Federal Taxation - Chapter 16

Sport Franchise

- Professional sports franchises are subject to 1253 - Player contracts and other intangible assets acquired in the purchase of the sports franchise are amortized over a statutory 15-year period

Jack owns a large tract of land and subdivides it for sale. Assume that Jack meets all of the requirements of 1237 and during the tax year sells the first 10 lots to 10 different buyers for $10,000 each. Jack's basis in each lot sold is $3,000 and he incurs total selling expenses of $4,000 ($400 for each lot) on the sales. What is Jack's gain?

$65,000 Calculations: Selling Price: (10 x $10,000) $100,000 Less: Selling expenses (4,000) Amount realized $96,000 Basis(10 x $3,000) (30,000) Realized and Recognized Gain $66,000 Classification of Recognized Gain: Ordinary Income Five percent of selling price (5% x $100,000) $5,000 Less: Selling expenses (4,000) Ordinary gain 1,000 Capital Gain (R&R Gain less Ordinary Gain) $65,000 **portion of the gain is given ordinary treatment because the sixth lot was sold in the current year

Noncorporate taxpayers

- Capital gains and losses must be netted by holding period - Short-term capital gains and losses are netted - Long-term capital gains and losses are netted - If possible, long-term gains or losses are then netted with short-term gains or losses - If the result is a loss: - The capital loss deduction is limited to a maximum deduction of $3,000 - Unused amounts retain their character and carryforward -IF net from capital transactions is a gain, tax treatment depends on holding period: - Short-term: taxed at ordinary income - Long-term: alternative tax calculation is available using preferential tax rates -Net long-term capital gain is eligible for one or more of five alternative tax rates: 0%, 15%, 20%, 25% and 28% - 25% tax rate applies to unrecaptured 1250 gain and is related to gain from disposition of 1231 assets - 28% rate applies to collectibles and small business stock gain - 0%/15%/20% rates apply to any remaining net long-term capital gain

Accounts and Notes Receivable

- Collection of an ACCRUAL BASIS account or note receivable does NOT result in a gain or loss b/c the collected equals the receivables basis - If sold, the receivable is an ordinary asset - If declared worthless, may result in ordinary deduction - Collection of a CASH BASIS account or note receivable does not result in a gain or loss b/c the amount collected is ordinary income - If sold ordinary gain generated - If worthless no bad debt b/c no basis

Business Fixed Assets

- Depreciable personal property and real estate (both depreciable and non-depreciable) used by a business are NOT capital assets - addressed in Section 1231

Differences is corporate capital treatment

- NO net capital gain (NCG)alternative tax rate - Capital losses can only offset capital gains (no $3,000 deduction in excess of capital gains) - Net capital losses are carried back three years and carried forward 5 years as short term losses

Capital loss carryover

- Short-term capital losses carries over as a short term loss and is combined with the short-term items of the current year - Net long-term capital loss carries over as a long-term capital loss and is combined with the current-year long term loss - total long-term loss is first offset with the 28% gain of the current year, and then 0%/15%/20% gain until it is absorbed

Restrictions on gain exclusions

- Stock must have been newly issued after Aug 10, 1993by a regular corporation, NOT an S corp - Taxpayer selling the stock must NOT be a corporation - Taxpayer must have held stock for more than five years - Issuing corp must use at least 80% of its assets, determined by their value, in the active conduct of a trade or business - When the stock was issued, the issuing corp's assets must not have exceeded $50 million at adjusted basis, including the proceeds of the stock issuance - Corp does NOT engage in banking, financing, insurance, investing, leasing, farming, mineral extraction, hotel or motel operations, restaurant operations, or any business whose principal asset is the reputation or skill of its employees Transactions that FAIL to satisfy ANY ONE of the applicable requirements are taxed as capital gains

Dealers in Securities

- a merchant (e.g. brokerage firm) that regularly engages in the purchase and resale of securities to customers. - securities held by a dealer are considered to be inventory and therefore NOT capital - dealer must identify any securities begin held for investment purposes by close of business on the acquisition date for gains to be capital gains

Section 1237 - Real Property Subdivided for Sale

- allows real estate investors capital gain treatment if they engage ONLY in LIMITED development activities Eligibility requirements: - taxpayer may not be a corporation - taxpayer may not be a real estate dealer - No substantial improvements may be made to the lots sold. (SUBSTANTIAL: gen > 10% increase in the value of the lot) Filling, draining, leveling, clearing are NOT considered substantial improvements IF above are met: - all gains are capital gains until the tax year in which the SIXTH lot is sold - Sales of contiguous lots tp a single buyer in the same transaction count as the sale of one lot - Beginning with the tax year the sixth lot is sold, 5% of the revenue from lot sales is potential ordinary income. The potential ordinary income is offset by any selling expenses from the lot sales (Since sales commission is often 5% of the sale price, typically none of the gain is treated as ordinary income -DOES NOT apply to losses

Significant powers, rights, or continuing interests include:

- control over franchise assignment - quality of products and services - sale or advertising of products or service - requirement that substantially all supplies and equipment be purchased from the transferor - the right to terminate the franchise at will - the right to substantial contingent payments

Retirement of Corporate Obligations

- debt obligation (bond or note payable) may have a tax basis in excess of or less than it's redemption value b/c it was purchased at a premium or a discount. Collection of a debt obligation is TREATED as a sale therefore any loss or gain can be capital gain or capital loss

Net Capital Loss (NCL)

- deductible FOR AGI - limited to $3,000 per year - if loss includes LTCL and STCL, STCL is counted first toward the $3,000 annual limit Indefinite carryover

Capital asset determination

- personal use - investment

U.S. Government Publications

- received from the US government (or its agencies) for a reduced price are NOT capital assets - prevents tax payer from later donating to charity and claiming a charitable contribution deduction equal to the fair market value of the publications

Holding period for short sales

- short sale gain or loss is SHORT term when, on the short sale date, the substantially identical property has been held short term - Short sale gain is LONG term when, on the short sale date, the substantially identical property has been held long term used to close the short sale. - Short sale LOSS is LONG term when, on the short sale date, the substantially identical property has been held long term. - Short sale gain or loss is SHORT term if the substantially identical property is acquired after the short sale date and on or before the closing date

Holding period

- starts on the day after the property is acquired and includes the day of disposition - based on calendar months and fractions of calendar months - Nontaxable exchanges: - Holding period of property received includes holding period of former asset if a capital or 1231 asset - When a gift occurs, if donor's basis is carried over to the recipient - Former owner's holding period tacks on to present owner's holding period - Certain disallowed loss transactions: - Under several Code provisions, realized losses are disallowed - When a loss is disallowed, there is no carryover of holding period - ex: related party losses or sale or exchange of personal use assets - Inherited property is always treated as long term no matter how long it is held by the heir

Gain and loss classification

- tax status of the property (capital or ordinary) - manner of the property's disposition (sale, exchange, casualty, theft, or condemnation) - holding period of the property (short-term: one year or less; long-term: more than one year)

capital loss

- the sale of an investment for less than its purchase price - limited to $3,000 for non-corporate tax payers

Short Sale - Disposition rules

-Occurs when the stock is borrowed from a broker by a seller and the seller already owns substantially identical securities - If the taxpayer has not closed the short sale by delivering the short sale securities to the broker before January 31 of the year following the short sale, the short sale is deemed to have been closed on the earlier of two events: - On the short sale date if the taxpayer owned substantially identical securities - On the date during the year of the short sale that the taxpayer acquired substantially identical securities

Collectibles

-even though held long-term are subject to a 28% alternative tax rate INLCUDE: - Work of art - Rug or antique - Metal or gem - Stamp - Alcoholic Beverage - Historical objects (docs, clothes, etc) - Most coins

Copyrights and Creative Works

-person whose efforts lead to copyright or creative work has an ordinary asset

Small business Stock

-special exclusion available to noncorporate taxpayers who derive capital gains from the sale or exchange of qualified small business stock - any amount not excluded from income is taxed at a maximum rate of 28% - exclusion is 100% for qualified small business stock acquired after September 27, 2010 -exclusion percentage is 50% or 75% if the qualified small business stock was acquired earlier

Sale or exchange

A requirement for the recognition of capital gain or loss. Generally, the seller of property must receive money or relief from debt to have sold the property. An exchange involves the transfer of property for other property. Thus, collection of a debt is neither a sale nor an exchange. The term sale or exchange is not defined by the Code. involuntary conversion is not a sale or exchange

capital gain

a profit from the sale of property or of an investment.

True or False Capital assets are directly defined in the Code.

False

Options

Grantee of the option, if the property subject to the option is (or would be) a capital asset in the hands of the grantee - Sale of an option results in capital gain or loss - Lapse of an option is considered a sale or exchange resulting in a capital lose Granter of an option, the lapse creates - Short-term capital gain, if the option was on stocks, securities, commodities or commodity futures - otherwise, ordinary income Exercise of an option by a grantee - Increases the gain (or reduces the loss) to the grantor from the sale of the property - Gain or loss is ordinary or capital depending on the tax status of the property Grantee adds the cost of the option to the basis of the property acquired Sale of an option - Grantee's sale or exchange of the option results in capital gain or loss if the option property is (or would be) a capital asset to the grantee Failure to exercise options - Lapse of the option is considered a sale or exchange on the option expiration date - Loss is capital loss if the property subject to the option is (or would be) a capital asset in the hands of the grantee

Worthless securities & 1244 Stock

Last Day Rule: - If the security is a capital asset, the loss is deemed to have occurred on the last day of the tax year. - Can have the impact of converting a short-term capital loss to a long-term capital loss

Nonbusiness bad debts

Loan not made in the course of ordinary business is classified as a nonbusiness receivable. - in the year the receivable becomes worthless, the bad debt is treated as a short-term capital loss *even if the receivable was held for over a year, STILL short-term loss

Section 1244 Stock (Loss)

Loss can be deducted up to $100,000 / $50,000 -Must be original owner -Capital of business did not exceed $1 million at time of issue.

Treatment of Capital Gains and Losses: Noncorporate Taxpayers

Ordering procedure (ensures any long-term capital gain is taxed at the lowest preferential rate possible, includes the following step: Step 1: Group all gains and losses into four groups: short term, and 28%, 25%, and 0%/15%/20% long term Step 2: Net the gains and losses within each group Step 3: Offset the net 28% and net 25% amounts if they are of opposite sign Step 4: Offset the results after step 3 against the 0%/15%/20% if they are of opposite sign. If the 0%/15%/20% amount is a loss, offset it against the highest-taxed gain first Step 5: Offset the net short-term amount against the long-term results of step 4 if they are of opposite sign

Inventions and Processes

Ordinary Assets: - patent - invention - model - design - secret formula or process

Lessor treatment

Payments received are ordinary income - considered to be in lieu of rental payments

Capital Gains & Losses: Reporting Procedures

Schedule D of Form 1040: - Part I: report short-term capital gains and losses - Part II: report long-term capital gains and losses - Part III: summarizes results of Parts I & II & indicated whether the taxpayer has a net capital gain or a net capital loss

Effect of Judicial Action

Supreme Court follows a literal interpretation of categories. - ex: corporate stock is not mentioned in Section 1221 - USUALLY a capital asset - However, if corporate stock is purchased for resale to customers, it is considered inventory Intent matters

Short Sales

Taxpayer sells borrowed securities and then repays the lender with substantially identical securities - Gain or Loss is not recognized until the short sale is closed - Generally, the holding period for a short sale is determined by how long the property used for repayment is held - IF substantially identical property is held by the taxpayer, the short-term or long-term character of the short sale gain or loss may be affected

Original Issue Discount (OID)

The difference between the issue price of a debt obligation (e.g., a corporate bond) and the maturity value of the obligation when the issue price is less than the maturity value. OID represents interest and must be amortized over the life of the debt obligation using the effective interest method. The difference is not considered to be original issue discount for tax purposes when it is less than one-fourth of 1 percent of the redemption price at maturity multiplied by the number of years to maturity. §§ 1272 and 1273(a)(3).

Patents

Transfer of a patent is treated as the sale or exchange of a long term capital asset when all substantial rights to the patent are transferred by a holder - All SUBSTANTIAL RIGHTS have not been transferred when the transfer is limited geographically within the issuing country or when the transfer is for a period less than the remaining life of the patent - The HOLDER of a patent must be an individual, usually the creator or an individual who purchases the patent from the creator before the patented invention is "reduced to practice" - When all substantial rights to a patent are transferred by a holder to another, the transfer produces long-term capital gain or loss - if the transfer meets these requirements, any gain or loss is automatically a long-term capital gain or loss

Lessee treatment

Treated as received in exchange for underlying leased property - Capital gain results asset leased was a capital asset - Ordinary income results if asset leased was an ordinary asset - Lease could be a 1231 asset if the property was used in lessee's trade or business and the lease has existed for more than a year when canceled

Contingent payments

When the transferor retains a significant power, right, or continuing interest, CONTINGENT PAYMENTS are ordinary income for the franchisor and an ordinary deduction for the franchisee - Payments are made at least annually throughout the term of the transfer agreement - Payments are substantially equal in amount or are payable under a fixed formula

noncontingent payments

When the transferor retains a significant power, right, or continuing interest, the transferee's NONCONTINGENT PAYMENTS are ordinary income to the transferor - franchisee capitalizes the payments and amortizes them over 15 years - If the franchise is sold, the amortization is subject to recapture under 1245

Alternative Tax on net capital gain

applies ONLY if taxable income includes some net long-term capital gain and/or qualified dividend income: - Net capital gain may be made up of various rate layers - For each layer, compare regular tax rate with the alternative tax rate on that portion of the net capital gain -Layers are taxed in the following order: - 25% gain, 28% gain, the 0% portion of the 0%/15%/20%, the 15% portion, and then the 20% portion - this allows the taxpayer to receive the lower of the regular tax or the alternative tax on each layer of net capital gain in 2020, the 0% alternative tax rate applies ONLY through $80,000 of taxable income or married taxpayers filing jointly or surviving spouses - $40,000 for single taxpayers and married taxpayers filing separately - $53,600 for head of household 2020 the 15% tax rate applies until taxable income exceeds $496,600 for married taxpayers filing jointly or surviving spouses - 441,450 for single taxpayers, 469,050 for heads of household, and 248,300 for married filing separately

Ordinary asset

asset held for business use

Section 1221

defines what is NOT a capital asset

Inventory

determined by taxpayer's business

Franchises, Trademarks, and Trade Names

licensing of franchises, trade names, trademarks, and other intangibles is generally NOT considered a sale or exchange of a capital asset - Therefore, the sale or exchange results in ordinary income for the transferor - Exception: capital gain (loss) may result if the transferor does not retain any significant power, right, or continuing interest

qualified dividend income

paid from current or accumulated earnings and profits (E&P) is eligible for 0%/15%/20% long-term capital gain rates: - After determining net capital gain or loss, qualified dividend income is added to the net long-term capital gain portion of the net capital gain and is taxed as 0%/15%/20% gain - If there is a net capital loss, it is still deductible FOR AGI - Limited to $3,000 per year with remainder of the loss carrying over - In this case, the qualified dividend income is still eligible to be treated as 0%/15%/20% gain in the alternative tax calculation - it is not offset by the net capital loss

Code definition of capital asset

property held by taxpayer that is NOT any of the following: -Inventory or property held primarily for sale to customers in the ordinary course of business - Accounts and notes receivable generated from the sale of goods or services in a business - Depreciable property or real estate used in business - A patent, an invention, a model, or a design (whether or not patented); a secret formula or process; certain copyrights; literary, musical, or artistic compositions; or letters, memoranda, or similar property created by or for the taxpayer - Certain US government publications - Supplies used in a business

General definition of capital assets

property other than inventory, accounts and notes receivable, supplies, and most fixed assets of a business