Income
Tax I
Bogdanski
Fall 2011
Sample Answers to Question 2
Exam No. 9315
Non-qualified Stocks:
Ken's stocks are non-qualified, therefore he is not subject to the limtations under IRC 422 that would have required him to retain it for a certain period of time, and would have limited him to receiving $100,000 from his employer. Also, under IRC 422 the ER could not have granted the options for an amount per share less than the FMV, but that did not happen with K's stock, so it would have been a non-issue.
The grant of options to Ken does not have any tax consequences for Ken (2011). Even though Ken is fully vested, he will not be taxed until he exercises his options.
When Ken opted to exercise some of his options in 2013, he must recognize a gain of $750,000. 1001 The amount for which the options are exercised, $1,250,000 less the total FMV of those shares from the grant, $500,000 (50,000 stocks X $10/share) is the gain that Ken must realize. This $750,000 gain is taxed at K's ordinary income rate. K does not receive the discounted tax rate for capital gains.
When Ken sells 40,000 shares in 2015, he will recognize a $200,000 gain. The amount he receives $1,200,000 less the total FMV of the shares from the date of exercise, $1,000,000 (40,000X25) is the gain that Ken must realize. This $200,000 gain is taxed at the capital gains rate of 15%.
Charitable Contribution:
Under IRC 170, K will get to take a deduction in 2015 for his donation of the 10,000 shares to charity. The non-profit selected by K would qualify under IRC 170(c) as it is a corporation formed in teh US orgainzed and operated exclusively for charitable purposes (medical education), which does not have private owners, and does not lobby. While 501(c)(3)'s are not supposed to lobby under the IRC, most of them do. If the medical school lobbies, they would still probably qualify for K's purposes. Ken would be able to deduct the FMV of the stock, $300,000 (10,000 shares X $30FMV)), subject to the ceiling or IRC 170(d). While there is no floor for deductions for charitable contributions, there is a ceiling of 30%-50% of AGI depending on the charity. Since this is a medical school, and not a church (the super good guys), it is likely Ken will be subject to the 30% ceiling in 2015. However, what ever deduction he is unable to use he may carry over into future years, until he has used all of it.
However, if Ken was not detached and disinterested in his
motive to donate to the medical school, he may not be able to claim this
deduction. There cannot be any sort of quid pro quo,
K will need to itemize in order to receive this deduction, as charitable contributions fall below the line. Ken would also need to keep proof of his deduction, and have records.
Child as dependent relating to charitable contribution, and exemption:
The abover analysis relating to Ken's charitable contribution assumes that K is still claiming his son as a dependent. Under IRC 152(a)(1), his son will be a qualifying child is he is K's child, under 24 and attending school, living with T for more than 1/2 the year, and the son does not provide more than 1/2 of his own support. Under this analysis, K would clearly be receiving a benefit from the school's grant of tuition, etc. If K's son was no longer a dependent of K, K may be able to argue that he did not receive any quid pro quo - the benefit went to his son, and therefore he may be able to use teh full $300,000 of charitable contribution.
Dependent exemption would be $3,700 and would be excluded from gross income. IRC 152
Employee Expenses:
Corp's payments of K's dues are gross income to K. IRC 61. Unless K can show that the dues are for the convenience of the employer and an ordinary and necessary expense, these dues are gross income to him, and are not deductible. IRC 274. This does not seem to be a gift by Corp to Ken. ER's cannot give EE's gifts. IRC 102(c). These dues are a payment in kind in connection with the performance of K's services for corp. While K only uses the club for business purposes, under IRC 61, these payments are gross income to Ken, and are not deductible. Meals while doing business are allowed as a business deduction under 162. In this circumstance, K's meals would all be business related as he only uses the club to entertain customers, investors, etc. However, it may be that K is taking meals at the club more often than he really needs to, under Moss, in order to conduct his business, in which case these would not qualify for a deduction. However, since Corp is reimbursing K for these expenses, he may take them as a deduction. In fact, he does not even need to list the gross income from the reimbursements. Corp will only get to take a 50% deduction for these meal expenses. IRC 274(n)(1)(B).
**It is liklely that many of the above meals are taken in conjunction with entertainment of customers (as well as conducting "no fun" business). As long as K has a bona fide business discussion before or after the recreation, then these will be deductible under IRC 274(a)(1). Meals in conjunction with entertainment can also only be deductioed up to 50% for Corp, 100% for K.
K will need to have to substantiate with adequate records including amount spent, time and place, business purpose, and business relationship.
This deduction for reimbursed employee expenses would go above the line. IRC 62.
These could not be said to be a deminimus fringe under IRC 274(n)(2)(B) because K eats there a substantial amount of the year.
Exam No. 9329
Nonqualified Stock Option
The first issue is the tax consequence to Ken of the stock
option. The facts state that this is not an incentive stock option or part of a
qualified retirement plan, so it will be treated as a nonqualified stock option
under § 83.
Under § 83, the person who is granted a stock option (Ken) does not have any income when the option is granted unless the option has a readily ascertainable fair market value, meaning the option is actively traded on an established market. Here, Corp options are not traded on a public market and therefore do not have a readily ascertainable fair market value. Therefore, Ken will not have any income or other tax consequences when he is granted the option.
However, when he exercises the option, he will have ordinary income in the amount of the spread between the value the shares are trading at (fair market value) and the exercise price. Here, the fair market value of the shares Ken purchased was $1,250,000 and his exercise price was $10 per share for 50,000 shares for a total exercise price of $500,000. Therefore, he will have ordinary income of $750,000 ($1,250,000 - $500,000). Ken will get a basis in these shares of their fair market value at the time of exercise, which is $1,250,000.
Finally, when Ken sells these shares on the market two years later, he realizes a loss under § 1001. His amount realized is $1,200,000 and his adjusted basis is $1,250,000. Therefore he realizes a loss of $50,000. Because Ken held the stock for more than one year (long-term) and he does not appear to be a stock broker (dealer), the loss he realizes will be a capital loss because stock is not excluded from the definition of capital assets in § 1221(a) (except when sold by dealers). This is unfortunate for Ken because capital losses are only deductible against capital gains and $3000 of ordinary income. Therefore, Ken can only deduct this loss to the extent that he has capital gains (or ordinary income of $3000). However, he can carry this loss over to future years when he does have capital gains if he doesn't have any this year.
Donation to Nonprofit
The next issue is the tax consequence of Ken's donation of the 10,000 Corp shares with a fair market value of $300,000 to the nonprofit medical school. Under § 170, donations to domestic organizations organized and operated exclusively for educational (among other) purposes are deductible (below the line). These deductions are allowed up to 30% of adjusted gross income (AGI) or in some cases, including donations to educational organizations, the deductions are allowed up to 50% of AGI. In addition, for donations of long-term capital gain property, the taxpayer gets to deduct the full fair market value of the property. As noted above, the stock Ken donated is long-term capital gain property because he has held it for more than 1 year and it is not excluded from the definition of capital assets in § 1221. Therefore, Ken may be able to deduct the full fair market value of the stock ($300,000) as long as it does not exceed 50% of his AGI. Even if it does exceed 50% of his AGI, he can carry over the excess into future years. In addition, even though this deduction is below the line, it is not a miscellaneous deduction subject to the 2% of AGI floor in § 67. The medical school's subsequent sale of the stock does not affect Ken's deduction.
Ken will have to substantiate his deduction under the rules of § 170(a)(1). He can likely easily satisfy this requirement by requesting a receipt from the charity. Because the stock has a fair market value, it will be easy to determine the value of his donation.
However, there may be a limitation on Ken's deduction. Where a taxpayer receives a substantial quid pro quo in return for their gift, the deduction is only allowed to the extent that the amount of the donation exceeds the amount of the quid pro quo. Here, the possible quid pro quo is not as obvious as when a person makes a donation to public radio and gets a tote bag in return. However, the quid pro quo need not be so obvious as was seen in Ottawa Silica case where the donation of land to a school district required the school district to build access roads that benefited the taxpayer. Similarly, the IRS might argue that the scholarship that Sam received was a quid pro quo for the generous donation Ken made, even though under § 117 the scholarship would not have been income to Sam. This argument is strengthened by the fact that Sam's academic record and test scores are slightly below what the school requires for admission, let alone for receipt of a scholarship. Sam's sub par credentials make it look more like the donation was in exchange for the scholarship (and maybe even admission). Therefore, to the extent that this scholarship is a quid pro quo, Ken will only be able to deduct $250,000 ($300,000 fair market value minus $50,000 quid pro quo) of his donation. If the IRS were able to prove that the donation was a quid pro quo for admission and the scholarship, the deduction might be disallowed all together as it was in Ottawa Silica.
Club Dues
Under § 274(a)(3), no deduction is allowed for membership dues for a club organized for business, pleasure, recreation, or other social purposes. Therefore, even though Ken uses the club membership solely to entertain customers, investors and other business contacts, he will not get any deduction for these club dues. Therefore, Corp's payment of these club dues will be considered ordinary income to Ken with no offsetting deduction.
Meals
The reimbursements that Ken receives for his meals at the club will be fully deductible to Ken. First, Ken cannot exclude the meals from his income under § 119 because meals can only be excluded under § 119 if they are provided on the business premises of the employer in kind, which is not the case here. Therefore, Ken must look to § 274 to be able to deduct the reimbursement he receives for his meals.
Under § 274, entertainment expenses can be deducted if they are "directly related to" the taxpayer's business or if they are "associated with" the taxpayer's business and preceded or followed by a substantial bona fide business discussion. Here, it appears that Ken is entertaining business contacts over meals and so one of the two requirements of § 274 is likely satisfied (directly related or associated with the business). However, under § 274(n), only 50% of the amount spend on meals is deductible. Luckily for Ken, under § 274(e)(3), if an employee is reimbursed for meals, the reimbursement is income, but the employee can deduct 100% of the expense. In addition, an employee's reimbursed expenses are deductible above the line, so Ken will get this deduction even if he does not itemize. Therefore, Ken will have income from the reimbursement, but he will have a full offsetting deduction, and so ultimately no tax consequences. His employer will not be so lucky. His employer, as the one ultimately paying for the meals, will be subject to the 50% limit set out in § 274(n).
However, in order to be eligible for this deduction as an entertainment expense, Ken will have to substantiate his expenses under § 274(d). Under those rules, he must have records of (1) the amount of the expense (2) time, place, and date of the meal (3) the business purpose and (4) the business relationship Ken has to the people he entertained. These substantiation rules will likely be easy for Ken to meet if he simply keeps the receipts from his meals and notes these details on the back.
Another impediment to Ken's (and his employer's) deduction for these meals is the issue of whether he is really entertaining in association with his business or whether he has gone too far as the law partners did in the Moss case. In that case, the partners in a law firm met for lunch at the same restaurant every day to discuss their cases and assignments. There the court found that the meals were not deductible because eating out every day went too far, even for those discussing business over the meal every day. Similarly, the IRS might argue that Ken (and his employer) should not be allowed to deduct all of these meal expenses because he is eating meals there 100 days out of the year. The IRS might argue that this goes too far. However, this argument will likely fail, as there is a big difference between going out to lunch once or twice a week and going out every day, as long as Ken can still connect these meals to his business.
Exam No. 9566
Option
The option granted by Corp (C) to Ken (K) is nto a preferred compensation price becasue the strike, or exercise price, is not less than the fair market value at the time the option is granted. K likewise not being offered an incentive stock option (which has limits on the amount of money each employee can invest each year and how long the employees ust retain the benefit -- §421-422. AS a nonqualified stock option, at hte time of grant when he i given the option to buy the stock at its fair market value there are no tax consequences. Because K does not have an inclusion in his gross income, there is no clear accession to wealth over which he has complete dominion (Glenshaw Glass), there is no basis that he can have in the stock at the time. In sum, he doesn't own the stock.
Exercise
At the point where K exercises the option to acquire 50,000 shares, he is exerpeincing a taxable event. Thsi would be included in his ordinary income. In order to figure out his ordinary income we would need to calculate his spread, which would be the option price ($10/share) subtracted from the price the stock is trading for at the market. Here, the stock was trading for $25/share, costing him $1,250,000 at exercise. His cost would be $500,000, giving him $750,000 in ordinary income (that is going to be a monster tax year for him. When K exercised his option, under the treatment of §83(a) his employer would ahve been entitled ot a corresponding deduction under §162. Under §1012, K's basis in the stock would be his cost, or $1,250,000 or $25/share. Because the income is ordinary, the tax rate applied to this income will be whatever his highest marginal tax rate is according the the appropriate rate table under Rev. Proc. 2011-2012.
When K sold his 40,000 share sof stock at $30/share, his tax situation would not be as gruesome as it was in 2013. The gain on his stock would be calcualted by taking the price the shares are being traded at ($30/share) and subjtracting the price he paid when he exercised his stock option ($25/share). He would thus have a gain of $1,200,000 (amount realized under §1001), minus his cost of $1,000,000 ($30/share x 40,000 shares), giving him a gain of $200,000. However, this gain is treated as a capital gain, because under §1221(a) corporate stock held by an individual is considered a corporate asset, and under §1(h)(11) he would be entitled to much more favorable tax rates.
Donation
Assuming K itemizes his tax return (given how high his
income is, he should be finding a way to creatively and legally minimize his tax liability), he will
be able to take a below the line deduction under §170 for his contribution of
stock to the nonprofit medical school.
First, to take this deduction, the donation has to be to a qualifying cahrity. Charities
that qualify incldue governmental entitles, and also,
a corporatin, trust, community chest, fund or
foundation that is created in the
However, there are special rules for the treatment of stock that is donated to a charity. When K made the donation, he may be entitled to include in the amount the FMV of hte property, not his original basis. The difference between the two here is substantial because he has $10/share basis, and when he donated the stock, it had a FMV of $30/share ($300,000 total FMV divided by the 10,000 shares). Under §170(e), if the property itself constitutes a long-term capital gain and is going to get worse treatment then other types of donations. Because the stock has been held for more than 1 year (exercised option in 2013, and donated in 2015), then the amount of the donation will be the lesser of FMV or basis for the stock. Because the stock's basis is $10/share, that is lower then the current FMV of $30/share. Thus, K is entitled to a deduction of $100,000 (his original basis) not the current FMV of the shares. Luckily for K, he is not subject to the §67 2% of AGI rule that would limit his deduction (although he would easily meet that floor), because charitable contributions under §170 are not miscellaneous expenses.
Scholarship
The medical school admitting Sam (S) may have an impact on the charitable contribution because they gave him a scholarship under §117 (which is not GI to S because it meets all the criteria of §117: is for books, supplies, tuition, and fees and he is seeking a degree). Under Ottawa Silica Co, if there was a quid pro quo relationship between K and the school, such that they would agree to admit his under performing son in exchange for him making a substantial gift of stock, then K would not be entitled ot any deduction whatsoever. The IRS would ask whether he received a "substantial benefit" in return for his contribution. If he did, any deduction under §170 would be precluded. If there was some explicit agreement between K and the school, that would be a substantial benefit because it is "greater than those that inure to the general public from the transfers for charitable purposes" -- i.e., not everyone who is testing with low MCAT scores, and undergrad GPAs is going to get into the school after K's donation. However, there is no explicit agreement between K and the school, so I think that K should be okay. Educational facilities are hungry for donors, and they may have decided to admit K's son because of his relationship, hoping that at some point in the future, they would be the benefiary to K's estate. That whim and hope on the part of the institution, as a unilateral action, does not itself create a quid pro quo relationship.
If the admission was not a quid pro quo relationship, but rather, was just a plain old vanilla benefit that K got from his donation, then the value of what he got in making his gift woudl be deducted from the gift. So of the $100,000 donation he received, if a "free ticket to med school" was what hte school was handing out for donations of highly valuable stock, his actual deduction under §170 would only be $50,000. I think the temporal disconnect between K's gift and the school deciding to admit S makes this scenario unlikely, albeit worth considering.
Because K isn't paying anything for S's education, he would not be entitled to take an education credit under §25A (probably as the lifetime learning credit of $2000). Moreover, S is a approaching an age where he may be too old to be a dependent (if he is over the age of 24), and he also might be claiming himself as an exemption and supporting himself. In this case, K would no longer be able to take S as a below the line dependent child exemption under §151 (which is permitted in addition to either his itemized deductions under §63(d) or his standard deduction under §63(c)).
Business Club Membership & Meal Deductions
C paying monthly dues on behalf of K at the downtown
business person club is not generally permitted under the code. §274(a)(3) bars a
deduction for membership in any club organized for business, pleasure,
recreation, or other social purpose.
However, §274(e) guts this rule a bit and leaves it toothless, providing
that (a) does not apply to reimbursed expenses (e)(3). K would argue that hte
money and time he spends at the club is soley
to entertain his customers, employee prospects, finacniers,
investors and other business contacts, and thus woudl
qualify for a business related expense, even if it was included in his gross
income. Thus, while membership fees are
generally not allowed, here the downtown club would qualify as a business
expense that C could reimbuse K for, and would be
excluded from K's GI.
C playing for the meals and entertainment, however, would be subject to
the 50% rule under §274(n)(1)(B). Meals are also a permissible thing for an
employer to provide if they are "ordinary and necessary
expenses." The facts tell us that K
is reimbursed for his meal expenses, and that is a benefit an employer can
provide to an employee under §162 that is excluded from an employees gross income
and is treated as a business expense.
Thus, K would not have to worry about a below the line deduction or
having to include that reimbursement in his gross income. Those meal reimbursements can be paid to K in
full, but C will only get to take the 50% business deduction under
§274(n).
If the membership did not fall within the (e) exemption of §274, and C reimbursed him, then at least the membership fee would be gross income to K (as a an accession to wealth, clearly realized, over which he had complete dominion). However, K would be able to deduct the costs he incurs as an employee as a §162 business expense. Any deductions that he made because they were not directly reimbursed by his employer would be below the line expenses that are subject to the §67 2% AGI floor. He would be able to deduct meals because he would be doing business over the meal with others, and also because he is entertaining his clients, customers and other business contacts. Because he is there 100 days a year (roughly 27% of the year), he may get push back from the IRS if they think he is excessively accumulating meal and entertainment charges. In Moss, the 7th circuit disallowed lunch meetings among the same small group of attorneys. However, this is not an every day thing where K is meeting with the same people, but rather, he is cultivating multiple business contacts and relationships and should be permittd the deduction as an "ordinary and necessary" bsuienss expense. Moreover, any expenses of K's for meal charged or expenses incurred would also be subject to the §274(n) 50% rule. This rule reflects a compromise congress was making between people taking advantage of meal deductions, and the fact that people would probably need to eat anyway.
The club is near C's head quarters, and if K incurs any transportation expenses that he is not reimbursed for, he could take a deduction for that as a nonreimbursed employee expense under §162, which would be below the line and subject to the §67 2% of AGI floor.