Character of Income and Computation of Tax
Recall that there are three principles that guide us through every question of income tax. See chapter 1. The first of these principles is that “[w]e tax income of a particular taxpayer once and only once.” A good bit of our study to this point has been to identify inconsistencies or anomalies with this principle, i.e., exclusions from gross income and certain deductions. In this chapter, we refine the notion of taxing all income once by adding this caveat: not all income is taxed the same. Taxable income has a “character” that determines the tax burden to which it is subject. Under § 1(h), an individual’s tax liability is actually the sum of the taxes of different rates on income of several different characters.
We have also seen that the Code states rules whose effect is to match income and expenses over time. See Idaho Power, Encyclopaedia Britannica, supra. We now find that the Code requires taxpayers – with only quite limited exceptions – to match income, gains, losses, and expenses with respect to character. Taxpayers who perceive these points may try to manipulate the character of income and associated expenses, and the Code addresses these efforts. Generally, a taxpayer prefers gains to be subject to a lower rate of tax, and deductions to be taken against income subject to a higher rate of tax.
The Tax Formula:
MINUS deductions named in § 62
EQUALS (adjusted gross income (AGI))
MINUS (standard deduction or itemized deductions)
MINUS (personal exemptions)
EQUALS (taxable income)
→ Compute income tax liability from tables in § 1 (indexed for inflation)
MINUS (credits against tax)
We consider here incomes of the following characters: long-term capital gain (and its variations), short-term capital gain, depreciation recapture, § 1231 gain, dividends, and passive income.
I. Capital Gain
We have already seen that § 61(a)(3) includes within the scope of “gross income” “gains derived from dealings in property.” Section 1001(a) informed us that taxpayer measures such gains (and losses) by subtracting “adjusted basis” from “amount realized.” Gains from the sale or exchange of “capital assets” might be subject to tax rates lower than those applicable to “ordinary income.”
So we begin with a definition of “capital asset.”
A. “Capital Asset:” Property Held by the Taxpayer
Read § 1221(a). Notice the structure of the definition, i.e., all property except … Do not the first two lines of this section imply that “capital asset” is a broad concept? Is there a common theme to the exceptions – at least to some of them?
In Corn Products Refining Co. v. Commissioner, 350 U.S. 46 (1955), taxpayer was a manufacturer of products made from corn. Its profitability was vulnerable to price increases for corn. In order to protect itself against price increases and potential shortages, taxpayer “took a long position in corn futures”188 at harvest time when prices were “favorable.” Id. at 48. If no shortage appeared when taxpayer needed corn, it would take delivery on as much corn as it needed and sell the unneeded futures. However, if there were a shortage, it would sell the futures only as it was able to purchase corn on the spot market. In this manner, taxpayer protected itself against seasonal increases in the price of corn. Taxpayer was concerned only with losses resulting from price increases, not from price decreases. It evidently purchased futures to cover (much) more than the corn it would actually need. See id. at 49 n.5. Hence, taxpayer sold corn futures at a profit or loss. Over a period when its gains far exceeded its losses, taxpayer treated these sales as sales of capital assets. This would subject its gains to tax rates lower than the tax rate on its ordinary income. At the time, the Code did not expressly exclude transactions of this nature from property constituting a capital asset. The Commissioner argued that taxpayer’s transactions in corn futures were hedges that protected taxpayer from price increases of a commodity that was “‘integral to its manufacturing business[.]’” Id. at 51. The Tax Court agreed with the Commissioner as did the United States Court of Appeals for the Second Circuit. The United States Supreme Court affirmed. The Court said:
Admittedly, [taxpayer’s] corn futures do not come within the literal language of the exclusions set out in that section. They were not stock in trade, actual inventory, property held for sale to customers or depreciable property used in a trade or business. But the capital-asset provision … must not be so broadly applied as to defeat rather than further the purpose of Congress. [citation omitted]. Congress intended that profits and losses arising from the everyday operation of a business be considered as ordinary income or loss rather than capital gain or loss. The [Code’s] preferential treatment [of capital gains] applies to transactions in property which are not the normal source of business income. It was intended ‘to relieve the taxpayer from * * * excessive tax burdens on gains resulting from a conversion of capital investments, and to remove the deterrent effect of those burdens on such conversions.’ [citation omitted]. Since this section is an exception from the normal tax requirements of the Internal Revenue Code, the definition of a capital asset must be narrowly applied and its exclusions interpreted broadly. This is necessary to effectuate the basic congressional purpose.
Id. at 51-52. Subsequent to this case, Congress amended § 1221 by adding what is now § 1221(a)(7). A “capital asset” does not include “any hedging transaction which is clearly identified as such before the close of the day on which it was acquired, originated, or entered into …”
In other cases, taxpayers successfully argued that a futures transaction that proved profitable involved a “capital asset,” whereas a futures transaction that proved unprofitable was a hedge against price fluctuations in a commodity that was definitionally not a “capital asset.” Losses therefore could offset ordinary income. This “head-I-win-tails-you-lose” whipsaw of the Commissioner should have ended with the holding in Corn Products. The Commissioner won in Corn Products. Should the Commissioner be happy about that? Do you think that hedge transactions of the sort described in Corn Products more often produce profit or loss?
• The statutory embodiment of the Corn Products rule creates the presumption that a hedge is a capital asset transaction unless the taxpayer identifies it as an “ordinary income transaction” at the time taxpayer enters the transaction. How does this scheme prevent the whipsaw of the Commissioner?
Corn Products is also important for its statements concerning how to construe § 1221. While the structure of § 1221 implies that “capital asset” is a broad concept, i.e., “all property except …”, the Court stated that the exceptions were to be construed broadly – thereby eroding the scope of the phrase “capital asset.” Furthermore, we might surmise that a major point of Corn Products is that a transaction that is a “surrogate” for a “non-capital” transaction is in fact a non-capital transaction.
In Arkansas Best Corp. v. Commissioner, 485 U.S. 212 (1988), taxpayer was a diversified holding company that purchased approximately 65% of the stock of a Dallas bank. The bank needed more capital and so over the course of five years, taxpayer tripled its investment in the bank without increasing its percentage interest. During that time, the financial health of the bank declined significantly. Taxpayer sold the bulk of its stock, retaining only a 14.7% interest. It claimed an ordinary loss on the sale of this stock, arguing that its ownership of the stock was for business purposes rather than investment purposes. The Commissioner argued that the loss was a capital loss. Taxpayer argued that Corn Products supported the position that property purchased with a business motive was not a capital asset. The Tax Court agreed with this analysis and applied it to the individual blocks of stock that taxpayer had purchased, evidently finding that the motivation for different purchases was different. The United States Court of Appeals for the Eighth Circuit reversed, finding that the bank stock was clearly a capital asset. The Supreme Court affirmed. The Court refused to define “capital asset” so as to exclude the entire class of assets purchased for a business purpose. “The broad definition of the term ‘capital asset’ explicitly makes irrelevant any consideration of the property’s connection with the taxpayer’s business …” Id. at 217. The Court held that the list of exceptions to § 1221’s broad definition of “capital asset” is exclusive. Id. at 217-18. The Court (perhaps) narrowed its approach to “capital asset” questions in Corn Products to a broad application of the inventory exception rather than a narrow reading of the phrase “property held by the taxpayer[.]” Id. at 220. The corn futures in Corn Products were surrogates for inventory.
• Thus, “capital asset” is indeed “all property” except for the items – broadly defined – specifically named in § 1221(a).
• Read § 1221(a)’s list of exceptions to “capital assets” again. Is (are) there a general theme(s) to these exceptions?
• Read again the excerpt from Corn Products, above.
• The phrase “capital asset” certainly includes personal use property. Thus if a taxpayer sells his/her personal automobile for a gain, the gain is subject to tax as capital gain.
B. Other Terms Relating to Capital Gains and Losses: Long Term and Short Term Gains and Losses
Read § 1222. You will see that the Code distinguishes between sales or exchanges of capital assets held for one year or less, and sales or exchanges of capital assets held for more than one year.189 Sections 1221(3 and 4) inform us that every single sale or exchange of a capital asset gives rise to one of the following:
• short-term capital gain (STCG);
• short-term capital loss (STCL);
• long-term capital gain (LTCG);
• long-term capital loss (LTCL).
Net capital gain: the point of mismatching NLTCG and NSTCL: It might appear that § 1222(11)’s definition of “net capital gain” requires some advantageous mismatching of income and losses with different characters. The opposite is true. We know that reductions in taxable income, whether by exclusion or deduction, “work” only as hard as taxpayer’s marginal bracket to reduce his/her tax liability. We learn momentarily that a taxpayer’s tax bracket on net capital gain is always less than his/her tax bracket on ordinary income. Since NSTCG does not figure into a taxpayer’s “net capital gain,” it is subject to tax at taxpayer’s marginal rate on ordinary income. However, NSTCL reduces income that would otherwise be taxed at a rate lower than taxpayer’s ordinary rate. Hence, such losses “work” no harder than taxpayer’s marginal rate on his/her “net capital gain” at reducing his/her tax liability – not as hard as taxpayer’s marginal rate on his/her ordinary income.
Mismatch of NSTCL and different types of LTCG: We shall momentarily see that different types of LTCG combine to make up net capital gain, and that these types are not all subject to the same tax rates to an individual taxpayer. NSTCL reduces first LTCG of the same type, e.g., collectible losses first offset collectible gains. Then in sequence, NSTCL reduces LTCG that would otherwise be subject to successively lower rates of tax, i.e., NSTCL first reduces “net capital gain” subject to a tax rate of 28%, then to a tax rate of 25%, and then to a tax rate of 20%, 15%, or 0%. See §§ 1(h)(4)(B)(ii), 1(h)(6)(A)(ii).
Sections 1221(5, 6, 7, and 8) direct us to net all short-term transactions and to net all long-term transactions.
• net short-term capital gain (NSTCG) = STCG − STCL, but not less than zero;
• net short-term capital loss (NSTCL) = STCL − STCG, but not less than zero;
• net long-term capital gain (NLTCG) = LTCG − LTCL, but not less than zero;
• net long-term capital loss (NLTCL) = LTCL − LTCG, but not less than zero.
Notice the precise phrasing of §§ 1221(9, 10, and 11). The definitions of these phrases is in § 1222, but other code sections assign specific tax consequences to them. Section 1222(11) defines “net capital gain” to be
NLTCG − NSTCL
We defer for the moment the definition of “net capital loss” to the discussion of capital loss carryovers.190
Notice that the definitions of § 1222 implement, at least initially, a matching principle to gains and losses. Short-term losses offset only short-term gains. Long-term losses offset only long-term gains.
Net short-term capital loss offsets net long-term capital gain. Section 1222 does not allow any other mismatching. The matching principle is very important because only the LTCG that remains after allowable offsets (LTCL and NSTCL) is subject to tax at reduced rates; other income is subject to tax at higher “ordinary income” rates.
C. Deductibility of Capital Losses and Capital Loss Carryforwards
Section 1211(b) provides that a taxpayer other than a corporation191 may claim capital losses only to the extent of capital gains plus the lesser of $3000 or the excess of such losses over gains. This is one of very few places in the Code where taxpayer may mismatch what might be NLTCL against income subject to ordinary income rates, whether STCG or otherwise.
In the event taxpayer incurred losses greater than those allowed by § 1211(b), i.e., a “net capital loss, § 1222(10), taxpayer may carry them forward until he/she dies. § 1212(b). Section 1212(b) treats a capital loss-carryover as if it were one of the transactions described in §§ 1222(3 or 4) in the next succeeding year.
• The Code creates a pecking order of capital loss carryovers by requiring taxpayer – before calculating his/her capital loss carryovers – to add a (hypothetical) STCG equal to the lesser of taxpayer’s § 1211(b) deduction or taxpayer’s “adjusted taxable income.” § 1212(b)(2)(A).192
• If the “net capital loss” results from NLTCL and NSTCL, the taxpayer first reduces the NSTCL by the amount of his/her § 1211(b) deduction, second reduces the NLTCL by the balance (if any) of his/her § 1211(b) deduction. Taxpayer carries forward all of the NLTCL and reduces the NSTCL by the amount deducted. § 1212(b)(2)(A).
• If NSTCL > NLTCG, taxpayer carries forward the “net capital loss” as a STCL transaction. § 1212(b)(1)(A) and § 1212(b)(2)(A).
• If NLTCL > NSTCG, taxpayer carries forward the “net capital loss” as a LTCL transaction. §§ 1212(b)(1)(B) and 1212(b)(2)(A).
Example 1: Taxpayer has $100,000 of ordinary income. Taxpayer does his/her § 1222 calculations. For the tax year, taxpayer has $5000 of NSTCL and $4000 of NLTCL. What is taxpayer’s § 1211(b) deduction, and what is taxpayer’s § 1212(b) capital loss carryover?
• Taxpayer’s capital losses exceed his/her capital gains by $9000. Taxpayer’s § 1211(b) deduction is $3000. Taxpayer’s “net capital loss” (§ 1222(10)) is $6000.
• We calculate taxpayer’s capital loss carryovers by first adding $3000 (the amount of taxpayer’s § 1211(b) deduction) to his/her NSTCL. Taxpayer’s NSTCL becomes $2000; taxpayer’s NLTCL is $4000. Taxpayer will carry these amounts forward. In the succeeding year, taxpayer will include $2000 as a STCL and include $4000 as a LTCL.
2. Taxpayer has $100,000 of ordinary income. Taxpayer does his/her § 1222 calculations. For the year, taxpayer has $7000 of NSTCL and $2000 of NLTCG.
• Taxpayer’s capital losses exceed his/her capital gains by $5000. Taxpayer’s § 1211(b) deduction is $3000. Taxpayer’s “net capital loss” is $2000.
• We calculate taxpayer’s capital loss carryover by first adding $3000 to his/her NSTCL. Taxpayer’s NSTCL becomes $4000. Taxpayer will carry this amount forward. In the succeeding year, taxpayer will include $4000 as a STCL.
Dividends: For many years, dividend income that individual taxpayers received was taxed as ordinary income. Dividend income comes from corporate profits on which the corporation pays income tax. The corporation may not deduct dividends that it pays to shareholders. Hence, dividend income that a shareholder actually receives is subject to two levels of income tax. This double tax has been subject to criticism from the beginning. Nevertheless, it is constitutional. A legislative compromise between removing one level of tax and retaining the rules taxing dividends as ordinary income is § 1(h)(11). An individual adds “qualified dividend income” to his/her net capital gain. § 1(h)(11)(A). “Qualified dividend income” includes dividends paid by domestic corporations and by “qualified foreign corporations.” § 1(h)(11)(B)(i). A “qualified foreign corporation” is one incorporated in a possession of the United States or in a country that is eligible for certain tax-treaty benefits, or one whose stock “is readily tradable on an established securities market in the United States.” § 1(h)(11)(C).
The effect of treating dividend income as “net capital gain” is to subject dividend income to the reduced rates that § 1(h) imposes on “net capital gain.” However, placement of this rule in § 1(h) means that capital losses do not offset dividend income.
3. Taxpayer has $100,000 of ordinary income. Taxpayer does his/her § 1222 calculations. For the year, taxpayer has $11,000 of NSTCG and $18,000 of NLTCL.
• Taxpayer’s capital losses exceed his/her capital gains by $7000. Taxpayer’s § 1211(b) deduction is $3000. Taxpayer’s “net capital loss” is $4000.
• We calculate taxpayer’s capital loss carryover by first adding $3000 to his/her NSTCG. Taxpayer’s NSTCG becomes $14,000. Subtract $14,000 from $18,000. Taxpayer will carry forward $4000 forward to the succeeding year as a LTCL. § 1212(b)(1)(B).
Matching the character of gains and losses: Aside from §§ 1211 and 1212, the Code strictly implements a matching regime with respect to ordinary gains and losses, and capital gains and losses. A taxpayer who regularly earns substantial amounts of ordinary income and incurs very large investment losses can use those losses only at the rate prescribed by § 1211(b) in the absence of investment gains.193
Do the CALI Lesson Basic Federal Income Taxation: Property Transactions: Capital Loss Mechanics
D. Computation of Tax
We already know that § 1 imposes income taxes on individuals.194 Section 1(h) creates income “baskets” that are subject to different maximum rates of income tax (see text box). Once an income “basket” has been subject to a particular maximum rate of tax, the principle that we tax income once applies.
Taxing Ordinary Income, “Net Capital Gain,” and “Adjusted Net Capital Gain:” Not all capital gain is taxed alike, but no capital gain income should be taxed at a rate higher than the rate applicable to a taxpayer’s ordinary income. To implement this principle, § 1(h) establishes various maximum rates. The highest maximum rate is the rate on ordinary income. In the event that taxpayer’s circumstances qualify different forms of capital gain income to a lower maximum rate, then, and only then, that lower maximum rate applies. Otherwise the ordinary income rate applies.
Section 1(h) distinguishes between “net capital gain” and “adjusted net capital gain.” Section 1(h)(3) defines the phrase “adjusted net capital gain” to be “net capital gain” MINUS “unrecaptured § 1250 gain,” MINUS “28-percent rate gain,” PLUS “qualified dividend income.” There are different maximum rates applicable to taxpayer’s “adjusted net capital gain” that depend on what taxpayer’s marginal bracket would be if all of his/her taxable income were subject to tax as ordinary income. Those maximum rates (0%, 10%, 20%) are applicable only if they are lower than the marginal rate otherwise applicable to taxpayer’s taxable income taxed as ordinary income. The maximum tax rates on unrecaptured § 1250 gain is 25%, and the maximum tax rate on 28% rate gain is 28%.
Section 1(h) refers to “net capital gain,” which we determined under § 1222 by netting gains and losses from sales or exchanges of various capital assets. Section 1(h) supplies more definitions, most of which refine the concept of “net capital gain.” The importance of placing definitions in § 1(h) rather than adding another sub-section to § 1222 is that the particular definition only applies to individuals195 – not to corporations.
Sections 1(h)(1)(B, C, D, E, and F) impose different maximum rates of tax on different forms of “net capital gain.” These rates are dependent on the rate of tax imposed on a taxpayer’s ordinary income – viz., they increase when a taxpayer’s marginal rate on ordinary income reaches 25% and increase again when a taxpayer’s marginal rate on ordinary income reaches 39.6%. In addition, there is a medicare “contribution” of 3.8% on the unearned income of (relatively196) high income earners. § 1411. [Thus the net of federal taxes on the long-term capital gains of some taxpayers is 18.8% or 23.8%, not 15% of 20%.]
Unrecaptured § 1250 gain and 28-percent rate gain: “Unrecaptured § 1250 gain” is the income attributable to recapture of depreciation that taxpayer has claimed on real property. It will be included in taxpayer’s net § 1231 gain. “28-percent rate gain” property is the net of collectibles gains and losses PLUS § 1202 gain, i.e., half of the gain from the sale of certain small business stock held for more than five years. § 1(h)(4). Temporarily, none of the gain from the sale of such stock was included in “28-percent rate gain.” A “collectible” is essentially any work of art, rug or antique, metal or gem, stamps or certain coins, an alcoholic beverage, and anything else that the Secretary of the Treasury designates. § 408(m)(2).
Section 1(h)(1)(A) isolates “ordinary income”197 and subjects it to the progressive tax brackets of § 1(a).198 Section 1(h)(1)(A) also assures that the “net capital gain” of a taxpayer is subject to the lower rates of tax on only so much of the gain otherwise necessary for a taxpayer’s total taxable income to reach the 25% bracket.
The next “basket” of income is “adjusted net capital gain” (see accompanying box). Section 1(h)(1)(B) subjects the “adjusted net capital gain” of a taxpayer whose marginal rate on ordinary income is less than 25% to a 0% tax. If a taxpayer’s ordinary income plus “adjusted net capital gain” is less than the 25% bracket threshold, to that extent the elements that distinguish “adjusted net capital gain” from “net capital gain” (see accompanying box) are subject to tax at ordinary income rates.
Section 1(h)(1)(C) subjects the “adjusted net capital gain” of taxpayers whose marginal rate on ordinary income is 25% or more to a tax rate of 15%. Section 1(h)(1)(D) subjects the “adjusted net capital gain” of taxpayers whose marginal rate on ordinary income is 39.6% to a tax rate of 20%. Section 1(h)(1)(E) subjects unrecaptured depreciation on real property up to the amount of net § 1231 gain to a maximum rate of 25%. Section 1(h)(1)(F) subjects “28-percent rate gain” property to a maximum rate of (surprise) 28%.
Taxpayer’s tax liability is the sum of the taxes imposed on these income baskets.
Do the CALI Lesson Basic Federal Income Taxation: Property Transactions: Capital Gain Mechanics (Do not worry about the questions on “capital gain net income”).
II. Sections 1245 and 1250: Depreciation Recapture
The basis of an allowance for depreciation is the notion that a taxpayer consumes a portion, but only a portion, of an asset that enables him/her/it to generate income over a period longer than one year. The Code treats that bit of “consumption” the same as any other consumption that enables a taxpayer to generate income, i.e., a deduction from ordinary income. See §§ 162, 212. Such an allowance requires an equal reduction in taxpayer’s basis in the asset. See § 1016(a)(2).
We learn shortly that the Code treats gain upon the sale of most assets subject to depreciation – and therefore not capital assets, § 1222(a)(2) – that taxpayer has held for more than one year as LTCG. This would mean that whatever gain taxpayer realizes that is attributable to basis reductions resulting from deductions for depreciation would be subject to a lower rate of tax than the income against which taxpayer claimed those deductions.199 The Code addresses this mismatch of character of income and deductions through “depreciation recapture” provisions, i.e., §§ 1245200 and 1250.201
A. Section 1245
Section 1245 provides that a taxpayer realizes ordinary income upon a disposition202 of “section 1245 property” to be measured by subtracting its adjusted basis from the lesser of the property’s “recomputed basis” or the amount realized.203 § 1245(a)(1).
• A property’s “recomputed basis” is its adjusted basis plus all “adjustments reflected in such adjusted basis on account of deductions (whether in respect of the same or other property) allowed or allowable to the taxpayer or to any other person for depreciation or amortization.” § 1245(a)(2)(A).
• Taxpayer may establish “by adequate records or other sufficient evidence” that the amount allowed for depreciation or amortization was less than the amount allowable. § 1245(a)(2)(B).
• Deductions allowed by provisions other than § 167 and § 168 – notably expensing provisions that reduce taxpayer’s basis in the property – are also considered to be “amortization,” § 1245(a)(2)(C), and so become a part of the property’s “recomputed basis.”
“Section 1245 property” is property that is subject to an allowance for depreciation under § 167 (which of course includes § 168) and is –
• personal property, § 1245(a)(3)(A),
• other tangible property – not including a building or structural components – that was used as an “integral part of manufacturing, production, or extraction or of furnishing transportation, communications, electrical energy, gas, water, or sewage disposal services,” § 1245(a)(3)(B)(i), that constituted a research facility in connection with these activities, § 1245(a)(3)(B)(ii), or that constituted a facility used in connection with such activities for the bulk storage of fungible commodities, § 1245(a)(3)(B)(iii),
• real property subject to depreciation and whose basis reflects the benefit of certain special or rapid depreciation provisions, § 1245(a)(3)(C),
• a “single purpose agricultural or horticultural structure,” § 1245(a)(3)(D),
• a “storage facility (not including a building or its structural components) used in connection with the distribution of petroleum” products, § 1245(a)(3)(E), or
• a “railroad grading or tunnel bore,” § 1245(a)(3)(F).
• Taxpayer is a professional violinist who plays the violin for the local symphony orchestra. She purchased a violin bow for $100,000 in May 2011. Treat a violin bow as 7-year property. In January 2013, she sold the bow for $110,000. What is the taxable gain on which taxpayer must pay tax and what is the character of that gain?
• Taxpayer will deduct a depreciation allowance under § 168. She will apply the half-year convention to both the year in which she placed the bow in service and the year of sale. § 168(d)(4).
• Go to the tables at the front of your Code. In 2011, she will deduct 14.29% of $100,000, or $14,290. In 2012, she will deduct 24.49% of $100,000, or $24,490. In 2013, she will deduct half of 17.49% of $100,000, or $8745.
• Taxpayer’s remaining basis in the violin bow is $52,475.
• Taxpayer’s “recomputed basis” is $100,000. It is less than the amount realized. Hence, taxpayer has depreciation recapture income of $47,525. This is ordinary income. The balance of taxpayer’s gain (i.e., $10,000) is § 1231 gain, which will be subject to tax as if it were long term capital gain.
• Suppose that taxpayer sold the violin bow for $90,000.
• Now the amount realized is less than taxpayer’s recomputed basis.
• Hence, taxpayer’s depreciation recapture income is $37,525. This income is subject to tax as ordinary income.
Section 1245 provides specific rules governing certain dispositions.
• Section 1245 does not apply to a disposition by gift. § 1245(b)(1). Instead, the donee takes the donor’s basis for purposes of determining gain – and includes recapture income in his/her income upon disposition of the gifted property.
• Section 1245 does not apply to a transfer at death. § 1245(b)(2). Since there is a basis step-up on property acquired from a decedent, § 1014(a), depreciation recapture is not subject to tax at all upon such a disposition.
• In certain tax-free dispositions of property between a subsidiary and its parent corporation, shareholders and a corporation, and partners and a partnership – there is no recognition of depreciation recapture. § 1245(b)(3). Instead, the recipient – who takes a carryover basis – will recognize depreciation recapture income upon disposition of the property.
• In a tax-deferred like-kind exchange (§ 1031) or involuntary conversion (§ 1033), depreciation recapture is subject to tax only to the extent the acquisition of property not qualifying for tax-deferred treatment is subject to tax plus the fmv of non-section 1245 property acquired. § 1245(b)(4). Instead gain on the disposition of the replacement property attributable to depreciation allowances on both the original and the replacement properties is depreciation recapture income.
• Section 1245 does not apply to a tax-deferred distribution of partnership property to a partner. § 1245(b)(5)(A). The partner will recognize depreciation recapture income upon his/her/its disposition of the property (subject to some very technical adjustments).
• Section 1245 does not apply to a disposition to a tax-exempt organization, § 1245(b)(3), unless the organization immediately uses the property in a trade or business unrelated to its exemption, § 1245(b)(6)(A). If the tax exempt organization later ceases to use the property for a purpose related to its exemption, it is treated as having made a disposition on the date of such cessation. § 1245(b)(6)(B).
• Special amortization rules apply to reforestation expenditures. § 194. An 84-month amortization period applies. § 194(a)(1). Ten years after acquiring the “amortizable basis” for incurring reforestation expenditures, gain on the disposition of such assets is no longer considered to be depreciation recapture. § 1245(b)(7).
• If taxpayer disposes of more than one amortizable section 197 intangible in one or more related transactions, all section 197 intangibles are considered to be one section 1245 property. § 1245(b)(8)(A). However, this rule does not apply to a section 197 intangible whose fmv is less than its adjusted basis. § 1245(b)(8)(B).
Section 1245(d) provides that § 1245 applies “notwithstanding any other provision of this subtitle.” This means that except to the extent § 1245 itself excepts its own applicability, depreciation recapture will be carved out of the gain on any disposition of depreciable or amortizable property and be subject to tax as ordinary income. This important provision limits taxpayer opportunity to mismatch the character of income against which his/she/it claims deductions with the character of subsequent resulting gain.
B. Section 1250
Section 1250 treats as ordinary income, § 1250(a)(1)(A), the recapture of so-called “additional depreciation,” i.e., the excess of depreciation adjustments over straight-line adjustments on “section 1250 property” held for more than one year. § 1250(b)(1). Section 1250 property is real property to which § 1245 does not apply. Since § 168 allowances on real property are all straight-line, the applicability of § 1250 is limited.
Nevertheless, depreciation allowances on real property are recaptured for individual taxpayers to an extent through the (complicated) interplay of § 1(h)(6) (supra) and § 1231 (infra).
III. Section 1231: Some Limited Mismatching
During World War II, the nation moved to a war economy. The Government seized many of the nation’s productive assets in order to convert them to production of items critical to the war effort. The Fifth Amendment to the Constitution of course requires that the owners of such properties be justly compensated. However, the owners of businesses may not have particularly wished to sell their assets to the Government and then to pay income tax (at wartime rates) on the taxable gains they were forced to recognize. Congress responded by enacting § 1231 – a sort of “heads-I-win-tails-you-lose” measure for taxpayers who found themselves with (substantial amounts of) unplanned-for taxable income. Basically, net gains from such transactions would be treated as capital gains; net losses from such transactions would be treated as ordinary losses. World War II ended a long time ago, but § 1231 is still with us. It has become a very important provision in the sale of a business’s productive assets.
Section 1231 applies to “property used in the trade or business” and to any capital asset held for more than one year in connection with a trade or business or a transaction entered into for profit. § 1231(a)(3). Section 1231(b) defines “property used in the trade or business” essentially as “property used in the trade or business, of a character which is subject to the allowance for depreciation provided in section 167, held for more than 1 year, and real property used in the trade or business, held for more than 1 year[.]” § 1231(b)(1). Such property is the same as the property that § 1221(a)(2) describes, but which the taxpayer has held for more than one year. Such property does not encompass property that § 1221(a)(1, 3, and 5) describes.
Section 1231 requires two netting processes – both of which adopt the “heads-I-win-tails-you lose” characterization of transactions that net to a gain as capital and transactions that net to a loss as ordinary. If the first netting process yields a gain, the net gain becomes a part of the second netting process. Those who write about § 1231 often describe this in terms of mixing ingredients in two pots. If the mixture in the first pot yields a net positive, it is added to the second pot; otherwise, it is not added. We are talking about non-statutory terms so we can use any terminology we wish – but let’s consider the first netting process to occur in a “firepot.” The second netting process occurs in a “hotchpot.”
Firepot: Section 1231 initially adopts the “heads-I-win-tails-you-lose” principle for “involuntary conversions” resulting from casualty losses of “property used in the trade or business” or of a capital asset held for more than one year in connection with a trade or business or transaction entered into for profit. § 1231(a)(4)(C). If a taxpayer’s gains and losses from such “involuntary conversions” resulting from casualty losses net to a loss, then § 1231 does not apply to any such gains and losses. § 1231(a)(4) (carryout paragraph). The upshot of this “inapplicability” is that such gains and losses are treated as realized on the disposition of non-capital assets, so the net loss will be an ordinary loss. If the gains and losses from such transactions yield a net gain or if the net gain and loss is $0, then § 1231 is applicable to them. See Reg. § 1.1231-1(e)(3). Such transactions are added to the § 1231 hotchpot.
Section 1231 Hotchpot: Section 1231 requires a netting of “section 1231 gains” and “section 1231 losses.” “Section 1231 gain” is
• gain recognized on the sale or exchange of “property used in the trade or business” plus
• gain recognized on the compulsory or involuntary conversion into money or other property as a result of whole or partial destruction, theft or seizure, or requisition or condemnation of “property used in the trade or business” or a “capital asset held for more than 1 year” that “is held in connection with a trade or business or a transaction entered into for profit.” § 1231(a)(3)(A). But
• Such gain does not include depreciation recapture. § 1245(d), § 1250(h), Reg. § 1.1245-6(a), Reg. § 1.1250-1(e)(1).
“Section 1231 loss” is loss recognized on such sales, exchanges, or conversions – but not, of course, net losses resulting from involuntary conversions resulting from casualties. Compare § 1231((a)(3)(A)(ii) with § 1231(a)(4)(C).
Section 1231(a)(1 and 2) implements the “heads-I-win-tails-you-lose” principle.
• If section 1231 gains for any taxable year exceed section 1231 losses, such gains and losses are treated as LTCG or LTCL as the case may be. § 1231(a)(1).
• If section 1231 gains do not exceed204 section 1231 losses for the taxable year, then such gains and losses are not treated as gains and losses derived from sales or exchanges of capital assets. § 1231(a)(2).
A provision so taxpayer-friendly would be subject to some abuse. With only a little planning, a taxpayer may dispose of section 1231 “winners” in one taxable year and section 1231 “losers” in a different taxable year. Hence, § 1231(c) creates a so-called “5-year lookback rule.” For any year in which taxpayer recognizes net section 1231 gains, such gains are taxed as ordinary income to the extent taxpayer recognized section 1231 losses during the five most recent preceding taxable years. § 1231(c).
Do the CALI Lesson Basic Federal Income Taxation: Property Transactions: Section 1231 Mechanics
IV. Some Basis Transfer Transactions: §§ 1031, 1033
Congress has identified some transactions in which it does not want taxpayers to “recognize” gain even though a taxpayer may have “realized” gain. The “technique” by which Congress accomplishes this is the basis transfer. Taxpayer simply keeps as the basis in the asset he/she/it acquires the basis in the asset he/she/it gave up. Some examples include –
• Like-kind exchanges under § 1031: Under certain defined conditions, taxpayer does not recognize gain or loss upon the exchange of property for other property of like kind. Instead, taxpayer has the same basis in the acquired property as he/she/it had in the property exchanged. § 1031(d) (with adjustments for receipt of and taxation of non-like kind property received).
• Involuntary conversions under § 1033: If taxpayer’s property is compulsorily or involuntarily converted because of theft, seizure, requisition or condemnation, taxpayer may, by complying with the rules of § 1033, elect to spend money received because of such conversion on replacement property. Taxpayer does not recognize the gain realized on such a conversion. Instead, taxpayer has the same basis in the replacement property that he/she/it had in the property compulsorily or involuntarily converted. § 1033(b) (with various adjustments).
• The gain or loss that a partner “realizes” upon contributions of property to a partnership in exchange for a partnership interest are not “recognized.” § 721. The partner’s basis in his/her/its partnership interest is the basis he/she/it had in the property contributed. § 722.
• The gain or loss that a shareholder “realizes” upon contributing property to a corporation in exchange for shares of stock in the corporation are not “recognized” if the conditions of § 351(a) are met. Shareholder’s basis in his/her/its shares is the basis of the property he/she/it contributed. § 358(a).
In these transactions and many more, tax on gain is not forgiven. It is merely deferred until the time when taxpayer disposes of the asset acquired in a taxable transaction.
V. More Matching
The following materials should make the point that matching income and expenses with respect to character is more than simply the rule of some Code sections: it is a principle that pervades construction of the Code.
Arrowsmith v. Commissioner, 344 U.S. 6 (1952)
MR. JUSTICE BLACK delivered the opinion of the Court.
This is an income tax controversy growing out of the following facts … In 1937, two taxpayers, petitioners here, decided to liquidate and divide the proceeds of a corporation in which they had equal stock ownership. Partial distributions made in 1937, 1938, and 1939 were followed by a final one in 1940. Petitioners reported the profits obtained from this transaction, classifying them as capital gains. They thereby paid less income tax than would have been required had the income been attributed to ordinary business transactions for profit. About the propriety of these 1937-1940 returns there is no dispute. But, in 1944, a judgment was rendered against the old corporation and against Frederick R. Bauer, individually. The two taxpayers were required to and did pay the judgment for the corporation, of whose assets they were transferees. [citations omitted]. Classifying the loss as an ordinary business one, each took a tax deduction for 100% of the amount paid. … The Commissioner viewed the 1944 payment as part of the original liquidation transaction requiring classification as a capital loss, just as the taxpayers had treated the original dividends as capital gains. Disagreeing with the Commissioner, the Tax Court classified the 1944 payment as an ordinary business loss. Disagreeing with the Tax Court, the Court of Appeals reversed, treating the loss as “capital.” This latter holding conflicts with the Third Circuit’s holding in Commissioner v. Switlik, 184 F.2d 299. Because of this conflict, we granted certiorari.
I.R.C. § 23(g) [(1222)] treats losses from sales or exchanges of capital assets as “capital losses,” and I.R.C. § 115(c) [(331)] requires that liquidation distributions be treated as exchanges. The losses here fall squarely within the definition of “capital losses” contained in these sections. Taxpayers were required to pay the judgment because of liability imposed on them as transferees of liquidation distribution assets. And it is plain that their liability as transferees was not based on any ordinary business transaction of theirs apart from the liquidation proceedings. It is not even denied that, had this judgment been paid after liquidation, but during the year 1940, the losses would have been properly treated as capital ones. For payment during 1940 would simply have reduced the amount of capital gains taxpayers received during that year.
It is contended, however, that this payment, which would have been a capital transaction in 1940, was transformed into an ordinary business transaction in 1944 because of the well established principle that each taxable year is a separate unit for tax accounting purposes. United States v. Lewis, 340 U.S. 590; North American Oil Consolidated v. Burnet, 286 U.S. 417. But this principle is not breached by considering all the 1937-1944 liquidation transaction events in order properly to classify the nature of the 1944 loss for tax purposes. Such an examination is not an attempt to reopen and readjust the 1937 to 1940 tax returns, an action that would be inconsistent with the annual tax accounting principle.
MR. JUSTICE DOUGLAS, dissenting. [omitted]
MR. JUSTICE JACKSON, whom MR. JUSTICE FRANKFURTER joins, dissenting.
This problem arises only because the judgment was rendered in a taxable year subsequent to the liquidation.
Had the liability of the transferor-corporation been reduced to judgment during the taxable year in which liquidation occurred, or prior thereto this problem under the tax laws, would not arise. The amount of the judgment rendered against the corporation would have decreased the amount it had available for distribution, which would have reduced the liquidating dividends proportionately and diminished the capital gains taxes assessed against the stockholders. Probably it would also have decreased the corporation’s own taxable income.
Congress might have allowed, under such circumstances, tax returns of the prior year to be reopened or readjusted so as to give the same tax results as would have obtained had the liability become known prior to liquidation. Such a solution is foreclosed to us, and the alternatives left are to regard the judgment liability fastened by operation of law on the transferee as an ordinary loss for the year of adjudication or to regard it as a capital loss for such year.
I find little aid in the choice of alternatives from arguments based on equities. One enables the taxpayer to deduct the amount of the judgment against his ordinary income which might be taxed as high as 87%, while, if the liability had been assessed against the corporation prior to liquidation, it would have reduced his capital gain which was taxable at only 25% (now 26%). The consequence may readily be characterized as a windfall (regarding a windfall as anything that is left to a taxpayer after the collector has finished with him).
On the other hand, adoption of the contrary alternative may penalize the taxpayer because of two factors: (1) since capital losses are deductible only against capital gains plus $1,000, a taxpayer having no net capital gains in the ensuing five years would have no opportunity to deduct anything beyond $5,000, and, (2) had the liability been discharged by the corporation, a portion of it would probably, in effect, have been paid by the Government, since the corporation could have taken it as a deduction, while here, the total liability comes out of the pockets of the stockholders.
Notes and Questions:
1. Upon liquidation of a corporation, the corporation distributes its assets to its shareholders in exchange for their stock. Shareholders treat this as a sale or exchange of a capital asset. § 331(a). Recall from our discussion of Gilliam that payment of a tort judgment would have been an ordinary and necessary business expense, deductible under § 162(a).
2. The opinion of Justice Jackson spells out just what is at stake. First, recognition of capital losses would save taxpayers less than recognition of the same losses as ordinary. Second, long term capital losses are – except to the narrow extent permitted by § 1211 – only offset by long-term capital gains. If a taxpayer does not or cannot recognize long-term capital gains, the long-term capital losses simply become a useless asset to the taxpayer. Also the tax liability of the liquidated corporation should have been less under the majority’s view because of the deductions, but the statute of limitations had no doubt run.
3. Two policies came into conflict in Arrowsmith. The Tax Court and Justice Jackson bought into the annual accounting principle. The other principle that permeates the Code is that a taxpayer may not change the character of income or loss – whether capital or ordinary. This is a very strong policy that only rarely loses to another policy. Often times, taxpayers’ machinations are much more deliberate than they were in this case.
A. Matching Tax-Exempt Income and Its Costs
Ours is an income tax system that taxes net income. But what if certain income is not subject to tax because it falls within an exception to the first of our three guiding principles? Logically, such expenses should not be deductible – and this is indeed a rule that the Code implements in at least two places.
Section 265 denies deductions for the costs of realizing tax exempt income. Section 264(a)(1) provides that a life insurance contract beneficiary’s premium payment is not deductible. Of course, the life insurance payment by reason of death is excluded from the beneficiary’s gross income. § 101(a)(1). This same principle generally applies to interest incurred to pay life insurance contract premiums. § 264(a)(4).
B. More Matching: Investment Interest
Section 163(d)(1) limits the interest deduction for investment income to the taxpayer’s “net investment income … for the taxable year.” Taxpayer may carry forward any investment interest disallowed to the succeeding taxable year.
C. Passive Activities Losses and Credits
A passive activity is a trade or business in which the taxpayer does not “materially participate.” § 469(c)(1). An individual taxpayer may not deduct aggregate passive activity losses in excess of his/her passive activity income, nor claim credits in excess of the tax attributable to the aggregate of his/her net income from passive activities. §§ 469(a)(1), 469(d). We defer discussion of the details of § 469 to a course in partnership tax. The important point here is that there is absolutely no mis-matching of losses derived from passive activities with any other type of income – whether ordinary income or portfolio (investment) income – until taxpayer has sold all of his/her interests in passive activities.
D. General Comment about Matching Principles
Perhaps it does not seem very significant that implementation of matching principles results in disallowance of a deduction, loss, or credit because usually there is a carryover. Your attitude may be “pick it up next year.” Reality may be quite different. When losses are “locked inside” a particular activity or type of income, it probably is the case that circumstances are not going to change radically for a taxpayer from one year to the next. The investor who loses a deduction because of insufficient income of a particular type is not likely suddenly to receive a lot of that type of income during the next year. The effect of implementing matching principles in reality may be that the excess expense or loss is simply disallowed – forever. However, forewarned is forearmed. Taxpayers may choose their activities or transactions so that he/she/it will have gains against which losses can be can be matched.
Wrap-Up Questions for Chapter 10
1. What policy (policies) is served by the exceptions to the definition of “capital asset” in §§ 1221(a)(1, 2, 3, 4, 6, 7, 8)?
2. In Fribourg Navigation Co. v. Commissioner, 383 U.S. 272 (1966), the Supreme Court held that a taxpayer was entitled to depreciation deduction up to the date it sold an asset. In the days before § 1245 (but after § 1231), why would this have been important?
3. Why should capital loss carryovers expire – and simply disappear – on the death of the taxpayer?
4. In what ways does § 1231 help facilitate growth within our economy?
5. Why should a taxpayer not be permitted to deduct the cost of obtaining tax-exempt income?