Income Tax I
Bogdanski
Fall 2015

Sample Answers to Question 2

Exam No. 3778

Stock Bonus.

Employers may compensate employees for their services with property (§ 83) -- and the FMV of that property is gross income to the employee. Here, the stock bonus is provide to Xio, a key employee, for his services and is thus part of his compensation. He must report it as gross income, but when?

He reports his income on the cash method. He will be taxed at the first time his rights are transferable (not for a 18 months) OR when they are not subject to a "substantial risk of forfeiture." Here, Xio's right to the stock is vested -- he has an absolute, non-forfeitable right to the stock, which has been set transferred to him contingent ONLY upon not selling the stock for 18 months. He must report the FMV ($4 times 5,000 shares, or $20,000) as ordinary income in the year he receives it. That $20,000 is the basis for the stock and when he sells it down the line -- because it's more than a year later -- any gains (or losses) will qualify as capital gains (or losses) subject to the favorable maximum 20% tax rate.

Stock Options.

This is not an ISO under § 422, but a nonqualified stock option. In that case, the individual has no tax consequences at the time of the grant -- as long as the option is offered at the current trading price of the shares. (It is, in this case.) Xio's basis in the option is $0, and it cannot be traded on any public market. Nonqualified stock options, unlike ISOs, are taxed upon exercise. The spread between the option price (here, $4.25) and the market price ($6.25) is taxed as ordinary income. Here, Xio purchases 1,000 shares at $4.25, paying $4,250 of his own money -- so the "spread" (or the good deal he got) is worth $2,000. That $2,000 will be taxable income in 2016. At 35% tax rate (his may be higher) that means $700 in tax paid.

The 1,000 shares have a basis of $6,250 -- the cash he paid plus the ordinary income he reported. If they continue to appreciate, and he holds them for longer than one year as he intends, he will pay favorable capital gain rates on the gain at the time of sale.

He retains the option to buy another 9,000 shares -- and the tax treatment upon exercise will be the similar to the above.

In hindsight (always 20-20), Xio should have borrowed money to buy his vacation house (see below) and used the cash to buy all 10,000 shares for which he had the option, at the time the option was granted. That would have cost him $42,500 (far less than the vacation house), with the value increasing to $62,500 in just one year. That's $20,000 in capital gains ($62,500 FMV sale minus the $42,500 cost basis), long-term gains (if he held just over a year), taxed at 20% at the most. After paying the $4,000 in capital gains tax, he'd have a net profit investment income of $16,000.

Parking Pass.

Employers may provide parking worth up to $250 a month to employees under a qualified transportation fringe 132(a)(5). The value of that benefit is excluded from gross income. This benefit does not carry a non-discrimination clause, so they may provide it only to "key employees" such as Xio. This pass is worth $200/month, well within the limit. It doesn't matter if that's the going rate or not, as long as it's within the statutory limit. Further, the parking does not need to be on premises -- the nearby garage is fine.

Principal residence and vacation home.

The Code allows for taxpayers to have up to two "qualified residences" -- so both Xio's principal home and his vacation home are "qualified." The property taxes he pays on both homes are deductible as itemized deductions (surely he itemizes). Mortgage interest on qualified residences is usually deductible, but there are rules. First, the interest on up to $1 million of "acquisition debt" secured by the qualified residence is deductible. "Acquisition debt" includes those loans used to acquire, construct or substantially improve a residence. § 163. In this case, the $400,000 mortgage on his primary residence is acquisition debt, but he bought the vacation home with cash. The interest on the $400,000 mortgage is entirely deductible against his ordinary income, as an itemized deduction.

The home equity loan he took out on the vacation home is not "acquisition debt." The code sets a $100,000 limit on equity loans (or $50,000 for a single filer -- it is unclear whether Xio is married, a head of household, or filing as an individual). His HEL is $150,000 -- over the limit for mortgage interest deduction -- so interest on only the first $100,000 (or $50,000) will be deductible. The code is generous to vacation homeowners, but not that generous! He should have borrowed to purchase the property, and saved his cash for his son's personal debts and for his vacations. (Of course, if he intended to pay off his son's debts, even if not deductible, a home equity loan almost certainly has lower interest rates than consumer credit.)

Exam No. 3479

X's stock bonus

Here, X's stock bonus will be immediately taxable as income to him under IRC 83. IRC 83 holds that if property is transferred to any person in exchange for services, the tax liability is the FMV of the property minus what the person pays for it. Under 83, a transfer will be considered income if the property is not subject to a substantial risk of forfeiture. Here, while X does indeed have to hold onto the stock for a period of 18 months, there does not appear to be a substantial risk of forfeiture because there does not appear to be any risk that X will lose the stock for any reason. Here, because X paid nothing for the stock, X will be immediately taxed on the full FMV of the stock at the time of the bonus. The 18 month restriction does indeed make the stock appear less valuable for X, but 83 is clear that the FMV is to be determined without regard to any restriction other than a restriction that will never lapse. This restriction will indeed lapse, so it is not considered. Here, X has received 5,000 shares at $4 per share (a total FMV of $20,000) as a result of his services to his employer. X will be taxed on that entire amount under IRC 83 at the moment he is vested with it (which here, is immediately upon acceptance). X may argue that this was a gift under section 102 and that he should not be taxed on it, but this won’t hold water because exchanges from employers to employees cannot be considered tax-free gifts. X will be taxed on $20,000 at an ordinary income rate at the moment he accepts. His basis in these shares will also be $20,000 ($4 per share). Any value gained from a future sale will be taxed at a capital rate.

X's stock Option

Here, because the option itself does not have any ascertainable market value (because it cannot be traded), X will not be taxed on the option until he decides to exercise it. IRC 83(e)(3) says that the option will not be taxed unless the option itself can be sold, that is not the case here. This is exact the situation presented by the Lobue case. The Lobue case held that a stock option will only be taxed at the FMV of the stock minus what you pay for it at the moment you exercise the option. Here, this is good for X. X will not be taxed on this option until he exercises it, and when he exercises it, he will be taxed on the spread of the FMV - $4.25 per share. This will be taxed as ordinary gain at the time he exercises it. However, X may want to consider making a section 83(b) election in this case. Under section 83(b), the person who is given the option can elect to be taxed immediately upon the grant of the stock option at a rate of the FMV - the option stock price. If X makes this election within 30 days of the grant, he will be able to avoid all additional taxable income until he decides to sell the stock (and then at that point all gain it will be taxed as capital gain). This situation seems like kind of a no brainer situation for X for 83(b) purposes, he is actually considered to be purchasing the stock for 25 cents more than the FMV, so I am not sure that he would be taxed on anything if he made an 83(b) election (in fact, I am not sure if the IRS would even allow this, but it may be worth a shot!). Assuming he can make an 83(b) election, he will pay tax on the FMV minus the option price of the stock (here, it would seem nothing), and he would then not have to repay the tax at the time of the exercise (even if the stock rose tremendously in value). If X believes the stock will rise in value, this would be a great move. If X decides to go with the 83(b) election, and the stock does rise in value, X will not be taxed on the increase in value until he sells the stock, and even then he will be look at capital gain rates. At this time, the best advice for X would be that unless he pursues an 83(b) election, he will not be taxed until he actually exercises the option. Notably, If X decides to exercise the option immediately, his basis will be $4.25 per share. Any value sold over that will be taxed at a capital gain.

X's 2016 exercise of the option

As stated above, assuming X did not elect to do an 83(b) election, he will be taxed on the FMV minus the exercise price at the time he exercises the option. This is exactly what the Lobue case stands for. Here, X will be taxed on the spread of $6.25-4.25 per share. In this case, X will be taxed on $2 per share. After doing the math, X will face an ordinary income rate tax of $2,000 at the moment he exercises the option. Upon exercise of the option at this time, X's basis in these particular 1,000 shares is $6,250. If X hangs onto these shares and decides to sell them later at a higher value, he will be looking at capital gain rates, but for now, the exercise of the option is considered ordinary income.

X's parking pass:

Here, X's parking pass will be considered an excludable fringe benefit under IRC 132(a)(5). IRC 132(a)(5) excludes form income the value of any qualified transportation fringe, and this includes parking costs. The limits of this exclusion are laid out in section (f)(6), but the $200 per month parking pass would likely fall below the threshold amount. If for whatever reason this amount did go over the limit, X would be taxed at an ordinary gain rate for the excess over the limit. However, assuming this $200 per month does not exceed the limit, X will not have to report the parking pass on his gross income under IRC 132(a)(5). X would not even have to itemize to get this exclusion because it is just not considered income.

X's principal residence

Here, X would be wise to consider the provision found in IRC 163(h)(3) that allows him to deduct a certain quantity home mortgage interest from his income taxes. In order to be eligible for this deduction, X would indeed have to itemize because it is considered a below the line deduction. However, assuming that X did itemize, he would be allowed to deduct the all of the interest paid on the mortgage (up to a mortgage limit amount of $1 million) from his income. Here, because X only has a mortgage of $400,000, he falls plainly within the threshold $1 million limit of 163 and he can deduct all interest paid on this mortgage from his income tax. It is important to note that any payments into the principal on the loan will not be deductible, but any payments towards interest will be.

X's Vacation Home:

Once again, X would be wise to consider the provision found in IRC 163(h) that allows him to deduct a certain quantity home equity interest from his income taxes. In order to be eligible for this deduction, X would indeed have to itemize because it is considered a below the line deduction. Section 163 allows a person to deduct any interest paid on a home equity debt. However, unlike the home mortgage provision, it is important to note that section 163 only allows a home equity debt to go up to $100,000. Here, X's $150,000 home equity loan is over the threshold $100,000 limit, so he would not be entitled to deduct all of the interest. X would be precluded from deducting any interest on this equity loan that goes to the portion of the loan in excess of $100,000. This would require a more detailed analysis of the terms of the loan, but X would be entitled to deduct at least some of the interest from this loan from his income taxes. Notably, because X apparently used the loan to give his son a gift in the form of paying of his debts, the son would have tax free gift income under section 102 (depending on other facts of course). That possibly gift transaction will have no effect on X's tax affairs though.

Exam No. 3212

TAX CONSEQUENCES OF THE STOCK BONUS TRANSACTION

§83 will govern this transfer of non-cash compensation. This is ordinary income to X. He received a valuable benefit in connection with his performance of services. This issue involved here is one of timing.

X may be taxed on the stock only once the stock is vested or the risk drops off, i.e. in 18 months, once the restrictions on selling the stock drop off; or X may elect under §83(b) to include the FMV of the stock in his gross income immediately. He must make this election within 30 days of receiving the stock. If X elects to pay the tax now, he will be taxed on the FMV at the time of the transfer minus any amount he paid for the stock. This may be ideal to him, if he expects that the value of the stock will increase significantly within 18 months, as he will be taxed on the pristine FMV of the stock at that time.

Once is taxed on the FMV of the amount (either now or in 18-months), he will acquire a basis in the stock equal to the value that he was taxed on. The corporate stock will be a capital asset to him and once he sells or exchanges the stock, he will realize a capital gain or loss.

TAX CONSEQUENCES OF THE STOCK OPTION

This is not an incentive stock option, and so X will get just what Phil LoBue received. He will not have any tax consequences at the grant, so long as the exercise price is not any lower than the current price of the stock. §409A. However, when he exercises the option he will be taxed on the spread. The spread is the difference between the FMV of the property and $4.25. Once X sells the share, he will then be taxed at capital gains rates on the difference between the FMV at the time of the sale and his basis in the shares.

Here, X purchases 1,000 shares for $4.25 a share. The stocks are trading at $6.25 per share. Therefore, at the time of the grant he will be taxed on $2000 as ordinary gross income. The difference between $6,250 (the FMV) and $4,250 (the price he got them for). At this point, he will have a basis in the stocks of $6250. As he intends to keep them as a long-range investment, he will be taxed at capital gains when he sells them as these stock options are capital assets.

This is in contrast to ISO's under §422 where they are not taxed until the sale of the stock at capital gains rates.

TAX CONSEQUENCES OF THE PARKING PASS

The value of $2,400 for his 12-month parking pass ($200 per month) will be excluded from X's gross income. This is excluded under §132(a)(5) as a qualified transportation fringe benefit. Under §132(f), if an e'er pays for your parking you may deduct (as of 2015), $250 a month. His e'er will be able to take a deduction in this amount as a current business expense.

TAX CONSEQUENCES OF HIS PRINCIPLE RESIDENCE

X is able to deduct the interest paid on his monthly mortgage to his principle residence, so long as the mortgage is secured to the property, under the qualified residence deduction so long as he elects to itemize his deductions. §163(h)(3). It is unknown what his salary is, but itemized deductions are subject to phase downs as income rises. X is also able to deduct property taxes on his residence. His basis in his property is equal to the downpayments made on the home and his $400,000 mortgage.

When he sells his principle residence, providing that he meets all of the requirements in order to have the gain not recognized, he will be able to take advantage of nonrecognition of $250,000 or $500,000 (if he is married) of his gains.

TAX CONSEQUENCES OF HIS VACATION HOME

X is not able to deduct any costs associated with renting his vacation home, since it is used exclusively for personal purposes. He can however deduct the property taxes. He may also take a qualified residence deduction on interest paid to this loan as well, however, as this is not property acquisition debt (in which he could deduct interest on a $1.1million loan), he is limited to only taking interest deductions on a $100,000 equity loan. Since his equity loan is valued at $150,000 he will not be able to take a deduction on the full amount of interest paid. X does not acquire any basis in paying of his son's personal loans, as his payments to relieve his son's debts will be treated as a gift. Moreover, he is not allowed any deductions for paying of personal loans.