Exam # 9405

The first issue relates to Eddie's uniform. Ordinarily, a uniform would be deductible a deductible business expense. This is valid as long as the work clothing is not suitable for ordinary use, and is not used in ordinary use. Eddie has a problem in that he has used the uniform for personal use by wearing it to a social function. This may cast some doubt on whether the expenses related to the acquisition and maintenance of the uniform are deductible. Eddie could probably successfully argue that his usage of the uniform is not "ordinary," based on his one time use of it. Since it would be deductible to Eddie as a business deduction if he had to pay for it himself, it is a fringe benefit when supplied by his employer. It is not taxable income to Eddie, and is deductible to the employer.

The second issue is Eddie's use of the dry cleaning services at the expense of the employer. Normally, a company can provide a service to an employee and have it excludable to the employee, as in the situation with provision of no-additional-cost service. That is not the case here. The employer is not in the dry cleaning business. Therefore the provision of the service is taxable income to Eddie. Eddie could try to argue that this is excludible under a de-minimus exception under §132(e). To meet that requirement, he would have to show that it really was impractical to track the cost of the dry cleaning. He may have a chance to do that, depending on the volume of dry cleaning that the employer does, and the relative cost cleaning Eddie's clothes. If Eddie is unsuccessful in arguing this, this will result in taxable ordinary income in the year the services were received, to him. 

When Eddie receives the stock option, the stock is trading at below the exercise price of the option. This makes it impossible to realize a gain at the time of grant. If the stock were trading at above the exercise price, Eddie could elect to be taxed on the option at the time of the grant, but he would run the risk that the price would go down before he could sell it, and would have no recourse at that time for having paid tax on greater value than he received. The option could be considered an ISO option. It might qualify as one, with the exercise price greater than FMV at grant. For this treatment, Eddie would have to keep the stock for 2 years from the date of grant, and 1 year from the date of purchase. He would then have a capital gain realized when he sold it calculated as FMV of stock - Grant price, taxes as a long term capital gain. But he does not meet these requirements. Thus, he will recognize an ordinary income gain on 7/15/03, when he exercises the options, which is the difference between the FMV of 3.50/share and 2.00/share, which is what it costs him to buy the stock. His basis at that point will be $3.50/share, because he is being taxed on the gain.

When Eddie sells the stock for 5.00/share, he recognizes a gain of 5-3.5 = $1.50 per share. This is capital gain, taxable on his 2004 return. Because stock appears to have been sold in less than 1 year, it will receive short term treatment, taxed at ordinary income rates, but offset-able by capital loss.

The 500 cost to process the transaction gets added into his basis for the purposes of computing this gain. Thus, the $1.50 X 10,000 = $15,000 gain is reduced by $500 to $14,500. 

The loan that Eddie used to purchase the stock was debt incurred in order to make a profit in an investment or business venture. The interest is deductible against investment income. The interest would not be deductible against the capital gain of his transaction, unless he elected to convert part of it to ordinary income for that purpose. But it would be available to offset investment income from other sources. But he doesn't seem to have any. He will have to convert some of the capital gain to ordinary income to deduct the interest.

The gift that Eddie receives probably needs to be examined in two separate parts: the part received from his co-workers, and the part received from his employer. The part received from his co-workers looks like a gift motivated by "detached and disinterested generosity." It is not made in the context of generating future business, as a reward for past business benefits received, ect. If it were, the co-workers might be able to deduct their proportional cost of the expense, and Eddie would have to include it as income. As it is, they could possibly each deduct $25 (max, per year, per person), as a business expense. Eddie would receive no income from his coworker's gift.

The portion of the gift from the employer is different. According to §102(c), transfers from an employer to an employee are not excludable from income in the context of the employer-employee relationship. There is a de minimis exception under §132(e), and an exception for employee achievement awards under §74(c) related to things like safety performance and years of service. This might have to given at a "ceremony." The portion that would be excludable to Eddie would be the cost of the award to the employer. This appears to be a birthday gift to Eddie, rather a recognition award. The party is to celebrate Eddie's birthday, not his employee achievement record. Thus, the receipt of the portion of the gift from the employer looks like taxable ordinary income to Eddie at the time received.
 

Exam # 9895

Elf Costumes (Supplied, cleaned & maintained) -

The cost of clothing is deductible as a business expense only if: (1) the clothing is specifically required as a condition of employment; (2) it is not adaptable to general usage as ordinary clothing; and (3) it is not worn as ordinary use clothing. Eddie's elf costume meets the first two requirements because it is required to be worn by employees of Puckland, and I am assuming it is not adaptable to general use clothing. However, the fact that Eddie wore the elf costume to the Halloween party might destroy the deductibility here. Since Eddie wore it other than for employment purposes at Puckland, the cost of any costumes provided to Eddie by his employer during the year should be includible in income under IRC 63(a). Alternatively, if Eddie was successful at arguing that wearing it to the Halloween party as a gag does not destroy that fact that the costume is not adaptable for general usage, the costumes provided to him will not be includible in income. In addition, the value of the dry-cleaning services provided Puckland for the costumes as well as his personal clothing is includable in Eddie's gross income unless Eddie can successfully argue that this is a di minimus fringe that should not be taxable. 

Stock Options -

At Grant (2002): As the court held in Lobue (and codified in IRC 83(a)), the grant of stock options is not a taxable event unless there is no substantial risk of forfeiture and the option has a readily ascertainable value. According to Reg. 1.83-7(b), the option only has an ascertainable value if the option itself is actively traded on an established market. Here, the facts state that the stock, but not the options are tradable. Therefore, Eddie does not have income upon the grant of the stock options. Even if there was no substantial risk of forfeiture and the option was actively traded, Eddie would not have income because the spread was not in has favor. He was given the option to pay $2 for shares that were trading for $1.75. The difference is not a realizable loss or deductible to Eddie in 2002. He has no basis at this time. 

At Exercise (July 15, 2003):

When exercising nonqualified stock options, the spread of the option price ($2) and FMV ($3.50) is includible in gross income of the employee as compensation under IRC 83(a). Since Eddie exercises his option and purchases all 10,000 shares, he has $15,000 ($1.50 - spread x 10,000) of ordinary income in 2003. However, if the stock options qualified for Incentive Stock Option treatment under IRC 422 and Eddie was not in AMT, he may be able to postpone all gain until the stock is sold and convert any income into capital and receive the lower capital gains treatment. Eddie would have a basis of $15,000 at this time since he paid tax on the $15,000 of ordinary income.

Sale of Stock (2004):

If Eddie's stock options were treated as nonqualified or he elected out if they were ISOs, he would have already paid tax on the spread at time of exercise ($15,000 - see above). Since Eddie paid tax on the spread, he would have a basis of that amount ($15,000). In 2004, he would have a capital gain of $34,500 ($3.50 x 10,000 - $500 broker commission). Since Eddie held the stock from exercise (July 15, 2003) until early 2004, he has short-term capital gain which can potentially offset capital losses. From the facts, it does not appear that Eddie has other capital losses. Therefore, his short-term capital gain will be taxed at ordinary rates. 

Since Eddie did not retain the stock for one year, the ISO rules would not apply. If I am wrong and the ISO rules applied, the full spread between the option and the sales price - $30,000 - less $500 for broker commission ($5 - $2 = 3 x 10,000) would be given capital gain treatment and there would have been no income at exercise. However, the character of gain is still short-term capital gain due to the holding period. 

Investment Interest-

Under IRC 163(a), a deduction may be allowed for investment interest, but only to the extent that it does not exceed the net investment income of the taxpayer for the taxable year. Since Eddie does not own any other investments for which he received investment income, he is not entitled to deduct the interest in 2003. However, under IRC 163(d)(3), Eddie may carry forward his $650 deduction to the succeeding taxable for potential offset. 

Eddie's Birthday Gift -

The bowling ball and matching shirt were given to Eddie out of detached and disinterested generosity as a birthday gift. However, IRC 102(c)(1) prohibits gifts in the employer-employee relationship. Therefore, the portion of the gift paid for by the company $150 would ordinary income to Eddie (treated as compensation) and the company would have to prove a sufficient business connection in order to deduct the $100. Since this gift was given on Eddie's birthday, it would be hard for the company to argue that it was not out of detached and disinterested generosity. If they wanted to preserve the deduction, they could include that amount as compensation on Eddie's W-2. 

Regarding the portion paid for by co-workers ($75), Eddie could exclude this under IRC (102)(a) and would have no income as a result of the gift. The fellow employees have no deduction since it is too personal.

However, the IRS might argue that since the gift was given at the company party celebrating Eddie's birthday, that it was 100% employment related and therefore the full amount is taxable to Eddie as compensation and not deductible to the company. Eddie would argue otherwise, but the IRS would look at the primary motivation behind the gift. Because the co-workers contributed might not change the outcome of 100% employment related. In addition, the fact that the company through him a party might also result in some income to Eddie, without a valid business deduction to the company. 
 

Exam # 9930

Does the provision of an elf costume by Puxco constitute income to Eddie?

Eddie does not receive any income due to Puxco’s supply of the elf costume.  Supply by an employer to an employee, of work clothes constitutes income to the employee only if the elements of the Pevsner test are not satisfied.  In that case, the employee was required to purchase her own work clothes and a deduction therefore was denied.  Here, the employer is providing the clothes, but that does not change the test.  If the test is failed, though, Eddie receives income due to the provision by Puxco of the costume.

The elements of the Pevsner test have been met.  Under the Pevsner test the cost of work clothes are deductible (if paid by employee) or not considered income (if paid by employer), if:

 1. the clothing is of a type specifically required as a condition of employment,

 2. it is not adaptable to general usage as ordinary clothing; and

 3. it is not so worn.

Here, Puxco’s employees are “all required to wear elf costumes.”  Elf costumes are not adaptable to general use as clothing, and they are not so worn.  True, Eddie wore his elf costume for Halloween of 2002, but that was for a costume party.  The costume was not worn as ordinary clothing.

Because the elements of the Pevsner test have been met, Eddie realizes no income due to his employer’s provision of the costume.
 

Does Puxco’s payment for Eddie’s personal dry cleaning constitute income to Eddie?

This is a closer issue than the last one, but Eddie probably does not recognize any income as a result of the free dry cleaning.  The free dry cleaning probably qualifies as a de minimis fringe benefit and is therefore excluded from income under § 132.  A benefit provided to an employee qualifies as a de minimis fringe benefit if the value of the benefit is “so small as to make accounting for it unreasonable or administratively impractical.”  Here, the dry-cleaning probably qualifies because Eddie uses the service only four times a year, and his clothes are apparently mixed with the elf costumes – making it difficult to apportion the costs due to each.  If Eddie has great amounts of clothing cleaned for free (e.g., bringing in his entire wardrobe each time) the free service probably would not qualify under § 132 and would be included as ordinary income (= to the FMV of the service).

Note: the free dry cleaning does not qualify as a working condition fringe (because the expense to clean personal clothes would not be deductible by Eddie if paid by himself) or as a “no additional cost service” (because Puxco is not engaged in dry cleaning as a business).
 

Does the grant of the stock option qualify as income?

The grant of the stock option probably does not qualify as income, but income was realized when the option was exercised.  LoBue provides the general rule: income is recognized at the time stock options are exercised.  There are two exceptions to the LoBue rule (§ 83 and § 422) but neither appear to apply.

IRC § 83 does not control the result because the section does not apply to transfer of options without readily ascertainable market value (§ 83(e)(3)).  Usually, the market value can only be readily ascertained if the options are traded on the exchange, and typically, e'er granted options are not transferable.  There is no specific clause, cited in the problem, that forbids the transfer of the option.  In case the fair market value of the option could be readily ascertained, § 83 would require a realization of ordinary income equal to the FMV of the option at time of granting (which cannot be determined from the problem – and note: the FMV of the stock was less than the option price when granted).

The stock option does not qualify as a § 422 incentive stock option.  There are several elements that must be met for an option to qualify under this section.  First of all, to get the favorable treatment (no income until the stock is actually sold), the employee must hold on to the stock for at least one year before selling it – and here, Eddie bought the stock in summer ‘03 and sold in early ‘04 (less than a year).  Secondly, the option must not be transferable – and no such restriction is specifically mentioned.  Third, the option must be restricted to use within a 10-year period, and no such restriction is mentioned.  In accordance with § 422, the option price was greater than FMV at time of grant, and the value was within the $100,000 cap; but due to the failure on the other elements, § 422 doesn’t apply.

Since LoBue controls, Eddie realized income when he exercised the option.  The amount of income equals the value of the stock minus the price paid.  Here, that is $35,000 (value) – $20,000 (price paid) = $15,000 ordinary income.
 

Eddie’s basis in the stock

Under LoBue Eddie’s basis in the stock equals the amount included in income ($15,000) plus the amount paid ($20,000) = $35,000.

If § 422 treatment is granted, then basis = price paid = $20,000.
 

Does receipt of loan proceeds = income?

The receipt, by Eddie, of $20,000 in loan proceeds does not constitute income because there is no accession to wealth (the amount rcvd is offset by a corresponding obligation to repay).
 

Is the $650 paid in interest deductible?

The $650 is not deductible because under § 163(d), investment interest is deductible only to the extent of net investment income.  Because the stock “does not pay dividends of any kind” and the “Puxco stock is the only investment asset Eddie owns” there is 0 net investment income.  Under § 163(d)(2), though, Eddie will be able to carry forward the $650 interest expense to set off against potential future investment income.
 

How much income is realized upon the sale of stock?

Eddie realizes $14,500 in short-term capital gain upon the sale of the Puxco stock.

§ 1001 provides that gain from the sale of property = amount realized - basis.  The amount realized is $49,500 ($50,000 purchase price - $500 expenses of sale) and as previously mentioned, Eddie’s basis in the stock is $35,000.  Thus, the gain = $49,500 - $35,000 = $14,500.

Because stock in a corporation is a capital asset, the gain is capital (rather than ordinary).  Because Eddie held the stock for < 1 year, the gain is short-term capital gain.  Short-term capital gains do not qualify for the law’s tax rates provided for long-term capital gains (so Eddie, probably should have held out another few months).
 

Are the bowling ball and the shirt income to Eddie?

The $150 paid by Puxco constitutes income to Eddie, but the $75 paid by the fellow employees is probably a gift – not income.  Duberstein held that gifts are transfers made out of detached and disinterested generosity.  It is somewhat difficult to imagine a different motive for the employee expenditures, so their portion of the purchase price should be treated as a gift.

On the other hand, § 102(c) provides that transfers from e'er to e'ee should never be considered gifts .....rather they should be treated as more in compensation for services rendered.  Furthermore, the e'ers expenditure is not excludable as a § 74 employee achievement award, because the transfer was made in recognition of Eddie's birthday, not for longevity on the job or safety achievement.  Thus, the portion paid by the e'er – $150 – should be included by Eddie as ordinary income.