basis

            3. must be provided to enable the employee to work overtime

        5. §132(f): Qualified transportation fringe

        6. §132(g): Qualified moving expense reimbursement

        7. §132(h): certain individuals (such as spouses) treated as employees for purposes of (§132(b) and (c)) (no-additional cost service and qualified employee discount).

        8. Other expenses not specifically relating to employees: Under the “convenience of the employer” standard some fringe benefits may be allowed under §132 which do not relate specifically to employees, such as allowing an exclusion from gross income for the cost of a flight for a law student to come in and interview.

    5. Property Transferred in Connection with the Performance of Services

      1. General Rule under §83: if employee purchases from employer, in connection with his employment, property at a cost of less than FMV, the difference between FMV and the price he paid will be included in his gross income. The question under §83 will then be whether or not he makes an §83(b) election and includes the income now rather than later (i.e. at the time when the property is no longer at substantial risk of forfeiture)

      2. Determining whether something is a §83 purchase:

        1. Is it for the convenience of the employer? EX: will the employee be on-call after hours?

      3. Once you determine that something IS a §83 purchase, then need to determine when to include the excess of price in taxpayer’s income.

        1. §83(a): the taxpayer would include in income the difference between what he paid for the building and the building’s FMV at the time that the building vests (i.e. is no longer subject to a substantial risk of forfeiture).

          1. EX: if taxpayer pays 2M for the building, and the FMV is 2.5M, and the property stands to vest in ten years, then under §83(a) he would not include anything in income at the time of the purchase, but would include that amount in income in the year that the property vests. That amount, and any amount of increase up until that point, will be treated as income, and taxed at ordinary rates. From that point on, increases in the property would no longer be salary.

        2. §83(b): if the taxpayer makes a 83(b) election, this would mean that he includes in his income at the time of purchase the difference between the purchase price and the FMV of the building.

          1. The effect of this would be that any increase between the time of purchase and the time when the property vests would not be taxed at ordinary rates, but rather would be treated as a capital gain (assuming that this is a property eligible for such treatment) as this would no longer be considered compensation.

        3. §83(c): Substantial risk of forfeiture – if the person’s rights to full enjoyment of the property are conditioned on whether he performs certain services, then the property is subject to a substantial risk of forfeiture. This relates to whether or not the property will ultimately vest.

      4. Regulation 1.83-(2)(a): you include in your basis the amount you have already paid in taxes.

      5. Regulation §1.61-2(a)(2): Property transferred to employee or independent contractor. If property is transferred to an employee or employer or independent contractor as compensation for services, and it is done for less than FMV, the difference between the price paid and the FMV will be treated as compensation and will be included in the employee’s income.

  4. Time Value of Money

    1. This is a very important concept. It deals with the idea that you would rather have a dollar today than a dollar in ten years, as a dollar in ten years is worth less.

      1. Calculation of the Present Value of Money: PV = Future Payment/(1+r)^t

  5. Tax Expenditures

    1. See big Outline PAGE 14

  6. Employer Provided Health Insurance

    1. §106: Excludes employer contributions to accident and health plans from the gross income of employees. There is no cap, it could be as big as they want and it would be all excluded from employee’s income, so long as it is provided to the employee by the employer.

    2. §105: Amounts received under accident and health plans

      1. §105(a) is the default, and says that amounts paid out by the health plans are included in gross income.

      2. §105(b) modifies §105(a) by listing amounts which are NOT included in gross income, such as amounts included for medical care (as defined in §213(d)). EX: under §105(b) you could NOT exclude from income payment for things like plastic surgery.

    3. §104: excludes in their entirety amounts from gross income which taxpayer may have received through things such as workmen’s comp or accident or health insurance etc…see p. 96 of the Code

    4. §104(a)(3): If an employee purchases accident or health insurance himself, no deduction is provided. (except to the limited extent an itemized medical expense deduction might be available – See §213) but the proceeds in the event of sickness or disability would not be taxed.

    5. §162(l): self-employed individuals can claim a 100% deduction for health insurance.

    6. Other Medical/Health Care Provisions

      1. See discussion under §213 p. 39 Below

  7. Imputed Income

    1. Definition: imputed income is when people use their own property to provide benefits to themselves or members of their families.

    2. General RuleNo tax consequences for imputed income, i.e. Imputed income is not taxed. There is not a statute which supports this, this is just what the IRS has done.

    3. No deduction for personal services related to living with a living thing.

    4. Leads to lots of policy issues because it creates incentives for people not to work.

  8. Gifts And Bequests

    1. General Rule:

      1. Common Law Test for Gift: was it given with a “detached and disinterested generosity.” (Commissioner v. Dubertsein)

      2. §102(a): Gross Income does NOT include the value of property acquired via gifts/bequests

    2. Gifts in the Business/Employee Context

      1. In the business context, it is not always clear whether a gift is a gift or whether it is compensation.

      2. Current Law regarding gifts to Employees: §102(c)(1) says that gifts from employers to employees cannot be gifts i.e. excluded from gross income.

        1. EXCEPTION: Regulation §1.102-1(f)(2) provides for an exception to §102(c)(1) in the case of gifts between related parties.

      3. Current Law regarding gifts to Business Associates: business associate might be able to exclude this under §102.

        1. NOTE: if a business associate excludes the item from income under §102, then §274(b) says that the payor may NOT take a business deduction under either §162 or §212. Moreover, even if a deduction is allowed for business gifts under §162/212, may only be for up to $25 for a gift to any particular individual.

        2. Analysis for Business Associate Gifts:

          1. Did the employer deduct it under §162(b)(1)? If so, not treating it like a gift, business associate should include in income.

          2. Did employer/payor have “detached and disinterested generosity”? If so, probably treating it like a gift and business associate can exclude from GI.

      4. Tips – Regulation §1.61-2(a)(1): tips which constitute compensation for services must be included in gross income. Of course this leaves open the possibility that someone will argue he received a tip not as compensation but rather out of “detached and disinterested” generosity.

    3. Pure Gifts

      1. General Rule: §102(a) → Donees get to exclude gifts from GI, and Donors do not get a deduction from income.

      2. §1015 - Recovery of Basis with Gifts

        1. For gifts of appreciated property: The basis of donor = basis of the donee.

          1. EX: Donor buys X for $100 and she gives it to Donee when it is worth $150, and Donee sells the property when it is worth $175. Donee’s basis = $100.

        2. “Lost Basis Rule” For gifts of depreciated property: The basis for determining loss is either the donor’s basis or the FMV at the time of the gift, whichever is lower.

          1. EX: Donor buys X for $100, it is worth $80 at the time of transfer, and then $75 at the time that Donee sells it. Donee’s basis is $80 and he recognizes a $5 loss.

      3. §1014 – Recovery of Basis with Bequests

        1. Stepped-Up Basis: Except as otherwise provided, with bequests there is a stepped up basis, which means that the person who gets the bequest gets a basis of the FMV at the time of the bequest (i.e. time of decedent’s death).

          1. Effect of the Stepped up Basis:

            1. Appreciated Property → property never taxed on the amount appreciated since testator acquired it.

            2. Depreciated Property → “lost” losses – better to sell the property right before death and realize the loss.

        2. NOTE: §1015(a) contains some provisions as to what to do when you cannot figure out the FMV in order to determine the basis.

  9. Prizes and Awards

    1. §74(a): gross income includes amounts received as prizes and awards.

    2. §74(b): Exceptions for certain prizes and awards transferred to charities. Generally do not have to include in income gifts made to charities as long as the following conditions are met

      1. the prize was given to charity

      2. the recipient did not do anything specific to get the prize

      3. need to be awarded the prize because of strength in science, charity etc….

        1. NOTE: charity is a “below the line deduction,” a less valuable deduction.

    3. Regulation 1.74-(1)(a)(1): Prizes and awards which are includible in gross income include (but are not limited to) amounts received from radio and television giveaway shows, door prizes, and awards in contests of all types, as well as any prizes and awards from an employer to an employee in recognition of some achievement in connection with his employment.

    4. Regulation 1.74-1(a)(2): amount included. If the prize or award is not made in money but is made in goods or services, the fair market value of the goods or services is the amount to be included in income.

    5. Regulation §1.102-1(a): the gift exclusion under §102 does NOT apply to prizes and awards. The recipient of a price or award generally includes the prize in income even if the transfer was gratuitous.


      1. §274(j): Certain Employee achievement awards are excludible from income – such as tangible personal property for length of service or safety achievements.

      2. §117(a): Gross income does not include any amount received as a qualified scholarship by an individual who is a candidate for a degree at an educational organization at an educational organization.

  10. Recovery of Basis

    1. Basis of Property (§10012): Basis of property is generally its cost.

    2. Determination of Gains or Losses (§1001): This section is used for computing the amount of gain or loss, which will then be used to adjust basis.

      1. §1001(a): Computation of gain or loss.

        1. Gains → Amount Realized – Adjusted Basis

        2. Loss → Adjusted Basis – Amount Realized

      2. §1001(b): Amount Realized - The amount realized from the sale or other disposition of property shall be the sum of any money received plus the fair market value of the property (other than money) received. In determining the amount realized

        1. there shall not be taken into account any amount received as reimbursement for real property taxes which are treated under §164(d) as imposed on the purchaser, and

        2. there shall be taken into account amounts representing real property taxes which are treated under §164(d) as imposed on the taxpayer if such taxes are to be paid by the purchaser.

    3. Adjusted Basis (§1011): The adjusted basis for determining gain or loss from the sale or other disposition of property is the basis as provided under §1012, adjusted as provided in §1016.

    4. Adjustments to Basis (§1016): §1016(a)(1) -Adjustments should be made to basis for things such as expenditures, receipts, losses, or other items properly chargeable to capital account.

    5. “First in First Out Rule” - Reg. §1.1012-1(c)(1): Determination of basis with similar assets acquired at different times. p. 4 of chart

    6. Recovery of Basis and the Time Value of Money

      1. For these questions need to look at Appendix A on p. 826 of Casebook.

        1. If looking at future value of a dollar from today → look at Appendix Table 2

        2. If looking at the present value of a dollar → need to look at Appendix Table 1

      2. NOTE: for these questions to have the same answer, need to have the same marginal tax rate in year 1 (now) and in the future year.

      3. Formula for Present Value of $1 to be received after t years = 1/(1+r) ^t r= interest rate

        1. EX: What is the value in today’s dollars of a $1 reduction in tax liability at the end of ten years if the interest rate (or rate of return) is 10 percent, compounded annually?

          1. Need to look at Appendix Table 1 – because we are looking at the present value of a dollar → 38.6 cents.

      4. Formula for Future Value of $1 received at the end of t years = (1+r)^t

        1. EX: What is the value of a $1 reduction in tax liability today at the end of ten years if the interest rate (or rate of return) is 10 percent, compounded annually?

          1. Need to look at Appendix Table 2 – because we are looking at the future value of a dollar → $2.59.

    7. Related Sections:

      1. Basis for Gifts §1015

      2. Basis for Bequests §1014

      3. See Allocation of Basis

  11. Allocation of Basis

    1. General Issues to consider

      1. How much is the basis?

      2. When is the basis recovered?

    2. Code Provisions

      1. Rent Treated as income - §61(a)(5): This is relevant if you have a building and are trying to determine how to recover your basis. If you are always treating rent as income, then you are effectively not allocating basis towards it.

      2. Gains from Property - §61(a)(3): included in income are “gains derived from dealings in real property.”

      3. Allocation when Part of Property sold – Reg. §1.61-6(a): when a portion of property is sold, the basis must be divided among the parts, and the gain or loss on each component must be determined at the time of the sale of each part, and cannot be deferred until the entire property has been sold. The basis must be allocated in proportion to their values.

        1. EXCEPTION: if it is impossible or impractical to rationally allocate basis, then consideration received on the sale may be credited against the basis for the entire property.

      4. Allocation of Basis in the case of a Part Gift/Part Sale – Reg. §1.1015-4: The initial basis of the transferee is the greater of the amount paid by the transferee for the property or the transferee’s basis under §1015(d). For determining a loss, basis is never greater than FMV of the property at the time of the transfer.

        1. EX: Mom sells property w/adjusted basis of $80 and FMV of $100 to Son for $75. Son’s basis is $80.

      5. Allocation of Basis in the case of a Part Gift/Part Sale to Charity – §170(e) and Reg. §1.1011-2: when a taxpayer makes a part gift, part sale to a charity, he needs to allocate basis between the gift and sales portions in proportion to their respective values.

        1. If M has a piece of property worth $100 with a basis of 80, and she sells it to charity for $75, then since she sold it to the charity for 75% of its value, need to allocate 75% of the basis ($60) towards the sale, which would lead to producing a $15 gain. M would have made a charitable contribution of $25 (the difference between the value of the property, $100, and the purchase price, $75).

    3. Cases

      1. Hort v. Commissioner: (“substitute for future income”)

        1. The termination money (for a lease cancellation) should have been considered gross income (rents) since it is the discounted value of unmatured rental payments

        2. Lease did not have a basis (future rents would have been ordinary income)

        3. Goals: deny capital treatment, deny offsetting basis

        4. KEY POINT: Look at what the payment was a substitute for in determining taxation

  12. The Realization Requirement

    1. General Rule: Gains or Losses are not recognized (i.e. appreciation is not taxed and losses may not be deducted) until the property is sold or exchanged. (Eisner v. Macomber)

    2. Recognition of Gain or Loss - §1001(c): unless otherwise provided entire amount of gain or loss, as determined under this section, which occurs upon the sale or exchange of property, shall be recognized.

    3. Test for Realization §1001(a): To realize a gain or loss in the value of the property, taxpayer must engaged in a sale or disposition of the property.

      1. Exchanges of Property: An exchange of property may be treated as a disposition only if the properties exchanged are materially different.

      2. Cottage Savings Ass’n v. Commissioner: the court said that properties are “different” in a sense that is “material” to the extent that their respective possessors enjoy legal entitlements different in kind/extent. i.e. legally distinct entitlements.

      3. Reg. §1.1001-1: There is a disposition if you exchange materially different property. Thus, the gain or loss realized from the conversion of property into cash, or from the exchange of property for other property different materially either in kind or extent, is treated as income or as loss sustained.

    4. Items which are Taxable Income

      1. Windfalls/Treasure Trove

        1. Reg. §1.161-14: Treasure trove, to the extent of value in US currency, is gross income for the taxable year in which it was reduced to undisputed possession.

        2. Cessarini v. United States

      2. A Sale

      3. Cash Dividends

        1. §301(c)(1) says that the portion of a distribution which is defined as a dividend in §316 is included in gross income.

        2. §316(a): dividend is defined as any distribution of property made by a corporation to its shareholders.

      4. Items over which taxpayer has exerted “complete dominion and control”

        1. Haverly v. United States: the element of “complete dominion and control” is satisfied by the unequivocal act of taking a charitable deduction for donation of the property.

        2. NOTE: as raised in this case, cannot take a business and charitable deduction for the same source. §162(b).

          1. See Also Revenue Ruling 70-498 Chart p. 6

    5. Items which are NOT Taxable Income

      1. Stock Dividends

        1. §305: A simple pro rata “common on common stock” dividend, in which the stockholder receives shares identical to those producing the dividend, and has no option to choose cash, produces no taxable income.

          1. NOTE: if taxpayer has a choice of cash then it WILL be a realization event.

        2. Eisner v. Macomber

      2. Gifts

        1. §102 provides that gifts do not result in taxable income.

      3. Unsolicited Samples

        1. However, if taxpayer takes a deduction for these (such as a charitable deduction) or if taxpayer uses them, they WILL be included in income

  13. Annuities

    1. General Rule - §72(a): general rule is that except as provided in other parts of the chapter, gross income includes any amount received under an annuity, endowment, or life insurance contract.

      1. Annuities often relate to a person’s life expectancy - Where the annuitant dies before reaching expectancy, he has a mortality loss; otherwise he has a mortality gain

      2. Annuities are taxed as the annuitant receives payments (not as interest accrues)

    2. Exclusion Ratio - §72(b): The amount from an annuity which is included in income is determined based on the exclusion ratio.

      1. Numerator: the investment in the contract

      2. Denominator: the investment in the return.

    3. Example of the Application of the Exclusion Ratio: Suppose taxpayer purchases an annuity for $267.30 which will pay $300/year.

      1. Exclusion Ratio = $267.30/$300 = 89.1%

      2. What this means: 89.1% of the annuity payments from each year is considered to be recovery of capital. Since the annual payments are $100, this would mean that $89.10/year is recover of capital, and taxpayer would report $10.90/year of income.

    4. Penalties for withdrawing early from Annuity

      1. if you withdraw prior to start date, you recover your basis and the rest is income under §72(q).

      2. there is a 10% penalty on certain withdrawals from annuities, such as if you receive a distribution before age 59.5, and if not part of a death payment.

    5. Deferred Annuities

      1. This is where taxpayer purchases an annuity with payments to begin at some future point. During the period between purchase date and beginning of payments, interest accrues on the annuity and typically insurance companies treat it as a return on purchaser’s investment. The interest is not taxed to the taxpayer as it accrues, but rather is taxed as taxpayer receives payment. (§72(b))

      2. See page 166 of Casebook if need more information on this!

  14. Insurance

    1. General Rule (§101(a)(2)): The basic rule is that amounts paid “by reason of the death of the insured” are not subject to income tax- regardless of the amount of gain that actually may be involved. Thus, the interest earned on savings through life insurance, or any other return on the taxpayer’s investment, and the portion of proceeds representing the amount covering the life insurance risk, are free of income tax if received by reason of the death of the insured.

    2. §7702: this section defines life insurance contracts, and was added in an effort to limit the preferential treatment of life insurance proceeds to cases where an insurance element is genuinely present.

    3. Elements of Life Insurance

      1. Term Insurance: the insured or someone else pays a premium in return for which a specified sum will be paid to his survivors in the event of his death.

      2. Savings Element: The size of the savings component relative to the pure insurance component varies. In some life insurance contracts (such as one of five year term policies) the savings element is small; in others (such as whole life policies) the savings element may be large.

    4. Types of Life Insurance Plans – see page 168 of casebook for more

      1. Ordinary Life Insurance: involves the payment of a uniform annual premium throughout the life of the insured and matures at death.

      2. Universal Life Insurance

      3. Variable Life Insurance

  15. Transactions Involving Borrowed Funds

    1. General Rule: A borrower does not realize income upon the receipt of a loan, regardless of how the loan proceeds are used.

    2. What constitutes borrowed funds (as opposed to stolen)?

      1. For something to be considered borrowing there needs to be mutual understanding between the borrower and the lender of the obligation to repay and a bona fide intent on the borrower’s part to repay the acquired funds. (Collins v. Commissioner/James v. United States)

        1. No real statutory authority, though this could be inferred from §61(a)(12), and this applies whether the borrowing is for business or personal use.

      2. Embezzled funds ≠ Borrowed Funds → This DOES count as income on which taxes are due. (Collins v. Commissioner)

    3. Gambling Considerations

      1. §165(d): gambling losses can only be used to offset gambling gains.

      2. §165(c): a thief/embezzler is entitled to a deduction in the year in which he actually repays/forfeits the illegally obtained gains.

    4. Discharge of Indebtedness

      1. General Rule - §61(a)(12): Gross income includes income from discharge of indebtedness. (United States v. Kirby Lumber)

        1. Zarin v. Commissioner: Gambler defaulted to casino for $3.4 million, and settling for $500k. Court held that discharge of $3 million was taxable under § 61(a)(12), and that losses were deductible under § 165(d) only to extent offset gains for that taxable year.

          1. NOTE: Decision overturned on grounds that loan (extension of credit) was unenforceable under NJ state law and thus Zarin could not have income from the discharge of a debt.

      2. Modifications of the General Rule

        1. Reg. §1.61-12(a): Not all discharge of indebtedness results in income. Discharge of indebtedness in whole or in part, may result in the realization of income.

        2. §108: Where the original consideration for the borrower’s debt is not cash equal to the face amount of the debt (such as in Zarin, where he received chips for betting) court has a harder time determining if there is cancellation of indebtedness income.

          1. §108(a)(1)(b): no cancellation of indebtedness if the corporation is insolvent.

          2. §108(a)(3): insolvent is defined as liabilities exceeding FMV of assets.

          3. §108(a)(1)(a): exclusion from income if something is a result of a discharge which occurs as the result of a Title 11 case (bankruptcy case).

          4. §108(e)(5): purchase-money debt reduction treated as a price reduction. purchase-money debt reduction treated as a price reduction rather than income if the reduction does not occur in the context of a title 11 case or when the purchaser was insolvent. This is a purchase price adjustment and is an exception to the general rule that cancellation of indebtedness is income.

            1. The payment must be from the seller to the buyer.

            2. This only applies in cases where the seller is also the lender.

          5. §108(d)(1): indebtedness of taxpayer. For purposes of this section, “indebtedness of taxpayer” means any indebtedness for which the taxpayer is liable or subject to which the taxpayer holds property.

    5. Effect of Debt on Basis and Amount Realized

      1. Main Points:

        1. Equity = FMV - Debt

        2. Amount of Basis - §1012: Loans (nonrecourse and recourse) used to purchase assets are included as part of taxapyer’s basis in the property.

        3. Amount Realized - §1001(b): Need to include loans (both recourse and nonrecourse, the amount still outstanding) in the amount realized.

      2. Recourse and Nonrecourse debt are treated alike, i.e. Nonrecourse loans are treated like true loans. (Crane v. Commissioner)

      3. Nonrecourse loans and Recourse loans are to be included in calculating BOTH the basis and the amount realized upon disposition. (Crane v. Commissioner)

      4. Is nonrecourse debt included in the amount realized when you sell property subject to nonrecourse debt and the amount of the debt exceeds the value of the property at that time? YES (Commissioner v. Tufts) – even if NRD is greater than FMV, need to include it in amount realized if it was included in basis.

        1. Reasoning: the only difference between a nonrecourse mortgage and a recourse mortgage is that in the former the mortgagee’s remedy is limited to foreclosing on the securing property. If FMV of the property falls below the amount outstanding of the obligation, mortgagee’s ability to protect himself is impaired, because mortgagor can just walk away and be relieved of his obligation. However, this does NOT erase the fact that the mortgagor received the loan proceeds tax free and included them in his basis on the understanding that he had an obligation to repay the full amount. When the obligation is canceled, the mortgagor is relieved of his responsibility to repay the sum he originally received and thus realizes value to that extent within the meaning of §1001(b).

      5. NRD should not go into basis in the first place if there is overvaluation. (Estate of Franklin)

        1. NOTE – this was the first case which treated RD and NRD differently. This is why the holding is limited to only apply to NRD for property which was overvalued.

        2. Following Estate of Franklin several Revenue Rulings were issued:

          1. Rev. Rul. 77-110: an inadequately secured nonrecourse loan generally is too contingent to merit characterization as indebtedness and hence will not allow any portion of the loan to be considered an acquisition cost includible in basis.

          2. Rev. Rul. 78-29: a loan should not increase basis where it is unclear whether the borrower will ever actually make principal payments. Contingent liabilities not included in basis until payment is made.

      6. Analysis after Tufts, Crane and Estate of Franklin:

        1. Tufts and Crane are still good law, so generally still need to include nonrecourse/recourse loans in basis and amount realized (to the extent that it has not yet been paid down), even in cases where FMV exceeds the amount of the loan. However, in cases where the property is tremendously overvalued, it is not clear that this will be the case, as this might be considered a tax shelter.

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