Income
Tax I
Bogdanski
Fall 2014
Sample Answers to Question 1
Exam No. 9275
Clothing:
The wardrobe supplied to Brett by the Net
is probably gross income to Brett. Under section 83, property can constitute
income, and the clothing that Brett receives from his employer does not fall
within into any of the fringe benefit categories. Brett will not get a
deduction for the income he receives on account of the clothing, because
clothing expenses are only deductible when the taxpayer (TP) does not wear the
clothing for general usage. Here Brett clearly does. The income that Brett
receives on account of the clothing will be the FMV of the clothing, and
this income will be ordinary income. This income will be treated as
having been received in the year in which Brett received the clothing. Brett's
basis in the clothing will be the amount that Brett reports as income--their
FMV.
Deduction for Plastic Surgery:
Brett's plastic surgery might be a
deductible expense for Brett as a business expense. Plastic surgery is not
deductible as a medical expense, so if the plastic surgery is not considered a business
expense, then it will not be deductible. Although the plastic surgery might be
a business expense for Brett, it is an unreimbursed business expense, and thus
falls below the line, so it will only be deductible if Brett opts to itemize
his deductions. Furthermore, the deduction Brett gets from his plastic surgery
is a miscellaneous deduction (b/c it's not listed in 67), so it will only be
allowed to the extent that Brett's aggregate miscellaneous deductions exceed 2%
of his AGI for the year.
Other Medical Expenses:
A deduction is available under 213 for
medical expenses, but only to the extent that they exceed 10% of the TP's AGI.
In this case, the $10,000 worth of medical expenses that Brett incurs as a
result of his allergic reaction are less than 10% of his AGI (2 million), so he
will not be entitled to a deduction for them (unless, somehow, Brett has
already incurred $200,000 worth medical expenses not covered by his insurance).
Settlement:
Brett's settlement with Syd creates several interesting tax questions. In
determining the tax effect of damages (or a settlement), the first step is to
ask what the damages (or settlement) replace (Raytheon). If the damages
replace income, then they will be considered income. Likewise, if they replace
a gift, then they will be considered a gift. If the damages replace property,
then the transaction will be treated as a sale of property, and the 1001
analysis will be applied. If damages restore damage to property, than they are
treated as a return of the basis. Finally, if the damages replace nothing, then
they are treated as income. However, 104(a)(2) provides an exception wherein
damages received on account of a personal physical injury are not
treated as income.
Brett's situation involves a settlement,
which presents a tricky allocation problem. The key to determining the tax
consequences of the settlement is determining the how it should be allocated.
The cases suggests that in making this determination, the intent of the payor
is controlling. Additionally, courts might look at the complaint for guidance
as to allocation.
Here there are five possibilities for how
the damages might be allocated.
•
Refund of the 50K paid to Syd
• Reimbursement for
medical expenses
• lost wages
• pain and suffering
• punitives
Here it's likely that at least half of
the settlement will be considered to be attributable to punitive damages,
because well over half of the damages that Brett requests in his complaint are
for punitives. Whatever part of the settlement is considered to be punitive
damages will be treated as gross income for Brett. This income will be ordinary,
and it will be treated as being received in the year in which Brett receives
(or has a right to receive) the settlement (assuming he using the cash method
of accounting). This classification and timing analysis will apply to any part
of the settlement included in Brett's gross income.
The rest of Brett's damages might be
excludable from his income, but only if he is considered to have suffered a
"physical injury or physical sickness." 104(a)(2). Here it's not
clear that Brett suffered physical injury, because his problems stemmed from an
allergic reaction. However, it seems likely that the allergic reaction will be
considered a physical sickness, so to the extent that Brett's damages for the
money paid for the plastic surgery and lost wages are treated as being received
on account of a personal physical injury or sickness, they will be excludable
from his income. Assuming the settlement is treated as having been received on
account of Brett's personal physical injury or sickness, whatever part of the
settlement is attributable to Brett's subsequent medical expenses will be
excluded from Brett's income if is not allowed a deduction for those expenses.
However, if Brett does get to deduct the medical expenses, then whatever
portion of the settlement that is attributable to the medical expenses will be
treated as ordinary income.
The portion of the settlement
attributable to pain and suffering will be excludable from Brett's income only
to the extent that they reimburse him for medical expenses resulting from that
pain and suffering (e.g. psychiatrist bills). Since there is no indication that
Brett received any medical treatment for his emotional distress, it's likely
that the portion of damages attributable to pain and suffering will be included
in Brett's gross income (as ordinary income).
Deferred Compensation Agreement:
Brett's new employment contract appears
to be a non-qualified deferred compensation plan. As such, might be able to put
off the tax on the income he receives two years after he performs the work, but
only if: (1) the payment is unsecured, (2) he doesn't have the right to
accelerate payments, and (3) the employer waits to take a deduction until Brett
reports the money as income. Here, if Brett's deferred payment is treated as
having been "secured," then he will be taxed on all of the income in
the year he earns it under the doctrine of constructive receipt.
Here it looks like the payment might not
actually be secured, because it is in shares of stock, the value of which might
not be secure. Additionally, if the stock is subject to the claims of Brett's
employer's creditors, then it is not secured. If the payment is not secured,
and the Net waits to deduct the payments until Brett reports the income, then
Brett will have ordinary income in the amount of half of his salary in the year
he his paid for his work, and ordinary income in the amount of the other half
of his salary when he is paid again two years later.
Exam
No. 9356
Work Clothes:
Brett is allowed to keep the clothes, as
this is an accession to wealth (in the sense that he gets property) we need to
ask if it is gross income. It cannot be a gift because the IRC specifically
provides that employers may not provide a gift to their employees. The clothing
that the Net provides to Brett does not qualify as a fringe benefit. The
closest argument Brett would have that the clothing is a fringe benefit would
be that it is a working condition fringe in that it is an expense, that had
Brett been the one to pay for it, he would be able to claim a deduction under
IRC 162 or 167. It cannot qualify as a working condition fringe because the
cost of the clothes would not be deductible by Brett even if he purchased them
outright. The test for whether work clothing is deductible requires taxpayer to
meet three elements: (1) the clothes must be of a type specifically required as
a condition of employment; (2) the clothes cannot be adaptable to general usage
as ordinary clothing; and (3) the taxpayer cannot actually wear the clothing
outside of work. Here, arguably this would be clothing required to work as he
must be presentable as he is on network television. We do not know whether
Brett wears the clothing outside of work, but regardless this fails element two
because almost assuredly the clothing would be the type one could wear outside
of work. I am assuming that as a TV commentator he would not be wearing
anything outlandish or unsuitable for general wear (all commentators I have
seen see to wear suits or the like). Thus Brett will have ordinary (it is not
capital gain because it is simply the receipt of property), gross income in the
amount of the fair market value (FMV) of the clothing he receives from his
employer. His basis will be the FMV at the time of receipt.
Plastic Surgery:
Brett may try to argue that the cost of
the plastic surgery is a business expense because it was necessary for his
continued employment, but this is a losing argument. The advice did not come
from his employer, but rather his agent. In addition, there is nothing in the
facts to indicate that Brett was in any danger of losing his job due to low
ratings or the appearance of aging. Thus, Brett cannot claim a business
deduction for the cost of the plastic surgery.
If Brett does not itemize deductions, he
would not be able to argue that he can claim a medical expense deduction
because a medical expense deduction is a below the line deduction and only
available to those who itemize. If Brett does choose to itemize his deductions,
then he may try to claim the IRC 213 medical expense deduction, however he has
several problems. There is also no insurance covering the cost of the medical
attention, a prerequisite of applying a IRC 213 deduction, so that is one thing
in his favor. First, the deduction only
applies to qualifying "medical care" and plastic surgery is
specifically excluded. Thus the cost of the plastic surgery cannot be a medical
expense deduction. Additionally, there is a "floor" to the medical
expense deduction such that a taxpayer can only deduct medical expenses in
excess of 10% of their adjusted gross income (AGI). Because Brett's AGI is $2
million, he may only claim medical deductions to the extent that they exceed
$200,000. Clearly the $50k is below that. So no deduction is available for the
cost of the plastic surgery.
When Brett pays for the plastic surgery
this is a purchase, thus there are no tax consequences to his payment to Sid of
the $50,000.
Cost of Additional Medical Attention:
If Brett does not itemize, as discussed
above, he has no option to try and claim the below the line deduction for
medical expenses. There is also no insurance covering the cost of the medical
attention, a prerequisite of applying a IRC 213 deduction. If he does itemize, this is an example of
qualifying "medical care" because it involves the "diagnosis,
cure, [or] mitigation" relating to "any structure or function of the
body." In other words this is an example of Brett seeking treatment for a
medical problem, squarely within the coverage of IRC 213. Again, the problem is
the 10% of AGI floor. As noted above, the plastic surgery does not count, so,
as far as the facts state, Brett has only had $10k in qualifying medical
expenses to date, far below the $200k floor. Thus, Brett cannot claim any
deduction for the $10,000 he pays for the additional treatment.
Again, this is a purchase of services,
thus no consequences to Brett for making the payment of $10k.
Missed Work:
Based on the facts of the lawsuit, it
sounds like Brett lost out in $200,000 worth of wages by missing work due to
this additional health problem. There are no tax consequences to Brett however
because lost wages are not a deductible loss for tax purposes.
Settlement of Lawsuit:
The tax consequences of damage awards
will depend on the nature of what they were replacing (i.e. a question of what
damages are received in lieu of). This situation presents a problem because the
settlement agreement does not stipulate what the $300 damage award is for. It
is possible that it is merely $300k for pain and suffering and zero for all of
the other claims, possible that it is a portion of a damage award for each
claim, or any number of possibilities. Faced with a situation like this the
test is to look at the intent of the payor (here Syd) and ask what they
intended the payment to cover. Realistically it is arguable that all Syd really
cared about was making the lawsuit go away, but a court will look for anything
that indicates the relative merits of the claims to help gauge what the damage
award damage represents. In theory courts claim that they are not holding a
mini-trial on the other case (here the tort and contract claims), but in a
sense that is what is needed. The fact that a claim is settled out of court as
opposed to a court judgment has no impact on the tax consequences of damages
received by Brett.
Likelihood that particular damages are
included in the $300k settlement award AND tax treatment if they are in fact
part of damage award:
**In all cases, when Brett does have
gross income from the settlement, it is ordinary gross income for the year in
which the settlement is received**
i) Punitive Damages:
-Brett claimed $1 million in punitive
damages on top of $760k in compensatory damages. While it is impossible to say
that there was no punitive damage element in the settlement agreement, it does
not appear likely (because more concrete things like the $10 medical expenses
and $200k in lost wages appear much more likely to be meritorious claims).
If punitive damages are included in the
settlement agreement then Brett will currently have gross income equal to full
punitive damage award. In a sense punitive damages are not in lieu of anything,
so they are entirely ordinary gross income.
ii) $10k reimbursement for medical
treatment
This appears much more likely to be
included in the settlement amount. On the facts it seems that Brett would be
able to show the link between the negligence and this expense as well as to
concretely quantify the expense by showing his medical bills.
If reimbursement for the $10k in medical
treatment this will not be included in gross income because it qualifies for
the exclusion of personal injury damages under IRC 104(a)(2). This code
provision provides an exception such that whenever there is a personal physical
injury, damages received in connection with that injury are excluded from gross
income. Here the personal physical injury is the adverse allergic reaction. The
medical expenses associated with treating that allergic reaction qualify for
the exception and thus to the extent that they are included in the settlement,
Brett does not have gross income corresponding to them.
iii) Lost Wages
From the facts it is very difficult to
tell whether lost wages will be part of the damage award. It is possible
considering that this is a much more concrete type of damage that Brett should
be able to prove by demonstrating he would have made this amount, but for the
negligence of the Syd (also doesn't look like any issue with proximate cause).
The general rule is that damages that
replace lost income would be gross income. However the personal injury damage
exception discussed above also applies to amounts awarded for lost earnings.
Thus, to the extent that the settlement includes amounts for lost wages, that
amount is not gross income to Brett.
iv) Refund for Plastic Surgery Cost
It does appear likely that this will be
included, at least partially, in the settlement. The plastic surgery is what
kicks this whole thing off.
Brett may try to argue that this should
also qualify as personal injury damage, however he is really seeking the
reimbursement of a price he paid for a service. Thus, the exception would not
apply and if included in the settlement, such amounts are compensatory damages
and included currently as ordinary gross income.
v) Pain and Suffering
It appears likely that at least some of
the settlement is to cover pain and suffering, although it is very difficult to
say how much.
If pain and suffering damages are included,
they are also not gross income to Brett because they also fit within the
104(a)(2) exception for personal injury damages.
Brett's Legal Fees:
If Brett does not itemize he will not be
able to try and claim a deduction for legal fees because, as a below the line
deduction, the legal expense deduction is only available to those who itemize.
If he were to itemize, then he would try to argue that at least some of his
legal fees are deductible. The rule for whether a plaintiff (here Brett is the
plaintiff) seeking to try and claim a deduction for legal expenses may do so is
to look forward to what type of damages the plaintiff is trying to recover. If
what they are trying to recover would be taxable income, then the legal fees
are deductible. Here, Brett is trying to recover a mix of damages, some of
which are not includable in gross income (e.g. the pain and suffering) and some
that are (the punitive damages). A plaintiff can recover qualifying legal
expenses regardless of whether they win their case, thus I think that because
Brett was claiming damages that would be taxable income to him if he was
awarded them, he should at least be able to claim a deduction for the portion
of the legal fees attributable to the work the attorneys performed on the punitive
damage claim and the refund for the plastic surgery cost claim.
Deferred Compensation Plan
The half of Brett's income that he
receives each year as he earns it will be included in gross income in that
year. It is payment for services performed so it is ordinary income. The other
half of his income is being placed into a non-qualified deferred compensation
plan. Brett will point to the fact that he has no right to accelerate payments,
which is in favor of conclusion that it is not gross income until received,
however the problem is that the funds set aside are secured (i.e. there is more
than a mere promise by his employer to pay). Because the funds set aside in the
plan are secured by company stock as collateral, the income is attributable to
Brett as soon as it is earned. Thus Brett actually has ordinary gross income
for the full amount in year it is earned.
Exam
No. 9535
Tax bracket
I hope I'm Brett's tax bracket someday,
despite the fact that he is in the highest bracket of 39.6%, regardless of his
filing status. But, his actual rate is probably different on account of the AMT
which is he probably subject to. Some of the deductions otherwise available to
taxpayers will not be available to Brett b/c of the AMT. He probably could
benefit from a tax attorney to help advise him on reducing his tax burden!
Wardrobe
Under 132, gross income may exclude
fringe benefits if certain requirements are met. Under 132(d) clothing (such as
a uniform) may meet the definition of a working condition fringe. Brett is
receiving clothing that he wears on broadcasts, and the clothing is purchased
(and presumably selected) by The Net. However, the facts do not state that this
particular clothing is so specific to his work, or that it cannot be worn in
another purpose. Because he is nationally known and high paid, I think it is
likely that this is just general business clothing (rather than containing logos
or having a utilitarian nature such as would be worn in a work environment like
coveralls or a taco bell uniform.) Additionally, because the clothes have only
been worn twice on broadcasts, they are likely fairly new and Brett is getting
substantial value out of the clothing. Therefore, it should not meet the
definition of a working condition fringe, and Brett should be taxed on the
value of the clothing calculated under 83 - the FMV of the property, less any
value he paid.
If
however, the clothing is so specific that it can only be used for work (perhaps
something with the station logo all over it) then this may be excluded from his
income under 132(d).
A
similar case here is the Ozzie and Harriet case - they were allowed to deduct
the cost of clothing they wore while on the set b/c it was not generally
something they would wear normally. Brett's clothing is something he would wear
normally and does not qualify.
Cost of Plastic Surgery -Deductible?
Brett will have a tough time arguing that
this was a trade or business expense under 162, but the IRS has accepted
successful arguments from persons such as celebrities where their personal
appearance has a direct impact on their ability to make income. Brett will need
to show several things - first, that the expense was "ordinary and
necessary" - his agent provided the advice, so he could gather information
about marketability of broadcasters, and possibly supplement this with an
opinion or request of the station that they desire he have the surgery. Second,
he will also need to disprove that it was a current expense of capital
investment. Because Brett will make money off of his new look for many years to
come (at least, until his forehead starts to resemble Burt Reynolds' at which
time his marketability might decrease significantly!) he will have a tough time
showing this. A capital expense is something that is a permanent improvement or
betterment made to increase the value which extends beyond the close of the
taxable year. Brett's face will earn him money for many years after this one.
Third, he will need to show that the expense was incurred for business reasons
and not for personal reasons. There is little that is less personal than our
facial appearance so this is also a difficult one for Brett to show. Perhaps it
will help if he has been married for many years and has nothing to gain
personally by a younger appearance? Overall, the origins must be in
business//profit activities. If Brett is successful, he could deduct the cost
as a below the line deduction under 212, which means it is subject to the 2%
miscellaneous floor. He could deduct $50 - $40 = $10k.
Another route (also likely not successful) is
to try to deduct the cost under 213 as a medical expense, which is also below
the line and only deductible in amounts that exceed 10% AGI. Under 213(d)(9)
all deductions for "cosmetic surgery" are disallowed so Brett's
cosmetic surgery would not be allowed as deductible because it falls below this
10% floor.
For both reasons discussed, Brett's expenditures
will probably be disallowed under 262 as a personal expense and not as a
business expense.
Injury and medical expenses
Brett's $10k in medical expenses to
remediate the drug reaction might be deductible under 213. Deductible expenses
are defined in (d) as expenses for "medical care" including
mitigation of a disease affecting bodily structure or function. His drug
reaction has caused him to miss several broadcasts, so this sure sounds like it
is affecting his bodily structure or function. If Brett is not compensated by
regular health insurance for these costs, he can deduct only the amount that
exceeds 10% of his AGI, which is zero because he has such high income. That's
probably one reason why he tried a lawsuit.
Lawsuit and Release
Brett has alleged many claims in the
lawsuit, and they have varying tax implications:
1. $50k - represents a return of Brett's
advance payment. This is a recovery of Brett's payment for services and
represents a return of his capital "investment". Accordingly, it should
not be taxed b/c Brett would already have reported this amount on his annual
tax filing. To tax him again would be duplicative. However, if Brett
successfully deducted this amount as a business expense as discussed above, he
will be taxed on the amount as per the tax benefit rule.
2. $10k - reimbursement for medical costs
for a personal physical injury. Under 104(a)(2) this is not taxed b/c it is an
amount received on account of personal physical injury. However, if Brett
successfully deducted anything under 213 (which he didn't, but just for illustrative
purposes) he would be taxed on the amount he deducted as per the tax benefit
rule.
3. $200k - in lost wages. This would be
fully taxed as a recovery, because it represents replacement of something Brett
would have been taxed on anyway - wages from an employer. Glenshaw Glass.
4. $500k - pain and suffering is not
typically allowed, except when physical injury is also present, then damages
for emotional distress are allowed. $500k seems high, but some amount might be
appropriate because he did suffer physical injury. Some amount might be tax
free if Brett is successful with this argument. Otherwise, he is taxed on the
amount.
5. $1M - punitive damages. Under
104(a)(2), punitive damages are always considered income and taxable to the
recipient.
When a case settles for one lump sum and
includes damages that are a combination of includible and excludible from
income, the proper way to resolve is to ask "what was the intent of the
payor?" That is quite difficult, so in tax court it is common that they
will look at the evidence of the negotiations to attempt to determine what the
money was attributable to. Because the amount is quite low ($300k) in
comparison to what he was asking for, it seems reasonable to conclude that this
represents $200k in lost wages, $60k in medical expenses, and a remaining
amount of $40k in emotional distress. End result, Brett wouldn't be taxed on
anything (if successful with his arguments made above). If he is taxed,
everything would be ordinary income tax because none of these are capital
expenses.
Deferred Compensation
Rev Rul 60-31 provides rules for taxing
compensation that is deferred to a future year, and there is no limit on what
can be carried over. Rev Rul 60-31 requires that the income is unfunded and in
an unsecured plan subject to a risk of forfeiture by the employee. If not
found, the default is that constructive receipt applies - meaning the taxpayer
is taxed on income at the time it is credited or set apart without any
substantial limitations or restrictions as to the time or manner of payment,
and receipt is within control or disposition of the taxpayer. The general test
for constructive receipt is whether the income was "made available."
Brett has an interest in deferring compensation if he can avoid taxation by
doing so, because if he does not need the money but suspects he might have less
income in the future he will save on tax payments if he is in a lower tax
bracket. A choice of two years in the future seems odd to me so maybe Brett is motivated
by something he suspects will occur two years in the future (maybe he is
leaving employment to retire and sit on the beach with an umbrella drink.)
So
which applies? Brett knows the amount set aside (half his income) but he has no
right to accelerate the payments. The Net has pledged stock as collateral, but
this is still within the control of the company, and if it were to go bankrupt
for example, the stock (and therefore the collateral) would be worthless. Brett
would have a risk of forfeiture b/c he would be waiting with all of the other
creditors in bankruptcy proceedings. Although The Net has secured the debt by
stock, I do not believe this qualifies as "funding" and therefore the
obligation is unfunded and subject to risk from the employee's perspective.
Rules under 60-31 are met and Brett is not taxed on the half of his income that
will be paid in two years. This is similar to Minor v US when a physician group
placed the money in trust, but it was still under full control of the employer
and reachable by the company's creditors. That arrangement was not taxed to the
employee. I believe Brett's arrangement is similar.
If
however, this payment does not qualify for deferred treatment, Brett is taxed
in full in the year in which the money was earned (set aside on his behalf)
under the doctrine of constructive receipt. Brett is taxed as ordinary income,
just like salary.