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Wednesday, August 02, 2006

Need More Tax Charts? They're Waiting for You 

While I was away, news reached me that Andrew Mitchel, the unchallenged champion of tax chart web publishing, added another batch of charts to his already impressive collection of visual aids to understanding Code provisions, cases, rulings, and other tax concepts. This time he focused on some well-known tax cases, names that should roll with ease off the tongues of tax experts. Yes, any person claiming to be a tax expert who reacts with a blank stare when hearing another person mention INDOPCO, Kirby Lumber, Tufts, or Glenshaw Glass, to name a few, is not a tax expert. Would you be comfortable getting medical treatment from someone unfamiliar with penicillin?

Never one to rest on his laurels, or charts, Andrew also revised several charts that he had previously put up on his web site. This recent activity brings the total number of charts to 279. According to Andrew,
The recent charts include:

1. Davis (Transfer for Release of Marital Claims)
2. Eisner v. Macomber (Stock Dividends are Not Taxable)
3. General Utilities (No Gain on In-Kind Corporate Distributions)
4. Glenshaw Glass (Accessions to Wealth)
5. Hendler (Liability Assumption was Boot in a Reorganization)
6. INDOPCO (Deductibility of Takeover Expenses)
7. Kirby Lumber (Gain on Bond Retirement)
8. Knetsch (Sham Interest Expense)
9. Lucas v. Earl (Income is Taxed to the Person who Earned It)
10. Schlude (Prepaid Dance Lessons)
11. Tufts (Debt Relief from Nonrecourse Mortgage: FMV of Property Less Than Debt)
12. Welch v. Helvering (Deductibility of Reputation Payments)
and charts have been revised for
:1. Crane (Debt Relief from Nonrecourse Mortgage)
2. Gregory v. Helvering (Spin-off with Transitory Controlled)
3. Seagram (Pre-Acquisition Continuity of Interest in Multi-Step Forward
Triangular Merger)
For those needing cross-references to my previous commentary on Andrew's chart work, look here, here, here, here, here, here, here, here), here, here, here, and here.

Andrew continues to welcome comments on his charts. You can contact him through his web site. For direct access to the charts, you can enter by Topic, by Alpha-numeric order, or by Date uploaded . I suppose if you don't see a chart for something you'd like to see in visual representation, you can send Andrew a nomination for another chart. I have a feeling he'd be glad to add one to the growing collection.

Monday, May 26, 2014

Windfalls Are Taxed, Even If The Taxpayer Thinks It is Unfair to Do So 

It is a basic tax law principle that economic windfalls are taxed. That principle applies to a variety of transactions, and as a recent tax court case, Debough v. Comr., 142 T.C. No. 17 (2014), demonstrates, comes into play when property sold by the taxpayer is reacquired by the taxpayer. In this case, the property in question was the taxpayer’s principal residence and the taxpayer was unable to shelter any of the gain under section 121.

The taxpayer sold his principle residence in 2006 under an installment sale agreement. The taxpayer sold the residence for $1,400,000. Under the sales agreement, the buyers paid $250,000 at the time they entered into the contract, and promised to pay $250,000 on July 12, 2007, along with $25,000 semi-annually until July 11, 2014, when the balance was due.

The taxpayer had purchased the residence for $25,000, and recomputed his adjusted basis after his wife died. Using an adjusted basis of $742,204, he computed gain of $657,796. Before trial, the IRS and taxpayer stipulated that the basis was $779,704.

In 2006, the taxpayer reported gain of $28,178. He did so by excluding $500,000 of gain under section 121, because his wife had died within the past two years, permitting the taxpayer to use the $500,000 limitation rather than the $250,000 limitation. Thus, the taxpayer computed taxable gain of $157,796 ($657,796 minus $500,000), and divided it by $1,400,000 to generate a gross profit ratio of 11.27 percent. Multiplying the $250,000 payment received in 2006 by 11.27 percent generated taxable gain of $28,178. In 2007, the taxpayer received the second $250,000 payment, and again reported $28,178 in taxable gain. In 2008, the taxpayer received only $5,000, and using the 11.27 percent gross profit ratio, reported taxable gain of $564. Thus, the taxpayer reported total taxable gain of $56,920.

The buyers failed to comply with the terms of the contract. The taxpayer reacquired the property in July of 2009, incurring costs of $3,723. The taxpayer treated the reacquisition as full satisfaction of the indebtedness, reporting gain of $97,153. Subsequently, the taxpayer amended the 2009 return and removed the $97,153 gain. Before trial, the IRS and the taxpayer agreed that the taxpayer was obligated to report at least $97,153 of gain. The IRS, however, took the position that the taxpayer ought to have recognized $443,644 of gain. The IRS computed this gain by subtracting the $56,920 reported by the taxpayer from 2006 through 2008 from the $505,000 of cash received by the taxpayer.

Under section 1038(b), a taxpayer who reacquires real property in satisfaction of debt secured by that property is taxed on any money and other property received before the repossession, except to the extent previously reported as income. Section 1038(e) provides that if the taxpayer reacquires property with respect to the sale of which gain was not recognized under section 121, and within one year of the reacquisition the taxpayer resells the property, then section 1038(b) does not apply, and for purposes of section 121, the resale is treated as part of the original sale of the property. The taxpayer and the IRS agreed that section 1038(e) did not apply because the taxpayer did not resell the property within a year.

The taxpayer argued that section 1038(e) does not preclude applying section 121 to the original sale, because “if Congress had intended to completely nullify the section 121 exclusion upon reacquisition of a taxpayer’s principal residence, it would have drafted a provision explicitly so stating.” The IRS argued that the existence of section 1038(e) “confirms that Congress was aware of the interplay between sections 1038 and 121 and drafted section 1038(e) as a limited response thereto; the absence of a ‘more generous provision’ regarding the overlap of sections 1038 and 121 confirms that Congress intended for taxpayers in petitioner’s situation to be treated under the general rules of section 1038.”

The court agreed with the IRS. It held that section 1038 applied to the reacquisition, and that section 121 does not apply to a transaction subject to section 1038 unless it is within section 1038(e). Accordingly, because section 1038(e) did not apply, the taxpayer was subject to section 1038(b) and section 121 did not apply.

The court pointed out that economically, the taxpayer began with property and ended up with property and $505,000. The court cited the Glenshaw Glass decision in support of its conclusion. That case stands for the proposition that windfalls are gross income. The $505,000 was a windfall, as the taxpayer ended up retaining the property. It was not “unfair,” according to the court, to tax the $505,000. Because $56,920 had already been reported as gain, the other $443,644 of gain was taxable in 2009. Presumably, though the court did not mention it, the $3,723 cost of reacquisition is added to the taxpayer’s adjusted basis in the property to be taken into account when the property is resold.

Had the taxpayer resold the property within a year, the taxpayer would have escaped taxation, though how the “unused” portion of the exclusion would have been recovered is unclear. But the taxpayer did not do so, presumably because of adverse market conditions. Perhaps one year is too short of a window in which to resell principal residences under these circumstances. But that one-year period is a creature of the Congress, and cannot be changed by the IRS or by the courts. I don’t expect Congress to change that time period, not only because it isn’t accomplishing much of anything these days in terms of tax law, but also because it isn’t focusing on section 1038 and its interplay with section 121.

Friday, September 01, 2006

The Murphy Opinion and Tax Protesters 

The Murphy case is creating quite a stir. Considering what the court said, it's not a surprise. When I commented on the opinion last Wednesday, I focused on the technical deficiencies in the opinion, something that triggered a response to which I replied the next day. This afternoon I was interviewed by a reporter for Tax Notes, whose article should show up next week.

Like many others, both within and without the tax profession, I am riveted by this case. Why? It's not just the technical flaws. Those aren't infrequent when tax cases reach the courts, particularly when the tax expertise isn't quite what it ought to be. It's also the inspiration that the opinion is giving to the tax protest movement. Specifically, the folks who have argued that wages are not gross income because they are not income have relied on the idea that wages are received in return for "human capital" and thus cannot be "incomes" within the meaning of the Sixteenth Amendment.

So what does the Murphy opinion do for these folks? Consider these two excerpts from the opinion, and understand that tax protestors love to take pieces of judicial opinions and connect them together:
Broad though the power granted in the Sixteenth Amendment is, the Supreme Court, as Murphy points out, has long recognized “the principle that a restoration of capital [i]s not income; hence it [falls] outside the definition of ‘income’ upon which the law impose[s] a tax.”
* * * * *
According to Murphy, the Supreme Court read the concept of “human capital” into the IRC in Glenshaw Glass. * * * * In Murphy’s view, the Court thereby made clear that the recovery of compensatory damages for a “personal injury” -- of whatever type -- is analogous to a “return of capital” and therefore is not income under the IRC or the Sixteenth Amendment.
Under tax protestor logic, because Murphy won her appeal, the court accepted her arguments as valid. Of course, a court that is aware of the "wages are not gross income" tax protester movement easily could put into its opinion language that restricts its opinion to the specific issue in front of it, but considering that the court was so quick to hold unconstitutional a Code provision that isn't "responsible" for the taxation of which Murphy complained it's no surprise that the court was not considering the impact of its opinion on the administration of the tax law.

Will these sentences be cobbled together by the "wages aren't income" crowd? Undoubtedly. Don't believe me? Or the others making the same prediction? Take a look at the way bits and pieces of legal authorities are mixed and matched in an attempt to prove that the Constitution prohibits the taxation of wages. It takes deep concentration to make it through this explanation. Someone named "bonked" shares this thought: "You see, a tax on wages is not authorized by the constitution, unless it is apportioned..." I could have fun with this one, but I'll restrain myself. And the comments following this LibertyPost article, which proclaims that "Court ruling shakes ground under IRS," are worth reading, but don't be distracted by the references to things such as "Section C of the Tax Code."

What happens if these arguments are made in front of a judge who analyzes the tax law in the same manner as did the three-judge panel of the D.C. Circuit in Murphy? Imagine how small the jump from "unconstitutional to tax damages from human capital" to "unconstitutional to tax wages" looks to someone who doesn't quite grasp the nuances and accepts the language of the Murphy opinion on its face. It will take only one such case. Just one. What will Congress do? Start the process for a constitutional amendment? Hope for a Supreme Court reversal? How long will either of those reactions take? Remove wages from the income tax base and tax revenues plummet.

A footnote: As I wandered the Internet last night, I came across an interesting commentary on a post that quoted part of my first commentary on Murphy. The sentence begins "Maule's of course right that". How could I not keep reading?

Friday, February 24, 2006

The Taxation of Kidney Swaps 

Reader James Butler has brought to my attention a story about two women, each of whom is donating a kidney to the other's husband. They are not donating to their own husbands because of blood type mismatches.

The two women connected through the Paired Donation Consortium, which facilitates matching between living donors. So far, the Consortium has registered 80 pairs of donors and recipients, leading to 12 kidney swaps already in place.

James, who is a tax lawyer, reacted to the story as tax lawyers do. He immediately saw the tax issues. He wrote:
It would seem each women is "donating" a kidney to the
other's husband in exchange for a like donation. While the IRS may never dare raise the issue, could this create taxable income to each couple? They aren't gifts since something is expected in return. There isn't a like kind exchange since this isn't a business or investment type activity. Selling a kidney is illegal but swapping them seems ok.

Is it taxable? If it is taxable, would it be income to the wife or the husband? The husband gets something of value in exchange for something given up by the wife. Maybe they are constructive gifts to the husbands followed by an exchange?
I think James gets an A for describing the black letter law. The exchange is not a gift because they each get something in return. Each has a basis of zero in the exchanged kidney. Each has an amount realized equal to the fair market value of a kidney. The like-kind nonrecognition rules do not apply because it's not a trade, business, or investment activity. No other non-recognition provisions are relevant. There's no exclusion applicable to the transaction. The lack of cash is not an obstacle to the taxation of bartered exchanges. Though James didn't mention it, IRS rulings with respect to the sale of blood and blood products suggest that the income would be ordinary income and perhaps personal services compensation income. There's no charitable contribution deduction because no charity receives the kidneys. The substance over form doctrine treats the exchange as a swap of kidneys between the two women, each then making a gift to her husband. My guess is that there are medical expenses, which ought to be deductible to the extent they exceed the 7.5 percent adjusted gross income floor.

That's the easy part. The tough question is whether the IRS would require taxation. What a heartless (ouch) approach to take. The IRS does have a track record in this area. So, too, does the Justice Department.

The first case is that of United States v. Garber, 607 F.2d 92 (5th Cir. 1979). Dorothy Garber learned, after the birth of her third child, that her blood contained a rare antibody useful in producing blood group typing serum. At the time she was one of only two or three people in the entire world with the antibody. A manufacturer of diagnostic reagents, Dade Reagents, persuaded her to sell to them blood plasma. The process involved withdrawing a pint of her blood, putting it through plasmapheresis to extract plasma by centrifuge, and returning the red blood cells to her body. Each appointment lasted from 90 to 150 minutes, generated a pint of plasma from two pints of blood, required injection of an incompatible blood type to increase the antibodies, caused pain and discomfort, and posed the risk of blood clots and hepatitis. Garber was paid on a sliding scale reflecting the strength of the plasma obtained in the particular appointment.

Eventually, other reagent manufacturers lured her away from Dade Reagents by offering higher prices for her plasma. She began selling both to Associated Biologicals and to Biomedical Industries. Both paid money for each extraction, and Biomedical also provided a salary, a leased automobile, and a bonus. At one point Garber was doing six extractions a month.

Although she reported the salary, Garber did not report the other payments as income, even though she received a Form 1099 from Biomedical. She did not receive such forms from Associated Biologicals. Consequently, she was INDICTED for willfully and knowingly attempting to evade a portion of her income tax liability by filing false and fraudulent income tax returns. She was convicted with respect to one of the years in issue, and sentenced to 18 months in prison, all but 60 days of which was suspended, placed on probation, and fined $5,000 in addition to her civil liabilities and penalties.

On appeal, the Fifth Circuit held that the trial court's refusal to admit the expert testimony of a CPA retained by Garber, after permitting the government's witness, an IRS agent, to testify that the transactions generated unreported income, was reversible error and remanded the case. The appellate court noted that besides the disagreement over the characterization of the transactions as performance of services or sale of products, there was disagreement in the latter instance over the valuation of the plasma. The court then made a total mess of its explanation by confusing basis and value and making some rather bizarre assertions:
The cost of Garber's blood plasma, containing its rare antibody, cannot be mathematically computed by aggregating the market cost of its components such as salt and water. That would be equivalent to calculating the basis in a master artist's portrait by costing the canvas and paints. No evidence of any original cost exists in the case of Garber's unusual natural body fluid.

In such a situation it may well be that its value should be deemed equal to the price a willing buyer would pay a willing seller on the open market. [citations omitted] If this were the proper basis, the exchange would be a wash resulting in no tax consequences.
Sorry, but the basis in a master artist's portrait IS the cost of the canvas and paints. Moreover, setting basis equal to value makes no sense in the absence of taxation. Nor does setting value equal to the price at which something would exchange on the open market establish basis. And they wonder why I continue to insist that basic federal income taxation should be a required course. We're talking some very core concepts.

The concurring judge, though agreeing that the trial court's evidentiary decision was reversible error, stated, sensibly:
Because I conclude that the transactions under investigation constituted services and the income derived therefrom taxable under 61(a)(1), I should have preferred that the court say so in positive terms. The question would thus cease to be a novel one for those considering it in the future.
The dissent, in which three other judges joined, concluded that there was gross income, pointed out that Garber had spent for personal purposes the portion of her fees that the payor had put into a savings account earmarked for tax payments, had not been told by the IRS that the payments were not income, and had not sought professional advice. The dissent agreed, though, with the concurring judge that the majority opinion did not provide appropriate guidance on the legal question of whether the payments were gross income. It pointed out, accurately, that if the payments were not gross income, the case should be reversed and the indictment dismissed, but that by remanding the case, the majority implied that the payments were gross income.

The good news: After the remand, the government dropped the prosecution. There's no record of whether Garber paid the unreported tax.

A year later, the Tax Court addressed the deductibility of various expenses by another plasma donor, Margaret Cramer Green. Green v. Commissioner, 754 T.C. 1229 (1980). In this case, Green was paid by Serologicals, Inc. for generating plasma through plasmapheresis. Green reported the amounts she received as gross income, offset by claimed business expense deductions. The court's analysis is most interesting, especially in light of the Garber opinions issued a year earlier:
Both parties to this case base their respective arguments upon the implied assumptions that petitioner realized income upon receiving payment for her plasma and that this income should be characterized as ordinary. Although these assumptions may seem obvious, since this case presents some novel legal questions, we feel compelled to lay a firmer foundation for our conclusions herein.

Clearly, petitioner realized income. Section 61 states that "gross income means all income from whatever source derived.4 Such sweeping language must be broadly interpreted to fulfill the intent of Congress to implement a comprehensive income tax. [citations omitted] Congress intended "to use the full measure of its taxing power." [citations omitted] Fulfilling this intent, the well-settled test for income is that enunciated in Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955), which looks for "undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion." The Fifth Circuit, to which appeal in this case would go, has followed this test as a search for lasting economic gain realized primarily by the taxpayer personally, [citations omitted] See also the Fifth Circuit's general discussions of this and other matters as they specifically relate to blood plasma sales in United States v. Garber, 607 F.2d 92 (5th Cir. 1979), revg. and remanding, on rehearing en banc, 589 F.2d 843 (1979), a criminal fraud case. All of these gains are taxable, unless specifically excluded. [citations omitted] Petitioner received the payments for her plasma directly, without any conditions subsequent which might require repayment of the funds or might control her use of the funds. The payments were not subject to any exclusion from income. [footnote omitted] The payments were gross income to petitioner under section 61.

Next, we must determine the character of the income realized by petitioner for her plasma. This income was not capital gain. Capital gain involves the sale or exchange of a capital asset. Section 1222(1) and (3). If petitioner's activity is viewed as the sale of property held for sale to customers in the ordinary course of business, petitioner's blood plasma, the property held for sale, is not a capital asset. Sec. 1221(1). On the other hand, if her activity is viewed as a service, her blood plasma is an integral part of that service and is not part of a sale or exchange. [citations omitted] Therefore, regardless of how the activity is viewed, it is not the sale or exchange of a capital asset and the income realized therefrom is not capital gain.

Nevertheless, the identification of the activity as either the sale of a product or the performance of a service is important in determining gross income and the deductibility of certain items in the calculation of adjusted gross income and taxable income, which is the general issue before us. Under the facts of this case, we find that petitioner's activity was the sale of a tangible product. From petitioner, who did little more than release the valuable fluid from her body, the plasma was withdrawn in a complex process by the equipment of the lab. Petitioner performed no substantial service. She was paid for the item extracted by the lab. Except for the unusual nature of the product involved, the contact between petitioner and the lab was the usual sale of a product by a manufacturer to a distributor or of raw materials by a producer to a processor. A tangible product changed hands at a price, paid by the pint.

The rarity of petitioner's blood made the processing and packaging of her blood plasma a profitable undertaking, just as it is profitable for other entrepreneurs to purchase hen's eggs, bee's honey, cow's milk, or sheep's wool for processing and distribution. Although we recognize the traditional sanctity of the human body, we can find no reason to legally distinguish the sale of these raw products of nature from the sale of petitioner's blood plasma. Even human hair, if of sufficient length and quality, may be sold for the production of hairpieces. The main thrust of the relationship between petitioner and the lab was the sale of a tangible raw material to be processed and eventually resold by the lab.
So is there any difference between the extraction of plasma and the extraction of a kidney? In both instances, the taxpayer "performed no substantial service."

Not only do these cases affirm what James Butler and I think is the black letter law result, they suggest, at least to me, that the IRS probably would require reporting of the gross income by the kidney-swapping women. Are the cases different? If one tries to distinguish Garber and Green by characterizing them as motivated by economic gain, one can treat each kidney-yielding woman as motivated by economic gain, namely a kidney for her husband. If one tries to distinguish the kidney-swapping women by portraying them as altruistic and generous despite the kidney being received in turn, one can note that Garber and Green endured discomfort, pain, and risk in order to help all those unidentified individuals who benefit from medical science's use of the rare plasma.

If the IRS does so proceed, the outcry might be overwhelming. In that case, Congress can amend the Code if it so chooses, to provide an exclusion. The IRS should not arbitrarily add an exclusion to the tax law simply because it might be a good idea.

It is doubtful that the kidney-swapping women would be permitted to claim trade or business deductions. Unlike Garber and Green, who had been undergoing plasma extraction for years on a continual basis, the kidney-swapping women were engaged in a one-time transaction. It is highly unlikely the one-time transaction would rise to the level of a trade or business.

I wonder if the kidney-swapping women have consulted their tax advisors. If they did, I wonder what the tax advisors told them. I am most curious. If you were their tax advisor, what would you tell them?

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