Page 1 of 12

Tax Alvin Warren Spring 2007 – (In-Class) Grade: A 1. Pamela’s education expenses at Ames School for the Arts are not deductible to

the extent that this is a new profession she is entering and her education likely meets the minimum requirements for entry. If she has any loans coming out of Ames, she can deduct educational loan interest under 221 subject to phase-out. Pamela’s efforts fall under §212 as profit-seeking activity. As such, her travel expenses to identify a group of young actors and musicians would be deductible as ordinary and necessary for the production and collection of income. (One might argue on the other hand that she is just carrying out a childhood dream of writing plays irrespective of any profit motive, but given the substantial outlays she has made, it seems like profitseeking activity). Under the tests for 162(a)(2) – an analogous section to 212 – Pamela is away from home (her “place of business”) and in the pursuit of a trade or business. Insofar as these were expenses designed to benefit Pamela past just this year, she will have to capitalize these expenditures under §263 and cannot deduct them all immediately. Likewise, any payments she made to the actors would be deductible under 162(a) (1) that provides that reasonable salaries may be deducted. These are merely unknown actors, so it’s unlikely they’d be subject to any compensation limit under 162(m). The salary costs would be immediately deductible as per the post-INDOPCO treasury Reg. 1.263(a)-4(e)(4)(j) which treats employee compensation as an immediate expense no matter its effect beyond the taxable year.

Page 2 of 12

If Pamela paid interest on the initial financing from Apple, it is likewise deductible as an ordinary and necessary business expense under 212. Whatever Pamela earned in 2006 from her Miniworks contract would be taxable to her as ordinary income. This is income from property that she created herself. Pamela might try to classify her gains from the contract as capital gains. However, she might have two problems. First, there’s no indication she held the copyrights to the minioperas for more than a year. This is a requirement under 1222(3). Second, her copyrights are personal efforts created by the taxpayer and so not entitled to capital gains treatment under 1221(a)(3). Whatever she receives as payment from Miniworks is best characterized as ordinary income. It looks like she’s just getting paid for her services. This is more like PG Lake – the form of payment shouldn’t control. It doesn’t matter that she’s getting downloading fees each year, it’s really payment for her own creation. A court might take a purposive look at capital gains treatment and say that the goal was to relieve the tax burden on gains resulting from a conversion of capital investments. Taxing her at ordinary would not remove deterrent effect of realization; she NEEDS this money – it’s her livelihood. (Further discussion below with regard to sale and donation of these income rights) As for Pamela’s divorce, we need to determine first whether the transfer to her former husband is to be considered alimony or rather a transfer of property between spouses incident to divorce. Pamela will want to classify it as alimony because that would allow her to deduct the payment under §215. Her spouse would have to include it under §71. The couple may wish, however, to engage in private ordering and contract

Page 3 of 12

around this within §71(b)(1)(B) in order to have the lower-bracket spouse pay the tax and then they can adjust the amounts. If the couple is not able to classify this as alimony – we’ll classify this as a transfer of property under §1041. No gain or loss will be recognized on the transfer of property provided the agreement was within one year of marriage; there is no realization event and no tax on either party. The husband will carryover Pamela’s basis subject to §1041(b). If he later sold, he would be subject to her low basis. Pamela’s income from being an artist-in-residence at Ames is plainly taxable under §61 as gross income. Pamela’s sale of her 30% stake to a major financial institution for the $3,000,000 lump sum is taxable to her, but we should determine whether it’s best classified as a capital gain or ordinary income. Given that it’s such a large sum, she’ll want to classify it as capital gains to take advantage of the lower rate under 1(h). We’ll want to examine under the 3-part Laterra test used by the 3rd Circuit. In that case, the taxpayer won the lottery and sold rights to receive the income. Here, Pamela is selling rights to receive income she’s entitled to under a contract. As a “Family Resemblance,” the contract seems to be a compensation for her works. It’s just a recurring receipt, which we typically characterize as ordinary income. Further, under 1221(a)(3), income from personal services is not deemed to be capital gains income. This includes a copyright held by the taxpayer whose personal efforts created it. As a result, the payments she is due relating to her own work should be ordinary income. However, she might be able to treat the 5% owed her for the downloading fees of others as capital gain – this is not her benefiting from her own work. Second, this seems like a vertical carve-out; she’s giving

Page 4 of 12

away part of the principal here and keeping part of the tree. Finally, the income here is already earned. There’s no indication that Pamela needs to do anything else in the 10year contract; she’ll just wait for the money to roll in. Finally, we’ll want to inquire as to whether she is surrendering an equitable interest; can it be enforced in court as injunctive relief (specific performance) or merely money damages. Here the remedy is probably only money damages. If the downloading fees aren’t transferred to her, she can only sue for the fees to be paid. Pamela’s charitable contribution to Ames can be a charitable deduction under §170. It is available below-the-line as an itemized deduction and subject to the itemized deduction phaseout of §68. However, we will want to know how much she can deduct. Under §170(e)(1)(A), the amount of any charitable contribution of property is reduced by amount of gain which would not have been long-term CG if sold by the taxpayer. Plainly, if sale would not have been a capital gain, Pamela can only deduct up to her basis in the asset. If the sale would have been a capital gain, she can deduct up to the FMV. We’ll want to return to our analysis from above with the sale to the financial institution; to the extent that what she delivered was capital gain, she can only deduct a little (her basis, or cost of producing the copyright); but whatever she can classify as ordinary income, she might be able to take a larger deduction on. For simplicity’s sake, Pamela might consider making the gift in 2 parts: in one part, contributing a portion of her contract rights that she receives as downloading fees from her own work; then another donation of fees she receives from others.

Page 5 of 12

2.

The first thing we want to explore is the issue of the exchange of his theater.

Producer is right to try to get Manhattan University to buy the Los Angeles property and then exchange it with him. This could properly be classified as a Like-Kind Exchange under 1031. Even though the properties are not identical, they are both theaters and connected to the performing arts, plus Producer is still “in acres.” Besides, what two properties are “exactly” alike. Under 1031(a), a like-kind exchange will not count as a realization event, so Producer won’t have to realize his substantial appreciation in theater. We do this under the rationale that the investor is not really changing his investment. Given that he is using a third-party, Producer will want to be sure that the transaction takes place within 180 days under 1031(a)(3) for it to be counted as a like-kind exchange. Now this is a transaction involving a “boot’ because one party (Producer) is giving extra cash or property in order to even out the deal. This is still considered likekind under 1031(b); still like kind if it were not for the fact that the property received in exchange consists not only of like-kind property, but also of other property (i.e. stock) or money. In terms of realization under 1001(a), Producer would normally be gaining $9,400,000 on the real estate and $350,000 on the stock. However, he needn’t recognize the $9.4M under 1031(b). However, since it’s not a like-exchange with regard to the stock, Producer must recognize the stock gain of $350,000 (1001(c)  Amount realized minus basis = Gain). Assuming he has held the Google stock for more than a year, this gain would be a capital gain and subject to a lower rate under §1(h). (Interestingly, because Manhattan University is a non-profit organization, Producer might have preferred to gift that stock to them and be able to take a charitable deduction under 170. Manhattan might not have a problem doing this because it would

Page 6 of 12

still end up with the stock. The stock is a favored gift entitled to double benefit under §170(e)(1)(B) and therefore, Producer would be able to deduct the full FMV and the University being tax-exempt, could then sell that stock and would not pay tax on any gain.) Finally, we might like to calculate Producer’s basis in the Los Angeles property that he now retains. Under 1031(d), his basis would be that of the property he exchanged decreased by the amount of money he received ($0) and increased by the amount of gain received here. Thus, his new basis would be old basis + gain. Since Producer is the boot giver, we would start with his old basis ($600,000) then add in the $350,000 gain. His new basis would $950,000 which makes sense because we are increasing his basis to avoid taxing him again on this “gain” if and when he later sells the LA Property. As for Dumpsville, tax treatment will depend on whether it is a recourse or nonrecourse loan. It will be “recourse” if Producer is personally liable for the entire loan beyond the value of the property. On the other hand, it might be “non-recourse” if the bank won’t go beyond the asset (the apartment building). The tax system treats the two types differently. Since there’s no indication that the bank can’t go beyond the property and go after Producer personally, let’s start with recourse. If we do recourse, we’ll split it up the way of Justice O’Connor’s concurrence in Tufts. Treasury reg. §1.1001-2(c) holds that we will bifurcate for recourse debt into an asset and liability for separate tax treatment. This is important because an asset will likely qualify for capital gains treatment, while the liability is ordinary income. On the asset side, the amount realized (FMV of surrender) was $100k and he had an adjusted basis of $50k (Original basis was $200k because eit

Page 7 of 12

cost $200k total  20k from his own money and 180k from the bank. He then took $150k in depreciation deductions which come dollar-for-dollar off the basis under 1016(a)(2)). In total, he will realize a gain of $50k on the sale of the property. On the discharge of debt transaction, the face value of the loan outstanding was $165k ($180k to start minus $15k repaid) and he satisfied only $100k (FMV of surrender), so he would have gain of $65k on liability side. If we believe this is non-recourse, the analysis is simpler. Under Tufts, we’ll use the majority of approach. The majority held that even where FMV of the property sold or surrendered is less than the outstanding loan value, we’ll calculate the taxpayer’s AR as value of the loan and not of the property. The outstanding loan was $165k and we would subtract out his adjusted basis $50k of a gain of $115k. Note that the two match. Straight $115k using the Majority approach and a combination gain of $115k on the bifurcation approach. This squares with the real-world loss for Producer. In the real world, he lost $20k of his own money from the outset plus he repaid $15k of the loan. This leads to a $35k loss. BUT he was able to take $150k in depreciation deductions early and $150k minus $35k gets us to our $115k. The regular interest payments made on Dumpsville as noted in the fact pattern would have been taxable as ordinary and necessary business expense under 162. Finally, what to make of the donations to the children and grandchildren? Let’s first tackle the “gift” to the son of a 10-year interest in all the income from Downtown Parking Lot. This would likely be taxed to Producer. Put simply, Producer is still holding the tree. He has control over the parking lot, he remains the principal, and he still owns the parking lot. This looks a lot like Horst, where we taxed a dad who retained

Page 8 of 12

control and retained the principal, but gave recurring receipts (interest payments) to his children. There is a limited carve out for just 10 years and it seems that Producer would get the income after the period was over. This is not the type of carve out deserving of Blair treatment. The income would be taxed to Producer and then he could gift it to his son. The son could exclude the gift income under §102. As for the first exchange of Midtown Parking Lot (life interest in all income of the lot to daughter and remainder interest in that lot to daughter’s children), Producer would probably avoid taxation here. The income would be taxable to the daughter while she owned it (and then to the grandchildren when they assumed the remainder – but subject possible to the Kiddie Tax – see discussion below). This situation is analogous to Irwin v. Gavitt and Blair. It looks like Irwin insofar as Producer is giving income to his daughter for a term and the remainder is going onward – not back to Producer – but to a 3rd party. This is unlike Horst where the remainder went back to the donor; that situation had potential for great abuse, so we want to be sure to tax the donor. Instead, here, we would tax the donee – the daughter – on the income received in the interim. Irwin is codified at §102(b) which says that income from gifts (or gifts of income from property) are taxed to the donee. (Under Treasury Reg. 1-102-1(e), we might tax the donor – Producer – and then we could exempt the §102(b) mandate to tax the donee because someone would already be taxed; this might be something Producer is willing to do if he is feeling generous to his offspring, though it likely wouldn’t make sense because he would be in the higher tax bracket. He might instead put the tax onto the daughter, but gross her up by making an additional payment to cover the taxes). This tax-treatment conforms with Blair because Producer is giving away everything – he is surrendering the

Page 9 of 12

tree. It’s a substantial transfer and not just a small slice. Finally, the legal rights here rise to the level of “equitable rights.” If Producer reneged, the relief in court would likely be specific performance; the children could enforce the deal and get the Midtown Parking Lot. Note that the grandchildren would NOT be taxed upon receipt of the parking lot at the end because it is a gift from their grandfather. If the property did not transfer over to them until his death, they would be advantaged by a step-up in basis of the lot under §1014. We should note, however, that if the daughter’s children came to own the property before they turned 18, the income they received from it would be properly classified as capital income and would be taxed at the higher of child’s rate and their father’s rate under the 1(g) “Kiddie” tax. This would prevent the parties from shifting capital income to their dependents and paying lower tax rates on it The final thing Producer might note is that his move to California will likely cause him to be able to deduct less in state or local property taxes under the federal system (§164). While Californians often complain of excessive state taxes, New Yorkers are subject to both a state and city tax, both of which are deductible as below-the-line itemized deductions. He can still deduct his California state tax, but overall, this he may still have higher tax liability compared to what he could deduct in NYC.

Page 10 of 12

3.

The reason we are in a so-called “capital gains mess” is that our rationales

for providing this reduced-rate benefit are not effectively tied to the policies we have in our code. In my opinion, the best rationale for preferential capital gains treatment is the “Lock-in” concern. Because our system is based on taxation for realization events (and not changes in market value from the beginning of the period to the end), you control when your gains occur by deciding when to trigger a realization event. Without preferential treatment for capital gains, taxpayers will refrain from selling assets, even when market conditions would otherwise favor sales, because they would be subject to the high taxes post-realization. This lock-in effect reduces liquidity and impairs the mobility of capital. Holders of long-term appreciated capital might just keep it until they die and reach the “tax nirvana” and are able to allow for basis step-up to their children (or whomever they bequeath to) under §1014. We should continue giving a lower tax rate to decrease this “Lock-In” effect and encourage realization. The most obvious change to the system that we should consider is reducing the one-year requirement for holding of assets to receive the capital gains treatment. Currently, under §1222(3), a taxpayer can only go for the lower capital gains rate if they have held the capital asset for more than one year. This might seem like a fairly low barrier – just 12 months – but it still distorts liquidity and keeps us locked in to a single investment in order to meet the statutory requirement. By lowering the holding requirement, we would encourage realization within that first year. Second, we might try redefining our approach to what is a “capital asset.” We only want to include assets as capital assets if we feel that people will not sell or exchange those assets (and realize gain) if we don’t give the favorable treatment. For

Page 11 of 12

starters, let’s get rid of the preferential treatment for songwriters under §1221(b)(3), recognized widely as the “country music” exception. There is no reason to characterize this as a capital asset because people are going to realize gains on these songs anyway. We are treating the songwriter’s normal daily job as a capital gain even though she already has an incentive to realize the gain. It is just this type of loophole that contributes to this “capital gains mess” and the extensive abuse we have witnessed. We should treat these songwriters as we do artists selling under §1221(a)(3) need no encouragement to realize because this is their livelihood. The Corn Products and PG Lake courts had it right when they limited capital gains treatment to only those investments which would not have occurred but for the preferential treatment of capital gains. A third proposal would be to allow for more rollover provisions akin to what we allow under §1044 for rollover of stock gain to small business investment. Under that provision, we don’t tax you on gain from sale of stock to the extent that you apply that gain to an investment in a small business. We could extend the permissible rollover allowance which would encourage you to realize your appreciated capital gains but not subject them to such high taxes. For instance, if you applied capital gains to certain causes, you could defer gains. If you knew you could rollover your capital gains and avoid heavy taxation in the year of sale, we would be encouraging realization now. Next, we might eliminate the lock-in problem by just taxing unrealized gains as they accrue rather than waiting until the very end when you finally decide to pull the trigger. Taxpayers would report the value of the property at year’s end and be taxed on gain based on what it was worth at the beginning of the period. There would no longer be any benefit to holding on forever. Certainly this strategy would be administratively

Page 12 of 12

difficult, but it would ultimately reduce the complexities relating to tax planning and a desire to avoid paying tax on large unrealized appreciation. We would also reduce the strategic manipulation of losses by doing this, which is another concern in our system; sure, we limit capital losses to $3,000 now, but this would reduce the incentive entirely by making you take losses in the year they occur. Finally, we might also eliminate the step-up in basis allowed under §1014. In today’s world, people are holding onto their property and not incurring tax on their realized appreciation because we give them an out at death via the basis step-up, so they’re never taxed on the appreciation. If we take all or some of this incentive away, we’d reduce the likelihood that people would cling to their appreciated assets and thus encourage realization. This might be politically untenable – you’d anger a lot of rich people and donors – but political concerns are your problem. Alternatively, we could allow a moderate step-up in basis to the taxpayer now like we do under §121 for sale of a principal residence. Your basis would go up a little, so there would be more incentive to realize the gain. With the globalization of our markets and the need for increased liquidity, it is foolish to continue a system wherein Grandma holds on to her assets, doing nothing with them until death because of she’ll get hit with high taxes on her appreciated gains. The system should be sympathetic to her needs and allow for reduced tax consequences – be it either through reduced rates or through some of the basis manipulations I propose. However, if we are going to give preferred treatment based on encouraging realization, we should not benefit those who would realize gains no matter the rules.

Master your semester with Scribd & The New York Times

Special offer for students: Only $4.99/month.

Master your semester with Scribd & The New York Times

Cancel anytime.