Exam # 9626

Michelle realizes $30,000 income from her performances for Doc at the nightclub.  This is an example of barter; Doc performed services for Michelle and Michelle performed services for Doc. While taxpayers do not realize imputed income when they perform services for themselves, they do realize income when they barter.  If services are paid for other than in cash, the fair market value of the services or property are included in gross income.  So, here the value of the surgery is included as ordinary income.  There is no discharge of indebtedness income here, since the doctor bill was paid in full.

Michelle may try to deduct the cost of the surgery.  (It is an unreimbursed expense, since not covered by insurance & she doesn't have an employer.)  She will not be able to deduct it as an extraordinary medical expense under IRC 213, since cosmetic surgery is excluded.  She may also try to deduct it as an ordinary and necessary business expense, since she got the surgery only to excel (or maintain) in her career.  Michelle may be successful in this argument, although the IRS will likely argue that it is a personal expense and should not be deductible.  If Michelle is allowed a deduction for her surgery, she will arguably not be able to deduct the full amount in 2002.  Arguably, this would qualify as a capital expenditure; it was made with profit motive, is expected to yield long term benefits, and is a non-recurring outlay.  As such, Michelle would be forced to depreciate (or amortize) and recover the cost of her surgery over time.

Some of the annuity payments will be included in Michelle’s gross income; part of the payments will be treated as a return of her boss.  To figure out the amount that will be excluded in Michelle’s income, we must first determine her life expectancy in order to calculate the exclusion ratio.  According to Table V in 1.72.9, her life expectancy is 34 years.  Therefore, the expected return is 340,000.  By dividing the investment in the contract (170,000) by the expected return, we get an exclusion ratio of ½.  Therefore, half of each payment will be treated as a return of basis and half as income (ordinary).

Therefore, Michelle will be taxed on $5,000 in 2002 and $5,000 in 2003.  Since Michelle was killed before she recovered her full basis in the annuity, Larry or her estate will be able to take a deduction on her final tax return in order to recover the unused basis (160,000).

When Michelle was killed, she was owed $200,000 for services rendered at the outdoor concert.  When she is paid, this will be treated as income in respect of a decedent under IRC 104(c).  Therefore, Larry or the estate will realize $200,000 of ordinary income.  IRD is bad because it does not receive stepped up/stepped down basis that normally applies to bequests, gifts from decedents, etc.

Although we do not know whether Larry and Michelle filed jointly under IRC 1(c), while Michelle was alive, if they did so, Larry will still be able to claim that status since 2(a) defines surviving spouse to include a taxpayer whose spouse died during either of the two taxable years preceding the current taxable year.
 
 
 

Exam # 9939

Michelle would like to deduct the cost of the cosmetic surgery if she could.  She might first try to deduct the surgery under section 213, which would allow her to deduct the expense against her ordinary income for the amount that exceeds 7.5% of her AGI.  However, 213(d)(9) specifically says that cosmetic surgery cannot be deducted under its provisions.  No matter, Michelle might try to deduct this as a trade expense under section 162 because as a singer she needs maintain her good looks to remain successful.  If successful she would be able to deduct the entire amount as an ordinary business expense, above the line.  However, she may have some problems in that the expense, while arguably necessary, isn’t an ordinary expense in her business or trade.  Michelle could make the argument that singers and actresses are always getting plastic surgery in their line of work, i.e. Michael “No Nose” Jackson.  On the other hand, one may argue her business is singing and this is not an expense that comes up in the ordinary course of singing for money.  If it is not an ordinary expense, it might be a capital expense or an improvement in her face.  In fact, this looks more like a capital expense because it is unordinary and it is likely she will be receiving income from it for a long time.  If this is the case, she would have a basis of at least $30,000 in her face.  Capital expenses cannot be deducted in the year in which they are incurred, however, they can be depreciated over time and used to offset income in later years.  Still the question remains can she use double deprecation method for the first few years or does she have to begin with the straight line method to depreciate the capital in her face?  Is her face a passive or active investment.  If it is a passive investment she will have to use the straight line method because she is an individaul.  If it is an active investment she can use the accelerated cost recovery system even though she is an individual.  Because her face is part of her business as a singer I think she could use the method under 168.  The amount of deduction she could take in year 2002 would be her adjusted basis 30,000 / total number of years (we’ll say 4) X 2 or $15,000.  But since she purchase her new face in the middle of the year her applicable convention would be the mid year point and we would have to reduce that amount in ½ to $7,500 ordinary deduction for 2002.

At the time of her surgery Michelle incurs a $30,000 debt to her doctor.  Incurring debt is not income and therefore Michille would not have a gain at this point.  To pay back her debt she plays two shows for him, because when you payback debt with services is income at the time of the execution of the service, Michelle has satisfied her debt and she has ordinary income which she must pay tax on.

When Michelle purchased the annuity policy for $170,000 she did not receive income or a loss, she did receive $170,000 basis in the annuity policy.  In 2002 and again in 2003 she received a $10,000 payment on the policy.  The question is how much of this was income to Michelle?  The ratio to determine how much of an annuity payment is non-recognizable as income is the basis or amount invested divided by total payment expected over the life of the holder.  In this instance, Michelle invested $170,000 and the amount she can expect to be paid is her life expectancy (34 years according Table V) times the amount of each payment ($10,000) or a total of $340,000:

   170,000/340,000 = .5.

The ratio (.5) times the annual payment sum (10,000) tells us how much of each payment will not be recognized as gross income, or $5,000, that means that in 2002 she had $5,000 of ordinary income from the annuity.  The ratio stays the same for the entire term of the annuity so in 2003 she also had $5000 of income from the annuity.

In 2004, Michelle dies after performing a large show. At the time of her death she had a $200,000 fee that had not been paid for performing at that show, her husband, Larry, as her sole heir later received the payment from the promoter.  Typically, when someone dies the heir or estate assumes or steps into a basis in the property received in respect of a decedent equivilant to the fair market value of the property at the time of the death.  In this instance, Larry could argue that the right to receive payment had some kind of value or worth at the time of Michelle’s death, and perhaps the estate had paid some kind of estate tax on the note, and therefore he should have a basis in the right to payment.  However, 1014(c) provides an exception to the general rule by not allowing no stepped in basis for income that comes in respect of a decedent, but makes such income gross and ordinary.  So in this instance Larry has income of $200,000.

However, Larry isn’t done enjoying the tax goodies left behind by Michelle.  Presumably, since he is the sole heir and in charge of her estate he would be left to handle her final return.  In the case of her annuity she still has $160,000 of basis remaining in it, section 72(b)(3) says that a deduction in the amount of the remaining basis will be taken on your final return against any ordinary income that may also becoming in that year.  Presuming that Larry and Michelle file a joint return he could use this deduction to offset the $200,000 worth of income he received from the promoter.
 

Exam # 9847

As a self-employed singer, Michelle has ordinary income from her singing gigs, and ordinary expenses in the amounts ordinary and necessary to generate her income.  She did not appear to receive money for her two shows at the Doc’s nightclub, however, she still has ordinary income in the amount of $30,000 in 2002.  We know this from Barter Rev. Rul. 79-24.  She performed services, singing, and the fair market value of these services was $30,000.  We also know this is the correct amount, because her work satisfied her debt to Doc (who also has $30,000 ordinary income) in full.  For medical expenses paid by a taxpayer, there is a deduction available, which has a 7.5% floor, and requires itemizing of deductions.  This deduction would not be available to Michelle, however, for the same reason her medical insurance would not cover the expense, because it is “not medically necessary.”

Michelle might argue that the cosmetic surgery was actually a business expense for the production of income under §§ 212 or 162.  Arguably, if she didn’t have this procedure, her bookings would fall when word gets out of her appearance.  While we don’t know the nature of the cosmetic surgery, it doesn’t appear Michelle would have a good argument for deductibility.  After all, singing involves the vocal chords and a listener can appreciate the music by closing his eyes.  Take Barbara Streisand, for example.  Her (arguably unattractive) nose didn’t hinder her producing large amount of income from her singing career.  However, if Michelle were more of a Britney Spears type singer (more of a looker than a talented singer), then there would be a better argument for deductibility.  Given Michelle’s age, however, it appears more likely that the former is the case, and there would be no deduction due to the fact this appears to be a more personal in nature.  Interestingly, if Michelle had put on makeup for her shows to cover her imperfection, she probably would have been able to deduct those expenses.

Annuity payments received are partly ordinary income and partly a return of basis.  To determine the ratio of income, we need to determine how much Michelle was expected to have received overall.  This minus her basis is the income she expected to receive overall.  The overall income divided by the overall payments is the income ratio that each payment is multiplied by to determine the amount of ordinary income.  This is the inverse of the exclusion ratio described in IRC § 72(b).  To determine the overall payments we need to look at the life expectancy tables under Reg. § 1.72-9.  As a 49 year old person in 2002, Michelle was expected to receive 34.0 payments of $10,000.  Therefore, she expected a total of $340,000, which would yield $170,000 income with a $170,000 basis.  Therefore, 50% of each annuity payment is ordinary income (and the other 50% is return of basis).  Therefore, Michelle had $5,000 ordinary income from the 2002 payment and $5,000 ordinary income from the 2003 payment.  It doesn’t appear Michelle received a 2004 payment, because of her untimely death.  However, on the bright side, Michelle will get a $160,000 ordinary deduction on her final tax return, under § 72(b)(3), which represents her unused basis on the annuity.

Under the cash method of accounting, there is no income until it is actually or constructively received.  Under the accrual method, Michelle would have had the $200,000 of ordinary income after her performance.  The $200,000 will not be income to Michelle, because she did not actually or constructively receive the money.  Larry, who actually receives the money, will have $200,000 ordinary income in 2004.  This is called Income Respective Decedent, and there is no stepped up basis available to Larry.