Receipt of stock

Emma’s receipt of the stock, although done out of love for her, is not a gift. Under Section 102(c) of the Code, any transfer from employer to an employee is not a gift. The regulations suggest an exception if the employee is the “natural object of the employer’s bounty.” Because such a relationship is not suggested, the stock will not likely be considered a gift.

Because it is not a gift, the remaining option is the stock is property transferred in connection with services rendered under Code Section 83, the employee must include in gross income the excess of the property’s fair market value over what the person paid. Here, Emma paid nothing for the stock. Because of the restriction on the stock that if she leaves before Feb. 1, 2004, she forfeits it without compensation, the stock is at the time of receipt still subject to substantial forfeiture -- she may lose their benefit. Therefore, the value of the stock is not calculated until the risk of substantial forfeiture is gone OR immediately valued if she so elects under § 83(b).

If she elects for the valuation to be done at the time of the receipt, her basis in the stock would be $15/share. This is so because she will have gross income in the amount of $150,000, the FMV of the stock she received. This means her tax basis in the stock is $150,000 or $15/share. So her 2003 tax from receipt would include $150,000 share value, as ordinary income.

If Emma does not choose to count the shares as income at receipt, they will be valued on Feb. 1, 2004, because that is the date the substantial risk of forfeiture disappears and the interest becomes vested. The validation will be done without consideration of the restriction of transfer to employees because the restriction is not permanent. Because the shares are trading at that point for $18/share, her gross income would be FMV of stock ($180,000) minus the amount paid (-0-). So she would have $180,000 ordinary income in 2004. Her basis in shares is $180,000.

Sales of shares

When Emma sells her shares to her husband in 2005 for $10/share, her amount realized on the sale will be $100,000. Her adjusted basis depends on her earlier tax election. If she chose option 1, her basis was $150,000 so she would have a loss of $50,000. If she chose option 2, her basis was $180,000 and thus her §1001 calculation would show a loss of $80,000. In both instances it would be a capital loss, because stock is capital property. Therefore, it would be deductible only against any other capital gain she received, plus $3,000 by ordinary income. However, note that the gain will not be recognized if the transfer was pursuant to the divorce.

Rental property

Borrowing money from bank is not a taxable event. When Emma buys the property, she will have a basis in the property of $275,000. Although repairs are normally deductible as current expenses, whereas here they were part of the expense of getting a fully functioning rental house, and not repair of something she had owned in good repair which was later damaged, they will most likely be treated as capital expenditures and not repairs. This is similar to the treatment of the taxpayer in Mt. Morris Drive-In Theater Co. v. Commissioner. In addition, the costs of buying the property, the $10,000 paid in commission, becomes part of the basis and is not currently deductible. Therefore, at the purchase of the property she has no deductions or income.

The rents paid to Emma are ordinary income under § 61. The interest on the bank loan is deductible under § 62(4) in the year the interest is paid as an above-the-line deduction.

The basis of the property which is allocable to the rental property is depreciable over 27.5 years. Because it is real property, it must be depreciated using the straight-line depreciation method, according to § 168(b)(3)(B). In addition, it does not get the bonus depreciation in the first year. Because land is not depreciable, the basis would have to be apportioned between the land and house before the depreciation formula could be applied. When the basis was apportioned, the yearly deduction would be basis/27.5 years. This deduction would stay constant. The mid-month convention would be applied, because it is residential rental property. Therefore, the first year deduction will have to be prorated according to when she put the rental property into use. The depreciation deduction, if it created a loss, would be a passive activity loss under § 469 and deductible only against gains from passive activities, such as the rents received from the rental property (unless she fits the “Mom and Pop” exception).

Emma’s basis in the rental property would decrease each year in an amount equal to the depreciation deduction she took on the rental property.

Exam No. 3295

The transfer of stock to Emma is not a gift. Gifts are categorically barred in the employer/employee relationship. Thus, regardless of any love or generosity, Emma will need to include the value of the stock transferred as income received as compensation for services.

However, Emma need not include as income the value of any stock which is subject to a substantial list of forfeiture. Because 1,000 shares are subject to forfeiture if she leaves the company before Feb. 1, '04. Emma is not vested in that stock on Feb. 1, '03 and will not recognize income until the risk of forfeiture (Feb.1, '04) has passed. Therefore, Emma can delay recognition of the value of the 1,000 shares of stock until Feb. 1, '04, at which point in time she will recognize $18K ordinary income and have a basis of $18/share. Emma, however, may elect to include the value of the 1,000 shares as ordinary income in the year of the transfer. In this case, she will recognize $15K ordinary income in Feb. '03 and have a basis of $15/share in those 1,000 shares.

As for the other 9K shares, they are ordinary income at the date of transfer to Emma if they are transferable or are not subject to a substantial risk of forfeiture. Because Emma may, albeit in a limited manner, transfer the shares and they are not subject to forfeiture, Emma must recognize ordinary income of $15/share on the other 9K shares at the date of transfer in ‘03. Her basis in those shares will be $15/share.

Unless the sales of the shares to her ex-husband was part of a divorce settlement or w/in 1 year of their divorce, the sale will be treated as an ordinary arm’s length transaction. (If the sale of the shares to Harry was actually incident to divorce, then the transfer of stock for “payment” would be treated like a gift transaction. Emma would realize no loss on the transfer of the shares and would realize no gain on the $100K cash from Harry.) Emma will realize $100K, or $10/share on the sale. We then subtract her basis to determine her loss. In this case, she either lost $5/share on all 10K shares (if she made the election) or $8/share on 1K shares and $5/share on 9K shares. Therefore, her loss is either $50K or $53K, respectively. This amount would be a long term capital loss. This capital loss is deductible only against capital gains, if any, and up to $3K against ordinary income if Emma itemizes (she can then carry forward the loss indefinitely).

The $175K loan is not income to Emma. Emma will get no current deduction for paying $200K for the house. This amount will, however, go into her basis. The $10K commission is a cost of buying property and is not currently deductible, but will be added to her basis in the rental property. Although repairs are typically current expenses, these are made shortly after the purchase of the property. Emma will probably have to add the $15K cost of the overdue repairs to the basis of her rental and depreciate the expense over time. The repairs would be seen as start-up cost for her rental business. Finally, the $50K of long-term improvements are classic expenditures and this entire amount will need to be added to her basis as well. Therefore, Emma’s basis in her rental property will be 200 + 10 + 15 + 50 = $275K after all of the above transactions. Emma will be able to take some of that amount as depreciation in the current year. The rent is ordinary (passive) income to Emma. Her interest payments will be deductible against ordinary income as a current expense above the line. The principle payments are not deductible.