Income Tax I
Bogdanski
Fall 2007

Sample Answers to Question 1

Exam No. 6487 – See pdf file here.

Exam No. 6215 – See pdf file here.

Exam No. 6704

Pt. 1: Grant and Exercise of ISOs

Under § 83, when employers transfer property, as opposed to cash, to employees, this is gross income equal to the fair market value (FMV) of the property transferred, less any amount paid by the employee. The valuation, and inclusion, of income from property under § 83(a) is not done until the property “vests”—meaning either that there is no substantial risk of forfeiture to the employee (Betty), or that the property is transferable. The facts indicate that the stock options vested the day they were granted, so there is no substantial risk of forfeiture. Because of this, Betty’s stock options will be income, which she must report at specific points.

Incentive Stock Options (ISO’s), such as that which Betty was granted, have several requirements. First, they must require the employee to retain the stock for a specific period after the purchase, and second, there must be no “spread” at the time of the grant, meaning that the FMV of the stocks at the time of the grant is equal to the amount the employee is allowed to purchase them at. Here, we are told that the stock options are ISO’s, and that there is no spread at the time that the options were granted to Betty.

Incentive Stock Options carry with them a specific timeline for reporting of income. While unqualified stock options would require the employee to report some income at the time of exercise (and even at the time of grant, where those options have a readily ascertainable FMV because they can be traded on an options market, and there is a “spread” at the time of grant), with ISO’s the employee is not taxed upon the grant of the option, or the exercise of the option—rather, the employee is taxed only upon the sale of the stock later down the road.

This means that when Betty is granted the option to purchase the 10,000 stocks she has no income; additionally, when she exercises the option and purchases 10,000 stocks for $3/share, when the FMV was $6.50/share, she still had no income, because this is an ISO instead of a nonqualified stock.

The only exception to this would be if she is subject to the Alternative Minimum Tax (AMT)—in which case, the exercise of the ISO would be a taxable event for Betty. That would mean that when she purchased 10,000 shares of stock for $3/share, for a total of $30k—when the FMV was $65k—she would be taxed at the ordinary income rates for the difference between the FMV and the purchase price ($30k) in the year she exercised-- 2007. But there is no indication in the problem that she is subject to the AMT.

In any event, by exercising her stock options she creates basis in the options equal to the purchase price upon exercise—in this instance, $3/share or a total of $30k.

If or when Betty chooses to sell her stocks later, she will receive capital gains income (or, perhaps, a loss), by subtracting her $30k basis from the amount she sells them for. If it is a capital loss when she sells them, as opposed to a gain, she will only be able to deduct $3k of that loss against ordinary income—the rest of that loss would be deductible only against Betty’s capital gains.

Pt. 2: Cash Dividend

Cash dividends are included in gross income, even though stock dividends are not part of gross income (Eisner v. Macomber). This means that the cash dividend Betty received from Chipco of $9k is included in gross income. Because Betty uses the cash accounting method, the income should be reported in the year in which the income is credited to her account, set apart for her, or otherwise made available (Reg. § 1.451-2)—under the constructive receipt doctrine. Because she has received this check in the year 2007, and there are no restrictions on her legal right to cash it, she constructively receives the $9k—and thus must report it—in 2007, even though she does not actually deposit the money until 2008.

Cash dividends are not actually capital assets, but they are still taxed at the capital gains rate, so this is capital gain as opposed to ordinary income.

Pt. 3: Premarital Agreement

Under § 1041, where there is a transfer of property from one individual to that individual’s spouse (or former spouse, incident to divorce), there is no gain or loss recognized upon that transfer, and the transfer is treated as a gift to the transferee spouse. The transfer made from Jason to Betty the day after their wedding falls under § 1041, so that there is no income to Betty upon the transfer of the beachfront property.

However, despite having no income, Betty does create a basis in the property by this transfer—under the § 1015 gift basis rules, and because the property appreciated in the hands of the donor (Jason), Betty gets a “carryover” basis from Jason, meaning that her basis in the beachfront property would be $275k, Jason’s former basis. It’s vacant property, so that there are no depreciation deductions allowed, as land is not allowed depreciation. However, she should consider deductions of the property taxes, if any, for the land, if it is being held for investment, under § 212 as an “ordinary and necessary expense” of the investment.

The attorney’s fees are at least not immediately deductible. The attorney’s fees associated with the negotiation of the prenuptial agreement are not be deductible at all, as they are personal in origin— unless Betty was seeking alimony (Reg. § 1.-262-1(b)(7), which does not appear to be the case here. On the other hand, all costs associated with the buying and selling of property are to be capitalized into the basis of the property. So if this negotiated “gift” is treated as though it’s a sale, the attorney’s fees associated particularly with Betty’s acquisition of the property would be put into the basis of the property, to increase the basis of that property from $275k to something more than that (but less than $287k). However, it appears in this case that, under the “origin of the claim” test, even those fees are probably not deductible, as they are so wound up in the personal nature of the premarital agreement. However, just in case, Betty should request that her attorney itemize the hours spent on the premarital agreement from those hours spent closing the property transaction, so that if the two are really separate “transactions,” Betty may put the attorney’s fees associated with the property transaction into the basis of the property, so that she may have less income upon any later sale of that property.

So there is no income to Betty from either of these transactions at this time (2007).

Pt. 4: Return of Income

This scenario is very similar to the one in Lewis, where an employee was paid a bonus from his employer in one year, and then the following year the employer realized they’d miscalculated his bonus and requested that he pay some of it back. Because Betty received the salary in 2007, she should have reported it as gross income in 2007, under annual accounting rules. Then, in 2008, the employer requests that she return $4k of what they paid to her the previous year. The issue that arises from this is that Betty has previously paid income tax on income that she does not get to keep—so that the IRS should be refunding some income tax in some way. But the question is: should Betty’s return of $4k mean that she gets a refund of $4k’s worth of income tax at the rate of 2007 (which is the rate she originally paid the income tax at), or at the rate of 2008 (the current year)?

Lewis was decided detrimentally to the taxpayer, but § 1341 has since changed the answer. Under this provision, Betty has the choice of doing whichever is more beneficial to her: (1) taking a deduction of $4k in the current year (2008) at the current rate, OR (2) figuring out how much tax was paid on the $4k during the prior year (2007), and taking that as a credit toward her tax in 2008.

Betty should consider which would be more beneficial. If her tax rates are much higher in 2008 than they were in 2007, then she should take the deduction in the current year. If her tax rates were higher in 2007 than they will be in 2008, then she should take a credit against the current year’s tax.

In either event, it is an ordinary deduction, as opposed to a capital loss.

Created by: bojack@lclark.edu
Update:  14 Jan 08
Expires:  31 Aug 08