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Part I: Federal income taxation.

General Rules

7501. Who must file a return?

A return must be filed for taxable year 2010 by every individual whose gross income equals or exceeds the following limits:

(1) Married persons filing jointly--$18,700 (if one spouse is blind or elderly--$19,800; if both spouses are blind or elderly--$20,900; if both spouses are blind and elderly--$23,100). (1) A married taxpayer with gross income of $3,650 or more in 2010 must file a return if he and his spouse are living in different households at the end of the taxable year.

(2) Surviving spouse (see Q 7541)--$15,050 (if elderly or blind--$16,150; if elderly and blind--$17,250). (2)

(3) Head-of-household (see Q 7542)--$12,050 (if blind or elderly--$13,450; if elderly and blind--$14,850).

(4) Single persons--$9,350 (if blind or elderly--$10,750; if blind and elderly--$12,150).

(5) Married filing separately--if neither spouse itemizes, a return must be filed if gross income equals or exceeds $9,350 in 2010 (if blind or elderly--$10,450; if blind and elderly--$11,550). (3) If either spouse itemizes--$3,650.

(6) Dependents--every individual who may be claimed as a dependent of another must file a return for 2010 if he has unearned income in excess of $950 (plus any additional standard deduction if the individual is blind or elderly) or total gross income that exceeds the sum of any additional standard deduction if the individual is blind or elderly plus the greater of (a) $950 or (b) the lesser of (i) $300 plus earned income, or (ii) $5,700.

(7) Taxpayers who are non-resident aliens or who are filing a short year return because of a change in their annual accounting period--$3,650. (4)

If you are blind, you may need to attach supporting documentation to a tax return to support your claim for the additional standard deduction.

Certain parents whose children are required to file a return may be permitted to include the child's income over $1,900 on their own return, thus avoiding the necessity of the child filing a return. See Q 7515.

A taxpayer with self-employment income must file a return if net self-employment income is $400 or more. See Q 7550.

Even if you are not required to file a federal tax return, you may want to file one if withholdings of tax have occurred, or you are eligible for a refundable credit, such as the Making Work Pay Credit or the Earned Income Credit.

7502. Who must pay the estimated tax and what penalties are imposed for underpayment of the tax?

Taxpayers are generally required to pay estimated tax if failure to pay would result in an underpayment (see below) of federal income tax. (1a) Taxpayers must include the alternative minimum tax and estimated self-employment tax in their calculation of estimated tax (see Q 7548 and Q 7550, respectively). (2a) An underpayment is the amount by which a required installment exceeds the amount, if any, paid on or before the due date of that installment (due dates are April 15, June 15, September 15 and January 15 of the following year). (3a) The required amount for each installment is 25% of the required annual payment. (4a)

Generally, the "required annual payment" is the lower of (a) 90% of the tax shown on the return for the taxable year (or, if no return is filed, 90% of the tax for the year), or (b) 100% of the tax shown on the return for the preceding year (but only if the preceding taxable year consisted of 12 months and a return was filed for that year). (5a) However, for an individual whose adjusted gross income for the previous tax year exceeded $150,000 ($75,000 in the case of married individuals filing separately), the required annual payment is the lesser of (a) 90% of the current year's tax, as described above, or (b) the applicable percentage of the tax shown on the return for the preceding year. The applicable percentage for tax years beginning 2002 or later is 110%. (6a) ARRA 2009 provided that certain individuals could meet the estimated tax payment requirements for 2009 by paying 90% of the prior year's taxes. Such individual's adjusted gross income for the preceding year must be less than $500,000 and the individual must certify that more than 50% of the gross income shown on the return for the preceding year was income from a small business (average number of employees less than 500). (7a)

As an alternative to the required annual payment methods in the preceding paragraph, taxpayers can pay estimated tax by paying a specified percentage of the current year's tax, computed by annualizing the taxable income for the months in the taxable year ending before the month in which the installment falls due. The percentages that apply under the annualization method are: 22.5% (1st quarter), 45% (2nd quarter), 67.5% (3rd quarter), and 90% (4th quarter). (8a)

However, regardless of the method used to calculate estimated taxes, there is no interest penalty imposed if: (1) the tax shown on the return for the taxable year (or, if no return is filed, the tax) after reduction for withholdings is less than $1,000; or (2) the taxpayer owed no tax for the preceding year (a taxable year consisting of 12 months) and the taxpayer was a U.S. citizen or resident for the entire taxable year. (1b) Otherwise, underpayment results in imposition of an interest penalty, compounded daily, at an annual rate that is adjusted quarterly so as to be three percentage points over the short-term applicable federal rate. (2b) (See Q 7513).

If the taxpayer elects to apply an overpayment to the succeeding year's estimated taxes, the overpayment is applied to unpaid installments of estimated tax due on or after the date(s) the overpayment arose in the order in which they are required to be paid to avoid an interest penalty for failure to pay estimated income tax with respect to such tax year. (3b) For application of the estimated tax to trusts and estates, see Q 7557.

7503. What is an individual's "taxable year"?

The basic period for computing income tax liability is one year, known as the taxable year. The taxable year may be either (a) the calendar year or (b) a fiscal year. A "calendar year" is a period of 12 months ending on December 31. A "fiscal year" is a period of 12 months ending on the last day of a month other than December. (4b)

Generally, a taxpayer may decide whether he wishes to use the calendar year or fiscal year in reporting his tax liability. Most individuals report on a calendar year basis. The year used for reporting tax liability must generally correspond to the taxpayer's accounting period. (5b) Thus, if the taxpayer keeps books on a fiscal year basis he cannot determine his tax liability on a calendar year basis. But if the taxpayer keeps no books, he must report on a calendar year basis. (6b) Once the taxpayer has chosen his tax year, he cannot change without the permission of the Internal Revenue Service. (7b) A principal partner cannot change to a taxable year other than that of the partnership unless he establishes, to the satisfaction of the IRS, a business purpose for doing so. (8b)

Under certain circumstances, partnerships, S corporations, and personal service corporations are required to use the calendar year for computing income tax liability. (9b)

A short period return is required (1) where the taxpayer changes his annual accounting period, and (2) where a taxpayer has been in existence for only part of a taxable year. (10b) A short period is treated in the law as a "taxable year." (11b)

If the short period return is made because of a change in accounting period, the income during the short period must be annualized, and deductions and exemptions prorated. (12b) But income for the short period is not required to be annualized if the taxpayer is not in existence for the entire taxable year. (13b)

For the final regulations affecting taxpayers who want to adopt an annual accounting period (under IRC Section 441), or who must receive approval to adopt, change, or retain their annual accounting periods (under IRC Section 442), see Treas. Regs. [section][section]1.441-0, 1.441-1, 1.441-2, 1.4413, 1.441-4; TD 8996. (1c)

For the general procedures for establishing a business purpose and obtaining approval to adopt, change, or retain an annual accounting period, see Rev. Proc. 2002-39. (2c)

The procedure under which IRC Section 442 allows individuals (e.g., sole proprietors) filing tax returns on a fiscal year basis to obtain automatic approval to change their annual accounting period to a calendar year is set forth in Revenue Procedure 2003-62. (3c)

The exclusive procedures for (1) certain partnerships, (2) S corporations, (3) electing S corporations, (4) personal service corporations, and (5) trusts to obtain automatic approval to adopt, change, or retain their annual accounting period are set forth in Revenue Procedure 2006-46. (4c)

7504. What are the basic steps in computing an individual's tax liability?

The computation is made up of these basic steps:

... Gross income for the taxable year is determined (see Q 7505 to Q 7526).

... Certain deductions are subtracted from gross income to arrive at adjusted gross income (see Q 7527, Q 7528).

... The deduction for personal and dependency exemptions (taking into consideration any phaseout amount) is determined (see Q 7529, Q 7530).

... Itemized deductions (taking into consideration any limitations thereon) are totaled (see Q 7531 to Q 7535), compared to the standard deduction (see Q 7538), and (generally) the greater amount, along with the deduction for exemptions, is deducted from adjusted gross income to arrive at taxable income.

... The proper tax rate is applied to taxable income to determine the tax (see Appendix A).

... The following amounts are subtracted from the tax to determine the net tax payable or overpayment refundable: (1) credits (see Q 7543), and (2) prepayments toward the tax (e.g., tax withheld by an employer or payments made on an estimated tax return).

The steps in calculating the alternative minimum tax are explained in Q 7548.

(1c.) 67 Fed. Reg. 35009 (5-17-2002).

(2c.) 2002-1 CB 1046, as modified by, Notice 2002-72, 2002-2 CB 843, and further modified by, Rev. Proc. 2003-79, 2003- 2 CB 1036.

(3c.) 2003-2 CB 299, modifying, amplifying, and superseding, Rev. Proc. 66-50, 1966-2 CB 1260, and modifying and superseding, Rev. Proc. 81-40, 1981-2 CB 604. See also Ann. 2003-49, 2003-2 CB 339.

(4c.) 2006-45 IRB 859.

Gross Income

7505. What items are included in gross income? What items are excluded from gross income?

Gross income includes all income (whether derived from labor or capital) less those items that are excludable by law. Thus, gross income includes salary, fees, commissions, business profits, interest and dividends, rents, alimony received, and gains from the sale of property--but not the mere return of capital. IRC Sec. 61(a).

Some of the items that can be excluded from gross income and received tax free by an individual taxpayer are: gifts and inheritances; (1d) gain (within limits) from the sale of a personal residence (see Q 7832); 50% of gain (within limits) from the sale of certain qualified small business stock held for more than five years (see Q 7640 and Q 7641); interest on many bonds of a state, city or other political subdivision (see Q 7744); Social Security and railroad retirement benefits (within limits--see Q 7514); veterans' benefits (but retirement pay is taxable); (2d) Workers' Compensation Act payments (within limits); (3d) death proceeds of life insurance and, as to death proceeds of insurance on the life of an insured who died before October 23, 1986, up to $1,000 annually of interest received under a life income or installment option by a surviving spouse; (4d) amounts paid or expenses incurred by an employer for qualified adoption expenses in connection with the adoption of a child by an employee if the amounts are furnished pursuant to an adoption assistance program; (5d) contributions to a "Medicare Advantage MSA" by the Department of Health and Human Services; (6d) exempt-interest dividends from mutual funds (see Q 7886); interest on certain U.S. savings bonds purchased after 1989 and used to pay higher education expenses (within limits--see Q 7762); (7d) contributions paid by an employer to Health Savings Accounts; (8d) distributions from Health Savings Accounts used to pay qualified medical expenses; (9d) and federal subsidies for prescription drug plans. (10d) ARRA 2009 provides an exclusion from gross income for up to $2,400 of unemployment compensation in 2009.

7506. How are the commissions of a sales representative taxed?

Commissions are generally taxable as ordinary income in the year received, regardless of whether the taxpayer is on a cash or accrual method of accounting, and regardless of whether the taxpayer has a contingent obligation to repay them. Commissions on insurance premiums, however, are a special situation. (See Q 3582] regarding the limitation on certain employers' deductions.)

General rule for insurance commissions. First year and renewal commissions are taxable to the agent as ordinary income in the year received. If the agent works on commission with a drawing account, the amount he reports depends upon his contract with the company. If the drawing account is a loan that must be repaid (or upon which he remains personally liable) if he leaves, he reports only commissions actually received. If the drawing account is guaranteed compensation, he reports this compensation and any commissions received in excess of the amount that offsets his draw. This rule applies even if the agent uses the accrual method of accounting. (1e) The procedure by which an insurance company may obtain automatic consent to change its method of accounting for cash advances on commissions paid to its agents is set forth in Revenue Procedure 2001-24. (2e)

The Tax Court held that an agent's advance commissions were not compensation where they were repayable on demand, bore interest, and were secured by earned commissions as well as by the personal liability of the agent. Thus, even though the amounts were reported to the taxpayer as income on Form 1099-MISC, they were not income. (3e) The IRS determined that cash advances made to an agent by an insurance company were income in the year of receipt where the agent was not unconditionally obligated to repay the advances, and any excess in advances over commissions earned would be recovered by the insurance company only by crediting earned commissions and renewals against such advances. (4e) These positions are consistent with other IRS rulings and prior case law. (5e) A salesman who was discharged from the obligation to repay advance commissions received in previous years was required to recognize income in the year of discharge. (6e) The Tax Court determined that an agent had cancellation of indebtedness income where earned commissions had been used to offset advanced commissions (which were actually loans). Accordingly, the agent was held to have received gross income at the time any pre-existing deficiency in her commission account was offset, irrespective of the fact that she never received an actual check. (7e)

The Tax Court has held that amounts received by a district manager upon the termination of his agency contract are treated as ordinary income, and not capital gain resulting from the sale of a capital asset, if the money received was compensation for the termination of the right to receive future income in the form of commissions. (8e)

The Tax Court also held that where a retired insurance agent did not actually own any company assets he returned to the insurance company upon his retirement, termination payments received by the agent were not proceeds from a sale of capital assets subject to capital gain treatment, but instead were ordinary income. (9e)

Commissions on agent's own policies. Commissions on policies purchased by the agent for himself, on his own life or on the life of another, are taxable to him as ordinary income. Such commissions are considered compensation, not a reduction in the cost of the policies. (10e) This rule applies to brokers as well as to other life insurance salesmen. (11e)

Deferred income plan. If, before he retires, an insurance agent enters into an irrevocable agreement with the insurance company to receive his renewal commissions in level installments over a period of years, only the amount of the annual installment will be taxable to him each year--instead of the full amount of commissions as they accrue. (1f) Although the Oates case and Rev. Rul. 60-31 concern deferred compensation arrangements during retirement years, the same principle should apply if the agent during his lifetime elects a level commission arrangement for payments after his death. The IRS determined that an insurance agent's contributions of commissions to his company's nonqualified deferred compensation plan will not be includable in the agent's gross income or subject to self-employment tax until actually distributed. (2f) In Olmsted, the insurance company, by agreement with the agent, substituted an annuity contract for its obligation to pay future renewal commissions. The Tax Court and the U.S. Court of Appeals for the Eighth Circuit held that the agreement was effective to defer tax until payments were received under the annuity. (3f) However, the IRS did not acquiesce to the Olmsted decision. (4f)

Assignment of renewal commissions. If the agent assigns his right to renewal commissions as a gift, he still must pay income tax on them as they are received by the donee. (5f) The Tax Court determined that an insurance agent had to pay income tax on his commission income despite the assignment of that income to his S corporation. The court noted that the agent was the true earner of the income and that he made no valid assignment of his employment agreement with the insurance company. (6f) In Zaal, a 1998 memorandum decision, the Tax Court held that an agent's transfer to a corporation of his right to receive renewal commissions was ineffective for tax purposes, since it constituted an anticipatory assignment of income rather than a sale of property. Citing Helvering v. Eubank, the court held that the commission income continued to be taxable to the agent, not to the corporation to which he transferred the rights. (7f)

Sale of renewal commissions. It appears likely that a bona fide, arm's length sale of a right to receive renewal commissions can successfully transfer the federal income taxation of renewal commissions to the purchaser. The Court of Appeals for the Second Circuit has held that in the event of a sale of the right to receive renewal commissions, the sale price would constitute ordinary income to the agent in the year received. (8f) The court in Cotlow added that the purchaser receives the renewals tax free until he recovers his cost; then the excess is taxable to him as ordinary income as it is received. Other cases have held that the purchaser must amortize his cost. In other words, he can exclude from gross income each year only that portion of the purchase price that the renewals received in that year bear to the total anticipated renewals. (9f)

Commissions received after agent's death. Commissions owed to an agent before he died, but paid after his death, are includable in his gross income on his final return. Renewal commissions payable after his death are "income in respect of a decedent"; consequently, the value of the right to the commissions is includable in the agent's gross estate. The renewal commissions are taxable income to whomever receives them (e.g., his estate, beneficiaries, or a trust). (1g) However, the person who receives the commissions is entitled to take an income tax deduction against them for any portion of federal estate taxes and generation-skipping transfer taxes attributable to their value. If the decedent has purchased renewal commissions from another agent, the recipient will be allowed to amortize any portion of the decedent's cost unrecovered at his death. (2g) If the recipient of the right to commissions sells or otherwise disposes of his right to receive them, he is taxed on the fair market value of the right in the year of sale or other disposition (e.g., gift). But if the recipient dies, the fair market value of the right to commissions will not be included in his final return; the person who receives the income right from the second decedent by will or inheritance pays tax on the commissions as they are received by him. (3g)

Self-employment tax. Termination payments received by former insurance salesmen are not included in self-employment income if: (1) the amount is received after the termination of the agent's agreement to perform for the company; (2) the agent does not perform services for the company after the date of the termination of the service agreement and before the end of the taxable year; (3) the agent enters into a covenant not to compete with the company for at least a 1-year period beginning on the date of the termination; and (4) the amount of the payment (a) depends primarily on policies sold by or credited to the agent's account during the last year of the service agreement or to the extent such policies remain in effect for some period after termination of service, or both, and (b) does not depend to any extent on the length of service or overall earnings from services performed for such company (without regard to whether eligibility for payment depends on length of service). (4g) For termination payments that do not fall within the above description, earlier case law and rulings may apply.

The Tax Court held that because an independent insurance agent's renewal commissions were tied to the quantity and quality of the taxpayer's prior labor, and those payments derived from the carrying on of the taxpayer's business as an independent insurance agent, the taxpayer's renewal commissions were not exempt from self-employment tax. (5g) The Tax Court also held that an insurance agent was liable for self-employment tax because he was not a statutory employee, but instead was engaged in a self-employed trade or business activity. (6g)

The Eleventh Circuit Court of Appeals held that the FICA statute does not impliedly provide a private cause of action to purported "employees"--in this case, insurance agents claiming they had been improperly classified as independent contractors--to sue their purported "employer" for nonpayment of the employer's portion of FICA taxes. (7g)

7507. What is an insurance premium rebate? What are the income tax consequences of rebating premiums?

Generally

Insurance premium rebates are unlawful in most states. A premium rebate is a transaction in which a life insurance agent returns all or a portion of his commission to the purchaser of a life insurance policy, or simply pays the policy's first-year premium without contribution from the purchaser. The amount of the commission, allowance and/or bonus paid by the insurance company to the agent for the sale of the policy often exceeds the policy premium. The purchaser of the policy receives free or less expensive life insurance coverage.

Income Tax to the Agent

As mentioned above, almost all states have anti-rebating statutes that prohibit the sharing of insurance commissions with unlicensed persons. The tax consequences to the agent may vary, depending on the laws of the state in which the agent resides, as well as the position of the respective circuit court. In one state where such an anti-rebating statute was in force, the Ninth Circuit Court of Appeals found that an agent who rebated a premium was considered to have received taxable income in the amount of the total commission earned on the sale of the policy, including any portion used by the agent to rebate the premium to the insured. (1h) The agent in that case argued that the portion of the premium rebated should be excluded from income since the rebate was in the nature of a price adjustment. The court did not agree with this characterization. (2h)

Furthermore, the agent in the Alex case was not permitted to offset commission income earned on the sale of the policy with a business expense deduction for the payment of premiums because the Code disallows deductions for any payment that is illegal under a generally enforced state law that subjects the payor to a criminal penalty or to the loss of a license or privilege to engage in a trade or business. (3h) However, in the Custis case, an agent who rebated premiums was allowed to deduct the amount of the rebates under IRC Section 162 as business expenses since he was able to show that the state anti-rebating statute was not generally enforced.

The Court of Appeals for the Tenth Circuit decided that an insurance agent who expressly agreed with his clients to waive his right to collect basic commissions on policies sold by him was not in receipt of taxable income. The agent was required to collect and remit only the net premiums due on the policies he sold, which he did. The court found that since he was never in receipt of the basic commissions, taxable income could not be imputed to him. The court did not address the issue of whether the transactions violated state anti-rebating laws. (4h)

Income Tax to the Purchaser

A federal district court and the Tax Court have determined that the purchasers of universal and whole life policies are subject to tax on the full amount of any premiums illegally rebated to them by the agents who sold the policies. (5h) The courts rejected the purchasers' argument that the agents' reimbursements were really price adjustments. The court in Woodbury stated that the reimbursements were analogous to kickbacks and, as such, were includable in the purchasers' gross income. The court also rejected the purchasers' argument that their tax liability should be limited to the term element of the universal life policies. The fact that the purchasers did not intend to renew the policies did not convert the universal policies into term life insurance for tax purposes. The Tax Court has expressed its agreement with the district court's conclusions set forth in the Woodbury decision. In Wentz, it noted that the insurance agent was, in effect, a purchaser of the policies, and that he realized income in the amount of the kickbacks. Both the Tax Court and the Woodbury district court stated that the taxation of both the seller and the purchaser engaged in such an illegal scheme was permissible.

The Service has concluded that the purchaser of a life insurance policy is subject to income tax on the value of the free insurance coverage obtained as a result of receiving a premium rebate. (1i) However, the Service stated that the valuation process itself was outside the scope of the memoranda; thus, it is unclear how the Service will calculate the actual value of the free coverage. (See Q 3790 and Q 3754 for an explanation of how employer-provided life insurance coverage is valued under split dollar arrangements and qualified retirement plans, respectively.)

7508. Who is taxed on the income from property that is transferred to a minor under a uniform "Gifts to Minors" act?

As a general rule, the income is taxable to the minor. However, in the case of unearned income of most children under age 19 (age 24, if the child is a full-time student), the unearned income taxable to the child generally will be taxed at his parents' marginal rate when it exceeds $1,900. To the extent that income from the transferred property is used for the minor's support, it may be taxed to the person who is legally obligated to support the minor. (2i) State laws differ as to a parent's obligation to support. The income will be taxable to the parent only to the extent that it is actually used to discharge or satisfy the parent's obligation under state law. (3i)

7509. When does a cash basis taxpayer "receive" income? What is the doctrine of constructive receipt?

As a general rule, taxable income must be computed under the method of accounting regularly used by the taxpayer. (4i) There are two commonly accepted methods for recognizing income and expense: (1) the cash basis and (2) the accrual basis. (5i)

Under the cash basis, the general rule is that all items that constitute gross income (whether in the form of cash, property or services) are includable for the taxable year in which they are actually or constructively received. (6i) Salary checks received in one year but not cashed until a later year are income when received unless substantial restrictions are placed on current negotiation or the issuer is insolvent. (1j) A taxpayer who refused to cash a check in which his entire qualified plan balance was erroneously distributed was unsuccessful in deferring the date on which it was deemed received. (2j)

As a general rule, expenses are deductible by a cash basis taxpayer for the taxable year in which they are paid. (3j)

The doctrine of constructive receipt of income affects only cash basis taxpayers. Under this doctrine, a cash basis taxpayer is required to report income that has been credited to his account or set apart for him in such a way that he may draw on it freely at any time--even though he has not actually received it. (4j) Thus, a cash basis taxpayer must report the interest credited to his bank savings account in the year it is credited regardless of whether he withdraws the interest or leaves it on deposit (see Q 7879).

However, the doctrine applies only where the taxpayer's control of the income is unrestricted. Thus, a sum is not constructively received if it is only conditionally credited, or if it is indefinite in amount, or if the payor has no funds, or if it is subject to any other substantial limitation. Also the courts say, generally, that there can be no constructive receipt of an amount that is available only through surrender of a valuable right. (5j)

Under the accrual method, income is includable for the taxable year in which the right to receive the income becomes fixed and the amounts receivable become determinable with reasonable accuracy. (6j) Expenses are deductible for the taxable year in which the liability for payment becomes definite and the amounts payable become reasonably certain but only to the extent that economic performance with respect to the item has occurred. (7j)

For the revised comprehensive procedures by which taxpayers may obtain automatic consent to change their method of accounting, see Rev. Proc. 2002-9. (8j) The Service has proposed changes to the process for obtaining consent to change a method of accounting. (9j)

The Tax Court held that a contract for a deed resulted in a completed sale of real property for tax purposes in the year that the contract was executed; therefore, income attributable to that disposition was required to be recognized and reported in the taxable year in which the contract was executed. (10j) Controlling shareholders of a privately held company that sold derivative instruments through flow-through entities were required to recognize their pro rata share of the gain in the year that the shares were sold. (11j) An investor who experienced losses on foreign currency contracts that required repayment on a future maturity date, but who was unable to post adequate collateral in the year the losses were sustained, was entitled to deduct the losses in the year in which the debt was repaid. (1k) Under the constructive receipt doctrine, the mere right of an employee to make an election to cash out future vacation leave under the employer's plan would not result in taxable income for the employee under the cash method of accounting if the employee chose not to make such an election. (2k)

7510. What are the tax consequences of a discharge of indebtedness?

General

Gross income generally includes income from discharge of indebtedness. (3k) However, debt discharge is excluded from gross income if the discharge: (1) occurs in a Title 11 bankruptcy case; (2) occurs when the taxpayer is insolvent; (3) the indebtedness discharged is "qualified farm indebtedness"; (4k) (4) in the case of a taxpayer other than a C corporation, the indebtedness discharged is "qualified real property business indebtedness"; or (5) the indebtedness discharged is "qualified principal residence indebtedness" (see "Mortgage Forgiveness Debt Relief Act of 2007," below) that is discharged before January 1, 2013. (5k)

The Treasury regulations reiterate that the discharge of indebtedness, in whole or in part, generally results in the realization of income. For example, if an individual performs services for a creditor, who in consideration thereof cancels the debt, the debtor realizes income in the amount of the debt as compensation for his services. A taxpayer may realize income by the payment or purchase of his obligations at less than face value. In general, if a shareholder in a corporation that is indebted to him gratuitously forgives the debt, the transaction amounts to a contribution to the capital of the corporation to the extent of the principal of the debt. (6k)

Mortgage Forgiveness Debt Relief Act of 2007 (MFDRA 2007)

As stated above, qualified principal residence indebtedness discharged before January 1, 2013 is excludable from gross income under MFDRA 2007. (7k) The principal residence debt exclusion (under IRC Section 108(a)(1)(E)) takes precedence over the insolvency exclusion (under IRC Section 108(a)(1)(B)) unless the taxpayer elects to apply the insolvency exclusion in lieu of the principal residence debt exclusion. (8g) The principal residence debt exclusion applies to discharges of indebtedness on or after January 1, 2007. (9k)

Basis reduction. The amount excluded from gross income by reason of the exclusion for qualified principal residence indebtedness must be applied to reduce (but not below zero) the basis of the principal residence of the taxpayer. (10k)

Qualified principal residence indebtedness. For purposes of this exclusion, "qualified principal residence indebtedness" means "acquisition indebtedness" (within the meaning of IRC Section 163(h)(3)(B)--see Q 7924), with respect to the principal residence of the taxpayer, except that the amount of excludable indebtedness is limited to $2,000,000 (i.e., instead of $1,000,000). (1l)

Exception for certain discharges not related to the taxpayer's financial condition. The principal residence debt exclusion does not apply to the discharge of a loan if the discharge is on account of services performed for the lender or any other factor not directly related to a decline in the value of the residence or to the financial condition of the taxpayer. (2l)

Ordering rule. If any loan is discharged, in whole or in part, and only a portion of that loan is qualified principal residence indebtedness, the exclusion will apply only to so much of the amount discharged as exceeds the amount of the loan (as determined immediately before such discharge) that is not qualified principal residence indebtedness. (3l)

Principal residence. For purposes of this exclusion, the term "principal residence" has the same meaning as when used in IRC Section 121. (4l) See Q 7832.

7511. What are the income tax consequences of below-market loans?

Editor's Note: The Sarbanes-Oxley Act of 2002 (P.L. 107-204) adopted new securities law provisions intended to deter and punish corporate and accounting fraud and corruption, ensure justice for wrongdoers, and protect the interests of workers and shareholders of publicly-traded corporations. However, it would appear that one provision of the Act indirectly impacts below-market loans made to executives of publicly-traded corporations. See "Securities law restrictions on personal loans," below.

Generally, a below-market loan is any demand loan with an interest rate that is below the applicable federal rate (see below) or any term loan in which the amount received by the borrower exceeds the present value of all payments due under the loan. A demand loan is any loan that is payable in full at any time on the demand of the lender, or that has an indefinite maturity. All other loans are generally term loans. (5l) The IRC essentially recharacterizes a below-market loan as two transactions: (1) an arm's-length loan requiring payment of interest at the applicable federal rate, and (2) a transfer of funds by the lender to the borrower ("imputed transfer"). (6l)

Gift Loans

A below-market demand or term loan is a gift loan if the foregoing of interest is in the nature of a gift. (7l) The lender is deemed to have transferred to the borrower and the borrower is deemed to have transferred to the lender an amount equal to the forgone interest. (8l) "Forgone interest" is the excess of the amount of interest that would have been payable if it accrued at the applicable federal rate and was payable on the last day of the calendar year over any interest

actually payable on the loan during such period. (1m) In the case of below-market gift loans between natural persons, the transfer is treated, for both the borrower and the lender, as occurring on the last day of the borrower's taxable year. (2m) The amount of forgone interest is included in the gross income of the lender; deductibility by the borrower depends on how the interest is classified for tax purposes (i.e., personal, passive, etc.--see Q 7922).

These rules do not apply to any below-market gift loan between individuals on any day the aggregate outstanding amount of all loans made directly between them (husband and wife are treated as one person) does not exceed $10,000; however, this de minimis exception will not apply to any gift loan directly attributable to the purchase or carrying of income-producing assets. (3m) In addition, a special rule limits the amount of income included in the lender's gross income to the borrower's net investment income for the year if: (1) the aggregate outstanding amount of all loans made directly between individuals does not exceed $100,000; (2) the lender has a signed statement from the borrower, stating the amount of borrower's net investment income properly allocable to the loan; (3) the time or amount of investment income cannot be manipulated by the borrower, and (4) tax avoidance is not one of the principal purposes of the interest arrangements. (4m) Net investment income equals the excess of investment income over investment expenses, plus any amount that would be includable as interest on all deferred payment obligations were the original issue discount rules to apply. Deferred payment obligations include annuities, U.S. savings bonds and short-term obligations. Net investment income will be treated as zero in any year it does not exceed $1,000. (5m)

For the gift tax consequences of below-market gift loans, see Q 7584.

Compensation-Related Loans and Corporation-Shareholder Loans

In the case of demand loans that are compensation-related (e.g., employer to employee, between an independent contractor and the individual for whom the services are provided and, under proposed regulations, between a partnership and a partner in certain circumstances) or corporation-shareholder loans, the same transfer and retransfer of forgone interest is deemed to have occurred as explained in gift loans, above. (6m) The lender in a compensation-related loan will have interest income to the extent of the forgone interest and a corresponding deduction for compensation paid (if reasonable). The borrower will have compensation income, but a deduction for the forgone interest will be subject to the limitations on interest deductions (see Q 7922). The same consequences result in corporation-shareholder loans except that the forgone interest is treated as a dividend; therefore, there is no deduction available to the lender-corporation.

In the case of below-market term loans that are compensation-related or corporation-shareholder loans, the lender is deemed to have transferred to the borrower and the borrower is deemed to have received a cash payment equal to the excess of the amount loaned over the present value (determined as of the date of the loan, using a discount rate equal to the applicable federal rate) of all payments required to be made under the terms of the loan. (7m) The excess is treated as original issue discount and, generally, treated as transferred on the day the loan was made. The lender can deduct the amount treated as original issue discount as compensation in compensation-related loans and will include such amount as interest income as it accrues over the term of the loan. The borrower will have includable compensation on the day the loan is made, but deductions (if allowed--see Q 7922) for the "imputed" interest can be taken only as such interest accrues over the loan period. With regard to corporation-shareholder loans, the same results occur except that the amount treated as original issue discount is considered a dividend, and there is no deduction available to the lender-corporation.

Compensation-related loans and corporation-shareholder loans, whether demand or term, are not subject to either of the above rules on any day the aggregate outstanding amount of all loans between the parties does not exceed $10,000 and tax avoidance is not one of the principal purposes of the interest arrangements. (1n) With respect to term loans that are not gift loans, once the aggregate outstanding amount exceeds $10,000, this de minimis exception no longer applies, even if the outstanding balance is later reduced below $10,000. (2n)

In a case of first impression involving below-market loans made to noncontrolling shareholders, the Tax Court held that the below-market loan rules may apply to a loan to a majority or a minority shareholder. The court also held that direct and indirect loans are subject to these rules. (3n)

Securities law restrictions on personal loans. Section 402 of the Sarbanes-Oxley Act of 2002 (P.L. 107-204) amended Section 13 of the Securities and Exchange Act of 1934 (15 USC 78m) to prohibit "issuers" (i.e., publicly-traded companies) from directly or indirectly (1) extending or maintaining credit, or (2) arranging for the extension of credit, or renewing an extension of credit, in the form of a personal loan to or for any director or executive officer (or equivalent) of that issuer. The narrow exceptions to this rule are loans made for the following purposes: home improvement; consumer credit; any extension of credit under an open-end credit plan; a charge card; or any extension of credit by a broker or dealer to buy, trade, or carry securities. To fall within the exception, the loan must also be (1) made or provided in the ordinary course of business of the company, (2) of a type that is generally made available by the company to the public, and (3) made on market terms, or terms that are no more favorable than those offered by the issuer to the general public for such extensions of credit.

Thus, it would appear that a below-market loan made by a publicly-traded company to a director or executive officer for a purpose other than those outlined in the exceptions would be prohibited under the new securities law. Extensions of credit maintained by a company on July 30, 2002 are not subject to the prohibition so long as no material modification is made to any term of the loan and the loan is not renewed on or after that date.

Other Loans

In addition to the loans discussed above, below-market loans in which one of the principal purposes is tax avoidance or, to the extent provided for in regulations, in which the interest arrangements have a significant effect on the federal tax liability of either party, will also be subject to the above rules. (1o) The Service has determined that the interest arrangements of certain loans will not be considered as having a significant effect on the federal tax liability of either party--tax exempt obligations, obligations of the U.S. government, life insurance policy loans, etc.--and, unless one of the principal purposes is tax avoidance, such transactions will not be subject to the below-market loan rules. (2o)

Applicable Federal Rate

The applicable federal rate (see Q 7513) for demand loans is the short-term rate in effect during the period for which the forgone interest is being determined, compounded semiannually. (3o) In the case of a below-market loan of a fixed principal amount that remains outstanding for the entire calendar year, forgone interest is equal to the excess of the "blended annual rate" for that calendar year multiplied by the outstanding principal over any interest payable on the loan properly allocable to the calendar year. The blended annual rate is published annually with the AFRs for the month of July. (4o) The blended annual rate for the calendar year 2009 was 0.82%. (5o)

For term loans, the applicable federal rate is the corresponding federal rate (i.e., short-, mid-, or long-term) in effect on the day the loan was made, compounded semiannually. (6o)

The applicable federal rates are determined by the Secretary on a monthly basis. (7o) The Secretary may by regulation permit a rate that is lower than the applicable federal rate to be used under certain circumstances. (8o)

Reporting Requirements

In any taxable year in which the lender or the borrower either has imputed income or claims a deduction for an amount imputed under IRC Section 7872, he must, (1) attach a statement to his income tax return explaining that it relates to the amount includable in income or deductible by reason of the below-market loan rules; (2) provide the name, address and taxpayer identification number of the other party; and (3) specify the amount includable or deductible and the mathematical assumptions and method used in computing the amounts imputed. (9o)

7512. What is an installment sale? How is it taxed?

Editor's Note: JGTRRA 2003 reduced capital gain rates for sales or exchanges occurring on or after May 6, 2003 and before January 1, 2011. (10k) For the tax treatment of installment payments, see Q 7524.

An installment sale is a disposition of property (other than marketable securities, certain real property, and "inventory") where at least one payment is to be received by the seller after the close of the taxable year in which the disposition occurs. (1p) It is not necessary that there be more than one payment.

Unless the taxpayer elects out on or before the due date, including extensions, for filing his federal income tax return for the taxable year in which the disposition occurred, any gain must be reported under this method. (2p) An election out is made by reporting all of the gain on the transaction in the year of the sale. A decision by the taxpayer not to elect out is generally irrevocable unless the IRS finds that the taxpayer had good cause for failure to make a timely election. (3p) Good cause will not be found if the purpose of a late election out is tax avoidance. (4p) However, where a taxpayer intended to use the installment method but failed to do so through his accountant's error, the IRS permitted the taxpayer to revoke his election out of the installment method. (5l) Similarly, the IRS has granted permission to revoke an election out where the election was not the result of a conscious choice by the taxpayer. (6p) But see Krause v. Comm. (7p) (holding that an election out will not be revoked when one of the purposes for the revocation is the avoidance of federal income taxes).

Loss cannot be reported on the installment method. (8p) Dealers generally are not permitted to use the installment method (with exceptions for farm property and certain timeshares and residential lots). (9p) See Q 7638 for the treatment of gain from the sale of publicly traded stock.

Under the installment method, the total payment is divided into (a) return of the seller's investment, (b) profit, and (c) interest income. Generally, where the sale price is over $3,000 and any payment is deferred more than one year, interest must be charged on payments due more than six months after the sale at least at 100% of the "applicable federal rate," compounded semiannually, or it will be imputed at that rate. (10p) However, the following are exceptions to this general rule: (1) if less than 100% of the AFR, a rate of no greater than 9%, compounded semiannually, will be imputed in the case of sales of property (other than new IRC Section 38 property) if the stated principal amount of the debt instrument does not exceed $5,115,100 in 2010; (11p) (2) if less than 100% of the AFR, a rate of no greater than 6%, compounded semiannually, is imputed on aggregate sales of land during a calendar year between an individual and a member of his family (i.e., brothers, sisters, spouse, ancestors, and lineal descendants) to the extent the aggregate sales do not exceed $500,000 (the general rule of 100% of the AFR, compounded semiannually, applies to the excess); (12p) and (3) a rate of 110% of the AFR, compounded semiannually, applies to sales or exchanges of property if, pursuant to a plan, the transferor or any related person leases a portion of the property after the sale or exchange ("sale-leaseback" transactions). (13p)

The applicable federal rate (see Q 7513) will be the lowest of the AFRs in effect for any month in the 3-month period ending with the first calendar month in which there is a binding contract in writing. (1q)

All interest received by the taxpayer is ordinary income. (2q) In some cases, depending on the property and amount involved, the interest (or imputed interest) to be paid over the period of the loan must be reported as "original issue discount" that accrues in daily portions; in other cases the interest is allocated among the payments and that much of each payment is treated as interest includable and deductible according to the accounting method of the buyer and seller.

Once interest is segregated, any depreciation is recaptured and recognized as ordinary income in the year of sale to the extent of gain on the sale. (3q) In the case of an installment sale of IRC Section 1250 property (i.e., generally, most real estate subject to the allowance for depreciation under IRC Section 167, (4q) regulations state that unrecaptured IRC Section 1250 gain (which is generally taxed at a maximum marginal rate of 25%--see Q 7524) must be taken into account before any adjusted net capital gain (taxed at a maximum of 15%/0%--see Q 7524). (5q) This means that the allocation of unrecaptured IRC Section 1250 gain is front-loaded, not prorated over the life of the installment transaction.

For installment sales of IRC Section 1250 property occurring before May 7, 1997, the amount of unrecaptured IRC Section 1250 gain that is taken into account on payments received after May 6, 1997 under the regulations is determined as follows: amounts received after the sale date but before May 7, 1997 are treated as if unrecaptured IRC Section 1250 gain on payments received before May 7, 1997 had been taken into account before adjusted net capital gain. (6q) In other words, the taxpayer is permitted to treat payments after May 6, 1997 as though the regulations had already been applied to earlier payments. Also, if the amount of unrecaptured IRC Section 1250 gain on payments received after May 6, 1997 and before August 24, 1999 would have been less under the Internal Revenue Code than the amount as determined under the regulations, the lesser amount may be used to determine the amount of unrecaptured IRC Section 1250 gain that remains to be taken into account. (7q)

Once depreciation has been recaptured, any adjusted net capital gain (see Q 7524) is allocated to each payment by determining a profit percentage (ratio of total profit to be realized to total selling price, exclusive of interest and any recaptured depreciation) that is applied to the noninterest portion of each installment. (8q) Thus, if the selling price (the principal amount or imputed principal amount) was $10,000 and the total profit to be realized after depreciation has been recaptured is $2,000, 20% ($2,000/$10,000) of each dollar collected (after segregating interest) is gain that must be reported as income for that taxable year. Whether the gain is adjusted net capital gain or ordinary income is determined by the type of asset sold and the length of the holding period.

In determining the ratio, selling price may have to be adjusted for outstanding indebtedness on the property. (9q)

Sales Between Related Parties

There are strict rules governing installment reporting of sales between "related" parties. Except as noted below, "related" persons include the following: (1) members of the same family (i.e., brothers, sisters, spouses, ancestors and lineal descendants); (2) an individual and a corporation of which the individual actually or constructively owns more than 50% of the stock; (3) a grantor and a fiduciary of a trust; (4) fiduciaries of two trusts if the same person is the grantor of both; (5) a fiduciary and a beneficiary of the same trust; (6) a fiduciary of a trust and a beneficiary of another trust set up by the same grantor; (7) a fiduciary of a trust and a corporation of which the grantor of the trust actually or constructively owns more than 50% of the stock; (8) a person and an IRC Section 501 tax-exempt organization controlled by the person or members of his family (as described in (1) above); (9) a corporation and a partnership if the same person actually or constructively owns more than 50% of the stock of the corporation, and has more than a 50% interest in the partnership; (10) two S corporations if the same persons actually or constructively own more than 50% of the stock of each; (11) an S corporation and a C corporation, if the same persons actually or constructively own more than 50% of the stock of each; or (12) generally, an executor and a beneficiary of an estate. (1r)

For purposes of determining the ownership of stock, an individual is considered to own stock owned by family members (brothers and sisters, spouse, ancestors and lineal descendants), and stock owned by a corporation, partnership, estate, or trust in proportion to the interest in the entity owned by the individual or a family member, or a partner owning stock in the same corporation in which the individual owns stock. (2r) A different definition of "related" generally applies to sales made before October 24, 1986. A different definition of "related" also applies in the case of sales of depreciable property, as explained below. (3r)

If a related purchaser disposes of the property before the related seller has received the entire selling price, a special "second disposition" rule applies. This rule provides that the amount realized on the second disposition, (to the extent it exceeds payments already received by the related seller) will be treated as though it had been received by the related seller on the date of the second disposition. However, this rule generally does not apply if: the second disposition occurs more than two years after the first disposition; the second disposition is an involuntary conversion, the threat of which did not exist at the time of the first disposition; the second disposition occurs after the death of either of the related parties; or neither disposition had as one of its principal purposes the avoidance of income tax. (4r) If an installment sale between related parties is canceled or payment is forgiven, the seller must recognize gain in an amount equal to the difference between the fair market value of the obligation on the date of cancellation (but in no event less than the face amount of the obligation) and the seller's basis in the obligation. (5r) The Service ruled that no disposition occurred on the substitution of new installment notes, without any other changes, because there was no evidence that the rights accruing to the sellers under the installment sale had either disappeared or been materially altered. (6r)

A sale of depreciable property between related parties may not be reported on the installment method, unless it is shown that avoidance of income tax was not a principal purpose. For purposes of this rule only, "related persons" refers generally to controlled business entities, not natural persons related by family. (1s)

Interest Surcharge

Generally, an interest surcharge is applied to installment obligations in which deferred payments for sales during the taxable year exceed $5,000,000. Exceptions to this rule are provided for: (1) property used or produced in the trade or business of farming, (2) timeshares and residential lots, and (3) personal use property. (2s)

The amount of the interest surcharge is determined by multiplying the "applicable percentage" of the deferred tax liability by the underpayment rate in effect at the end of the taxable year. The "applicable percentage" is determined by dividing the portion of the aggregate obligations for the year that exceeds $5,000,000 by the aggregate face amount of such obligations that are outstanding at the end of the taxable year. If an obligation remains outstanding in subsequent taxable years, interest must be paid using the same percentage rate as in the year of the sale. (3s) In addition, if the installment obligation is pledged as security for a loan, the net proceeds of the loan will be treated as a payment received on the installment obligation (up to the total contract price); however, no additional gain is recognized on subsequent payments of such amounts already treated as received. The date of such constructive payment will be (a) the date the proceeds are received or (b) the date the indebtedness is secured, whichever is later. (4s)

Planning Point: This interest surcharge on installment sales with deferred payments can be minimized in some cases by splitting the sale between a husband and wife, and in two taxable years. For example, a $20 million business owned by a couple could be split into two $10 million sales, and the transaction could be completed in two stages: $5 million per spouse in December, followed by $5 million per spouse in January. Structured this way, the sale would not trigger the interest surcharge. Robert S. Keebler, CPA, MST, Virchow, Krause & Company, LLP, Green Bay, Wisconsin.

7513. What is the applicable federal rate?

The applicable federal rate (AFR) is used in determining the amount of interest in the case of certain below market loans for both income and gift tax purposes (see Q 7511, Q 7584), in imputing interest on debt instruments given on the sale or exchange of property (see Q 7829, Q 7512), and for determining interest and present values in connection with deferred payments for the use of property or services (see Q 7823).

The applicable federal rates are determined by the Secretary on a monthly basis (and published in a revenue ruling). The rates--short-term, mid-term and long-term--are based on the average market yield on the outstanding marketable obligations of the United States with maturity periods of three years or less, more than three but not more than nine years, and over nine years. (1t) The AFRs can be found at: www.taxfactsonline.com.

In the case of any sale or exchange, the applicable federal rate will be the lowest 3-month rate. The lowest 3-month rate is the lowest of the AFRs in effect for any month in the 3-month period ending with the first calendar month in which there is a binding contract in writing. (2t)

The Secretary may by regulation permit a rate that is lower than the applicable federal rate to be used under certain circumstances. (3t)

To determine the appropriate AFR to apply in the case of below-market loans, see Q 7511 and Q 7584. To determine the appropriate AFR in the case of deferred rent, see Q 7823.

7514. Are Social Security and railroad retirement benefits taxable?

If a taxpayer's modified adjusted gross income plus one-half of the Social Security benefits (including tier I railroad retirement benefits) received during the taxable year exceeds certain base amounts, then a portion of the benefits received must be included in gross income and taxed as ordinary income. "Modified adjusted gross income" is a taxpayer's adjusted gross income (disregarding the foreign income, savings bond, adoption assistance program exclusions, the deductions for education loan interest and for qualified tuition and related expenses) plus any tax-exempt interest income received or accrued during the taxable year. (4t)

A taxpayer whose modified adjusted gross income plus one-half of his Social Security benefits exceed a base amount is required to include in gross income the lesser of (a) 50% of the excess of such combined income over the base amount, or (b) 50% of the Social Security benefits received during the taxable year. (5t) The "base amount" is $32,000 for married taxpayers filing jointly, $25,000 for unmarried taxpayers, and zero ($0) for married taxpayers filing separately who have not lived apart for the entire taxable year. (6t)

In a case of first impression, the Tax Court held that for purposes of IRC Section 86(c)(1)(C)(ii), the term "live apart" means living in separate residences. Thus, where the taxpayer lived in the same residence as his spouse for at least 30 days during the tax year in question (even though maintaining separate bedrooms), the Tax Court ruled that he did not "live apart" from his spouse at all times during the year; therefore, the taxpayer's base amount was zero. (7t)

In addition to the initial tier of taxation as discussed above, a percentage of Social Security benefits that exceed an adjusted base amount will be includable in a taxpayer's gross income. The "adjusted base amount" is $44,000 for married taxpayers filing jointly, $34,000 for unmarried taxpayers, and zero ($0) for married individuals filing separately who did not live apart for the entire taxable year. (8t)

If a taxpayer's modified adjusted gross income plus one-half of his Social Security benefits exceed the adjusted base amount, his gross income will include the lesser of (a) 85% of the Social Security benefits received during the year, or (b) the sum of--(i) 85% of the excess over the adjusted base amount, plus (ii) the smaller of--(A) the amount that is includable under the initial tier of taxation (see above), or (B) $4,500 (single taxpayers) or $6,000 (married taxpayers filing jointly). (1u)

Example 1. A married couple files a joint return. During the taxable year, they received $12,000 in Social Security benefits and had a modified adjusted gross income of $35,000 ($28,000 plus $7,000 of tax-exempt interest income). Their modified adjusted gross income plus one-half of their Social Security benefits [$35,000 + (1/2 of $12,000) = $41,000] is greater than the applicable base amount of $32,000 but less than the applicable adjusted base amount of $44,000; therefore, $4,500 [the lesser of one-half of their benefits ($6,000) or one-half of the excess of $41,000 over the base amount (1/2 x ($41,000-$32,000), or $4,500)] is included in gross income.

Example 2. During the taxable year, a single individual had a modified adjusted gross income of $33,000 and received $8,000 in Social Security benefits. His modified adjusted gross income plus one-half of his Social Security benefits [$33,000 + (V2 of $8,000) = $37,000] is greater than the applicable adjusted base amount of $34,000. Thus, $6,550 [the lesser of 85% of his benefits ($6,800), or 85% of the excess of $37,000 over the adjusted base amount (85% x ($37,000 - $34,000), or $2,550) plus the lesser of $4,000 (the amount includable under the initial tier of taxation) or $4,500] is included in gross income.

An election is available that permits a taxpayer to treat a lump sum payment of benefits as received in the year to which the benefits are attributable. (2u)

Any workers' compensation pay that reduced the amount of Social Security received and any amounts withheld to pay Medicare insurance premiums are included in the figure for Social Security benefits. (3u) In Green v. Comm., (4u) the taxpayer argued that his Social Security disability benefits were excludable from gross income (5u) because they had been paid in lieu of workmens' compensation. The Tax Court determined, however, that Title II of the Social Security Act is not in the nature of a workmens' compensation act. Instead, the Act allows for disability payments to individuals regardless of employment. Consequently, the taxpayer's Social Security disability benefits were includable in gross income.

In a case of first impression, the Tax Court held that a taxpayer's Social Security disability insurance benefits (payable as a result of the taxpayer's disability due to lung cancer that resulted from exposure to Agent Orange during his Vietnam combat service) were includable in gross income under IRC Section 86 and were not excludable under IRC Section 104(a)(4). The court reasoned that Social Security disability insurance benefits do not take into consideration the nature or cause of the individual's disability. Furthermore, the Social Security Act does not consider whether the disability arose from service in the Armed Forces or was attributable to combat-related injuries. Eligibility for purposes of Social Security disability benefits is determined on the basis of the individual's prior work record, not on the cause of his disability. Moreover, the amount of Social Security disability payments is computed under a formula that does not consider the nature or extent of the injury. Consequently, because the taxpayer's Social Security disability insurance benefits were not paid for personal injury or sickness in military service within the meaning of IRC Section 104(a)(4), the benefits were not eligible for exclusion under IRC Section 104(a)(4). (1v)

Tax-exempt interest is included in the calculation made to determine whether Social Security payments are includable in gross income. (2v) It has been determined that although this provision may result in indirect taxation of tax-exempt interest, it is not unconstitutional. (3v)

Railroad retirement benefits (other than tier I benefits) are taxed like benefits received under a qualified pension or profit sharing plan. For this purpose, the tier II portion of the taxes imposed on employees and employee representatives is treated as an employee contribution, while the tier II portion of the taxes imposed on employers is treated as an employer contribution. (4v) Legislation enacted in 2001 provides increased benefits for surviving spouses and adjustments to the tier II tax rates. (5v)

7515. How is unearned income of certain children treated for federal income tax purposes?

Property Given Under the Uniform Gifts to Minors Act Or The Uniform Transfers To Minors Act

Taxable income derived from custodial property is, ordinarily, taxed to the minor donee. To the extent that the custodian uses custodial income to discharge the legal obligation of any person to support or maintain the minor, such income is taxable to that person. (6v) For this purpose, it makes no difference who is the custodian or who is the donor. State laws differ as to what constitutes a parent's obligation to support. A person who may be claimed as a dependent by another may use a standard deduction of $950 in 2010 to offset unearned income (or, if higher, the dependent may take a standard deduction in the amount of the sum of $300 and his earned income, up to a total of $5,700 in 2010, as indexed for inflation--see Q 7538). Dependents for whom another taxpayer is allowed a personal exemption cannot take a personal exemption for themselves (see Q 7529). For the treatment of unearned income for children, see below.

Unearned Income of Certain Children

Under certain circumstances, children under the age of 19 (age 24 for students) must pay tax on their unearned income above a certain amount at their parents' marginal rate. (See Q 7539 for the tax rates in 2010.) The tax applies to all unearned income, regardless of when the assets producing the income were transferred to the child.

The so-called "kiddie tax" applies to children who have not attained certain ages before the close of the taxable year, who have at least one parent alive at the close of the taxable year, and who have over $1,900 (in 2010) of unearned income.

The kiddie tax applies to:

(1) a child under age 18; or

(2) a child who has attained the age of 18 if: (a) the child has not attained the age of 19 (24 in the case of a full-time student) before the close of the taxable year; and (b) the earned income of the child does not exceed one-half of the amount of the child's support for the year. (1w)

The tax applies only to "net unearned income." "Net unearned income" is defined as adjusted gross income that is not attributable to earned income, and that exceeds (1) the $950 standard deduction for a dependent child in 2010, plus (2) the greater of $950 or (if the child itemizes) the amount of allowable itemized deductions that are directly connected with the production of his unearned income. (2w)

"Earned income," essentially, means all compensation for personal services actually rendered. (3w) A child is therefore taxed at his own rate on reasonable compensation for services.

Regulations specify that "unearned income" includes any Social Security or pension payments received by the child, income resulting from a gift under the Uniform Gift to Minors Act, and interest on both earned and unearned income. (4w) In the case of a trust, distributable net income that is includable in the child's net income can trigger the tax; however, most accumulation distributions received by a child from a trust will not be included in the child's gross income because of the minority exception under IRC Section 665(b). (5w) Generally, the tax on accumulation distributions does not apply to domestic trusts (see Q 7557). The source of the assets that produce unearned income need not be the child's parents. (6w) The application of the "kiddie tax" to funds provided to a child by sources other than the child's parents was held constitutional. (7w)

Example: Cole is a child who is 17 years of age at the end of the taxable year beginning on January 1, 2010. Both of Cole's parents are alive at the end of the taxable year. During 2010, Cole receives $2,400 in interest from his bank account and $1,700 from a paper route. Some of the interest earned by Cole from the bank account is attributable to Cole's paper route earnings that were deposited in the account. The balance of the account is attributable to cash gifts from Cole's parents and grandparents and interest earned prior to 2010. Some cash gifts were received by Cole prior to 2010. Cole has no itemized deductions and is eligible to be claimed as a dependent on his parent's return. Therefore, for the taxable year 2010, Cole's standard deduction is $2,000, the amount of Cole's earned income, plus $300. Of this standard deduction amount, $950 is allocated against unearned income, and $1,050 is allocated against earned income. Cole's taxable unearned income is $1,450, of which $950 is taxed without regard to section 1(s). The remaining taxable unearned income of $500 is net unearned income and is taxed under section 1(s).The fact that some of Cole's unearned income is attributable to interest on principal created by earned income and gifts from persons other than Cole's parents or that some of the unearned income is attributable to property transferred to Cole prior to 2010 will not affect the tax treatment of this income under section 1(s).

The parent whose taxable income is taken into account is (a) in the case of parents who are not married, the custodial parent of the child (determined by using the support test for the dependency exemption) and (b) in the case of married individuals filing separately, the individual with the greater taxable income. (1x) If the custodial parent files a joint return with a spouse who is not a parent of the child, the total joint income is applicable in determining the child's rate. "Child," for purposes of the kiddie tax, includes children who are adopted, related by the half-blood, or from a prior marriage of either spouse. (2x)

If there is an adjustment to the parent's tax, the child's resulting liability must also be recomputed. In the event of an underpayment, interest, but not penalties, will be assessed against the child. (3x)

In the event that a child does not have access to needed information contained in the tax return of a parent, he (or his legal representative) may, by written request to the IRS, obtain such information from the parent's tax return as is needed to file an accurate return. (4x) The IRS has stated that where the necessary parental information cannot be obtained before the due date of the child's return, no penalties will be assessed with respect to any reasonable estimate of the parent's taxable income or filing status, or of the net investment income of the siblings. (5x)

Certain parents may elect to include their child's unearned income over $1,900 on their own return, thus avoiding the necessity of the child filing a return. The election is available to parents whose child has gross income of more than $950 and less than $9,500 (in 2010), all of which is from interest and dividends. (6x)

The election will not be available if there has been backup withholding under the child's Social Security number or if estimated tax payments have been made in the name and Social Security number of the child. If the election is made, any gross income of the child in excess of $1,900 in 2010 is included in the parent's gross income for the taxable year. (However, the inclusion of the child's income will increase the parent's adjusted gross income for purposes of certain other calculations, such as the 2% floor on miscellaneous itemized deductions and the limitation on medical expenses.) Any interest that is an item of tax preference of the child (e.g., private activity bonds) will be treated as a tax preference of the parent. For each child to whom the election applies, there is also a tax of 10% of the lesser of $950 or the excess of the gross income of such child over $950. If the election is made, the child will be treated as having no gross income for the year. (7x) The threshold and ceiling amounts for the availability of this election, the amount used in computing the child's alternative minimum tax, and a threshold amount used in computing the amount of tax are indexed for inflation.

For treatment of the unearned income of minor children under the alternative minimum tax, see Q 7548.

7516. What is an Education Savings Account?

Education IRAs were renamed Coverdell Education Savings Accounts (ESAs) in 2001. (1y) An ESA means a trust or custodial account created exclusively for the purpose of paying the "qualified education expenses" of the designated beneficiary of the trust, and that is designated as an ESA at the time it is created. (2y) The designated beneficiary of an ESA must be a life-in-being as of the time the account is established. (3y) ESAs are exempt from taxation (except for unrelated business income tax, if applicable). (4y) Distributions from ESAs for "qualified education expenses" are not includable in income and contributions to ESAs are not deductible. (5y)

Annual contributions may be made up until the due date (excluding extensions) for filing the tax return for the calendar year for which such contributions were intended. (6y)

Contributions must be made in cash and must be made on or before the date on which the beneficiary attains age 18 unless the beneficiary is a special needs beneficiary. A special needs beneficiary is to be defined in Treasury regulations; however, according to the Conference Report, a special needs beneficiary will include an individual who because of a physical, mental, or emotional condition (including learning disabilities) requires additional time to complete his or her education. (7y)

In general, aggregate contributions to an ESA on behalf of a beneficiary (except in the case of rollover contributions) cannot exceed $2,000. (8y) The maximum contribution amount is phased-out for certain high-income contributors. The maximum contribution for single filers is reduced by the amount that bears the same ratio to such maximum amount as the contributor's modified adjusted gross income (MAGI) in excess of $95,000 bears to $15,000. (9u) For joint filers, the maximum contribution is reduced by the amount that bears the same ratio to such maximum amount as the contributor's modified adjusted gross income (MAGI) in excess of $190,000 bears to $30,000. (10y) For this purpose, MAGI is adjusted gross income without regard to the exclusions for income derived from certain foreign sources or sources within United States possessions. (11y) For taxable years beginning after 2001, contributions to an ESA are not limited due to contributions made to a qualified state tuition program in the same year.

Contributions in excess of the maximum annual contribution (as reduced for high-income contributors) that are not returned before the first day of the sixth month of the taxable year following the taxable year in which the contribution was made are subject to the 6% excess contribution excise tax under Code section 4973(a). (12y) Note that any excess contributions from previous taxable years, to the extent not corrected, will continue to be taxed as excess contributions in subsequent taxable years. (13y)

A distribution from an ESA is subject to income tax using the IRC Section 72(b) exclusion ratio for investment in the contract. (1z) However, distributions from an ESA are excludable from income tax if the distributions received during the year are used solely for the "qualified education expenses" of the designated beneficiary. (2z)

Qualified education expenses include both "qualified higher education expenses" and "qualified elementary and secondary education expenses." (3z) Qualified higher education expenses include tuition, fees, costs for books, supplies, and equipment required for the enrollment or attendance of the student at any "eligible educational institution," and amounts contributed to a qualified tuition program. (4z) Room and board (up to a certain amount) is also included if the student is enrolled at least half-time. (5z) An "eligible educational institution" is any college, university, vocational school, or other postsecondary educational institution described in section 481 of the Higher Education Act of 1965. (6z) Thus, virtually all accredited public, nonprofit, and proprietary postsecondary institutions are considered eligible educational institutions. (7z)

Qualified education expenses must be reduced by any scholarships received by the individual, any educational assistance provided to the individual, or any payment for such expenses (other than a gift, devise, bequest, or inheritance) that is excludable from gross income. These expenses must also be reduced by the amount of any such expenses that were taken into account in determining the Hope Scholarship Credit or the Lifetime Learning Credit. (8z) (Note that for taxable years beginning before 2002 these education credits could not be claimed in a taxable year in which distributions from an ESA were excluded from income. (9z))

Qualified elementary and secondary education expenses include tuition, fees, and costs for academic tutoring, special needs services, books, supplies, and other equipment that are incurred in connection with the enrollment or attendance of the designated beneficiary at any public, private, or religious school that provides elementary or secondary education (K through 12) as determined under state law. Also included are expenses for room and board, uniforms, transportation, supplementary items and services (including extended day programs) that are required or provided by such schools, and any computer technology or certain related equipment used by the beneficiary and the beneficiary's family during any of the years the beneficiary is in school. (10z)

If a designated beneficiary receives distributions from both an ESA and a qualified tuition program and the aggregate distributions exceed the "qualified education expenses" of the designated beneficiary, then the expenses must be allocated among such distributions for purposes of determining the amount excludable under each. (11z) Any "qualified education expenses" taken into account for purposes of this exclusion may not be taken into account for purposes of any other deductions, credits, or exclusions. (12z)

Where distributions from the ESA exceed the "qualified education expenses" of the designated beneficiary for the year, the amount includable is determined by: (1) calculating the amount subject to tax under IRC Section 72(b) (without regard to the following proration); (2) multiplying the amount in (1) by the ratio of "qualified education expenses" to total distributions; and (3) subtracting the amount in (2) from the amount in (1). (1aa)

If a distribution from an ESA is includable in the income of the recipient, the amount includable in income will be subject to an additional 10% penalty tax unless the distribution is (1) made after the death of the beneficiary of the ESA, (2) attributable to the disability of such beneficiary (within the meaning of IRC Section 72(m)(7)), (3) made in an amount equal to a scholarship, allowance, or other payment under IRC Section 25A(g)(2), or (4) includable in income because expenses were reduced by the amount claimed as a Hope Scholarship Credit or a Lifetime Learning Credit. (2aa) The penalty tax also does not apply to any distribution of an excess contribution and the earnings thereon if such contribution and earnings are distributed before the first day of the sixth month of the taxable year following the taxable year in which the contribution was made. (3aa) However, the earnings are includable in the contributor's income for the taxable year in which such excess contribution was made.

No part of the assets of the ESA can be used to purchase life insurance. (4aa) Nor can the assets of the ESA be commingled with other property except in a common trust fund or common investment fund. (5aa) If the beneficiary engages in a prohibited transaction, the account loses its status as an ESA and will be treated as distributing all of its assets. If the beneficiary pledges the account as security for a loan, the amount so pledged will be treated as a distribution from the account. (6aa)

An amount may be rolled over from one ESA to another ESA, without being treated as a distribution (and without being subject to taxation) only if the beneficiary of the recipient ESA is the same as the beneficiary of the original ESA, or a member of such beneficiary's family. The new beneficiary must be under age 30 as of the date of such distribution or change, except in the case of a special needs beneficiary. (7aa) The rollover contribution must be made no later than 60 days after the date of the distribution from the original ESA. However, no more than one rollover may be made from an ESA during any 12-month period. (8aa) Similarly, the beneficiary of an ESA may be changed without taxation or penalty if the new beneficiary is a member of the family of the previous ESA beneficiary and has not attained age 30 or is a special needs beneficiary. (9aa) Transfer of an individual's interest in an ESA can be made from one spouse to another pursuant to a divorce (or upon the death of a spouse) without changing the character of the ESA. (10aa) Likewise, non-spouse survivors who acquire an original beneficiary's interest in an ESA upon the death of the beneficiary will be treated as the original beneficiary of the ESA as long as the new beneficiary is a family member of the original beneficiary. (11aa)

Upon the death of the beneficiary of the ESA, any balance to the credit of the beneficiary must be distributed to his estate within 30 days. The balance remaining in an ESA must also be distributed within 30 days after a beneficiary, other than a special needs beneficiary, reaches age 30. (1ab) Any balance remaining in the ESA is deemed distributed within 30 days after such events. (2ab) The earnings on any distribution under this provision are includable in the beneficiary's gross income. (3ab)

Under Section 225 of BAPCPA 2005, funds placed in an "education individual retirement account" (as defined in IRC Section 530(b)(1)) no later than 365 days before the date of the filing of the bankruptcy petition may be excluded from the bankruptcy estate if certain conditions are met. (4ab)

For guidance regarding certain reporting requirements and transition rules applicable to Coverdell ESAs, see Notice 2003-53. (5ab) See Q 7567 for the estate tax treatment and Q 7593 for the gift tax treatment of ESAs.

7517. What is a qualified tuition program?

A qualified tuition program is a program established and maintained by a state (or agency or instrumentality thereof) or by one or more "eligible educational institutions" (see below) that meet certain requirements (see below) and under which a person may buy tuition credits or certificates on behalf of a designated beneficiary (see below) that entitle the beneficiary to a waiver or payment of qualified higher education expenses (see below) of the beneficiary. These plans are often collectively referred to as "529 plans." In the case of a state-sponsored qualified tuition program, a person may make contributions to an account established to fund the qualified higher education expenses of a designated beneficiary. (6ab) Qualified tuition programs sponsored by "eligible educational institutions" (i.e., private colleges and universities) are not permitted to offer savings plans; these institutions may sponsor only pre-paid tuition programs. (7ab)

To be treated as a qualified tuition program, a state program or privately sponsored program must:

(1) mandate that contributions and purchases be made in cash only;

(2) maintain a separate accounting for each designated beneficiary;

(3) provide that no designated beneficiary or contributor may directly or indirectly direct the investment of contributions or earnings (but see below);

(4) not allow any interest in the program or portion thereof to be used as security for a loan; and

(5) provide adequate safeguards (see below) to prevent contributions on behalf of a designated beneficiary in excess of those necessary to provide for the beneficiary's qualified higher education expenses. (8ab)

(The former requirement that a qualified state tuition program impose a "more than de minimis penalty" on any refund of earnings not used for certain purposes has been repealed. (1ac) See "Penalties," in Q 7518.)

With respect to item (3), above, the IRS announced a special rule stating that state-sponsored qualified tuition savings plans may permit parents to change the investment strategy (1) once each calendar year, and (2) whenever the beneficiary designation is changed. According to the IRS, final regulations are expected to provide that in order to qualify under this special rule, the state-sponsored qualified tuition program savings plan must: (1) allow participants to select among only broad-based investment strategies designed exclusively by the program; and (2) establish procedures and maintain appropriate records to prevent a change in investment options from occurring more frequently than once per calendar year, or upon a change in the designated beneficiary of the account. According to the IRS, qualified tuition programs and their participants may rely on the 2001 guidance pending the issuance of final regulations under IRC Section 529. (2ac)

A program established and maintained by one or more "eligible educational institutions" must satisfy two requirements to be treated as a qualified tuition program: (1) the program must have received a ruling or determination that it meets the applicable requirements for a qualified tuition program; and (2) the program must provide that assets are held in a "qualified trust." (3ac) "Eligible educational institution" means an accredited post-secondary college or university that offers credit towards a bachelor's degree, associate's degree, graduate-level degree, professional degree, or other recognized post-secondary credential and that is eligible to participate in federal student financial aid programs. (4ac) For these purposes, qualified trust is defined as a domestic trust for the exclusive benefit of designated beneficiaries that meets the requirements set forth in the IRA rules, (i.e., a trust maintained by a bank, or other person who demonstrates that it will administer the trust in accordance with the requirements, and where the trust assets will not be commingled with other property, except in a common trust fund or common investment fund). (5ac)

The term qualified higher education expenses means (1) tuition, fees, books, supplies, and equipment required for a designated beneficiary's enrollment or attendance at an eligible educational institution (including certain vocational schools), and (2) expenses for special needs services incurred in connection with enrollment or attendance of a special needs beneficiary. (6ac) Qualified higher education expenses also include reasonable costs for room and board, within limits. Generally, they may not exceed: (1) the allowance for room and board that was included in the cost of attendance in effect on the date that EGTRRA 2001 was enacted as determined by the school for a particular academic period, or if greater (2) the actual invoice amount the student residing in housing owned and operated by the private college or university is charged by such institution for room and board costs for a particular academic period. (7ac) For 2009 and 2010, AARA 2009 expands qualified higher education expenses to include certain expenses for computer technology while the beneficiary is enrolled at an eligible educational institution.

A safe harbor provides the definition of what constitutes adequate safeguards to prevent contributions in excess of those necessary to meet the beneficiary's qualified higher education expenses. The safe harbor is satisfied if all contributions to the account are prohibited once the account balance reaches a specified limit that is applicable to all accounts of beneficiaries with the same expected year of enrollment. (1ad) The total of all contributions may not exceed the amount established by actuarial estimates as necessary to pay tuition, required fees, and room and board expenses of the beneficiary for five years of undergraduate enrollment at the highest cost institution allowed by the program. (2ad)

Coordination rules. A taxpayer may claim a Hope Scholarship or Lifetime Learning Credit and exclude distributions from a qualified tuition program on behalf of the same student in the same taxable year if the distribution is not used to pay the same educational expenses for which the credit was claimed. (3ad) See Q 7546. An individual is required to reduce his total qualified higher education expenses by certain scholarships and by the amount of expenses taken into account in determining the Hope or Lifetime Learning credit allowable to the taxpayer (or any other person). (4ad)

A contribution to a qualified tuition program can be made in the same taxable year as a contribution to a Coverdell Education Savings Account for the benefit of the same designated beneficiary without incurring an excise tax. (See Q 7516.) (5ad) If the aggregate distributions from a qualified tuition program exceed the total amount of qualified higher education expenses taken into account after reduction for the Hope and Lifetime Learning credits, then the expenses must be allocated between the Coverdell Education Savings Account distributions and the qualified tuition program distributions for purposes of determining the amount of the exclusion. (6ad)

The total amount of qualified tuition and related expenses for the deduction for qualified tuition and related expenses is reduced by the amount of such expenses taken into account in determining the exclusion for distributions from qualified tuition programs. For these purposes, the excludable amount under IRC Section 529 does not include that portion of the distribution that represents a return of contributions to the plan. (7ad)

Reporting. Each officer or employee having control over a qualified tuition program must report to the IRS and to designated beneficiaries with respect to contributions, distributions, and other matters that the IRS may require. The reports must be filed and furnished to the above individuals in the time and manner determined by the IRS. (8ad) In 2001, the IRS released guidance regarding certain recordkeeping, reporting, and other requirements applicable to qualified tuition programs in light of the amendments to IRC Section 529 under EGTRRA 2001. (9ad) Qualified tuition programs and their participants may rely on Notice 2001-81 pending the issuance of final regulations under IRC Section 529. (Note that reporting was not required for calendar years before 1999. (10ad))

As a general rule, a qualified tuition program is exempt from federal income tax, except the tax on unrelated business income of charitable organizations imposed by IRC Section 511. (1ae)

Under Section 225 of BAPCPA 2005, funds used to purchase a tuition credit or certificate or contributed to an account under a QTP no later than 365 days before the date of the filing of the bankruptcy petition may be excluded from the bankruptcy estate if certain conditions are met. (2ae)

IRC Section 529 generally took effect for taxable years ending after August 20, 1996; special transitional rules applied for earlier programs. See Q 7518 for the tax treatment of distributions from qualified tuition programs. See Q 7568 for the estate tax treatment and Q 7594 for the gift tax treatment of qualified tuition programs.

Permanent extension of expiring provisions under PPA 2006: The qualified tuition program provisions that were scheduled to expire by reason of the EGTRRA sunset provision included: (1) the provision that makes qualified withdrawals from qualified tuition accounts fully exempt from income tax; (2) the repeal of a pre-EGTRRA requirement that there be more than a de minimis penalty imposed on amounts not used for educational purposes, and the imposition of the 10% additional tax on distributions not used for qualified higher education purposes; (3) the provision permitting certain private educational institutions to establish prepaid tuition programs that qualify under IRC Section 529 if they receive a ruling or determination to that effect from the IRS, and if the assets are held in a trust created or organized for the exclusive benefit of designated beneficiaries; (4) certain provisions permitting rollovers from one account to another account; (5) certain rules regarding the treatment of room and board as qualifying expenses; (6) certain rules regarding coordination with Hope Scholarship and Lifetime Learning Credit provisions; (7) the provision that treats first cousins as members of the family for purposes of the rollover and change in beneficiary rules; and (8) certain provisions regarding the education expenses of special needs beneficiaries. All of the above provisions have been made permanent. (3ae) The Act also provides that the Secretary shall prescribe such regulations as may be necessary or appropriate to prevent abuse of 529 plans. (4ae)

7518. How are distributions from a qualified tuition program taxed?

Distributions from state qualified tuition programs are fully excludable from gross income if the distributions are used to pay "qualified higher education expenses" (see Q 7517) of the designated beneficiary. (5aa) (For the general rule governing nonqualified distributions, see below.) Beginning in 2004, distributions from pre-paid tuition programs sponsored by private colleges and universities are also fully excludable from gross income to the extent those distributions are used to pay qualified higher education expenses of the designated beneficiary. (6ae)

In the case of excess cash distributions, the amount otherwise includable in gross income must be reduced by a proportion that is equal to the ratio of expenses to distributions. (7ae) In-kind distributions are not includable in gross income so long as they provide a benefit to the distributee which, if paid for by the distributee himself, would constitute payment of a qualified higher education expense. (1af)

Nonqualified distributions (i.e., distributions that are not used to pay "qualified higher education expenses") are includable in the gross income of the distributee under the rules of IRC Section 72 to the extent they are not excludable under some other Code provision. (2af) Distributions are treated as representing a pro rata share of the principal (i.e., contributions) and accumulated earnings in the account. (3af) For purposes of applying IRC Section 72, the Code provides that (1) all qualified tuition programs of which an individual is a designated beneficiary must generally be treated as one program, (2) all distributions during a taxable year must be treated as one distribution, and the value of the contract, income on the contract, and (3) investment in the contract must be computed as of the close of the calendar year in which the taxable year begins. (4af)

The IRS announced in 2001 that the final regulations are expected to provide that only those accounts maintained by a qualified tuition program and having the same account owner and the same designated beneficiary must be aggregated for purposes of computing the earnings portion of any distribution. (5af) The IRS also stated that the final regulations are expected to revise the time for determining the earnings portion of any distribution from a qualified tuition account. Specifically, for distributions made after 2002 such programs will be required to determine the earnings portion of each distribution as of the date of the distribution. A different effective date applies to direct transfers between qualified tuition programs. (6af)

Penalties on nonqualified distributions. For taxable years beginning before 2002, a qualified state tuition program was required to impose a "more than de minimis penalty" on any refund of earnings not used for qualified higher education expenses of the beneficiary. (7af) See Prop. Treas. Reg. [section]1.529-2 for the safe harbor definition of "more than de minimis." For taxable years beginning after 2001, the state-imposed penalty is repealed. (8af)

In place of that penalty, a 10% additional tax will be imposed on nonqualified distributions in the same manner as the 10% additional tax is imposed on certain distributions from Coverdell Education Savings Accounts (see Q 7516). (9af) However, the 10% additional tax will not apply to any payment or distribution in any taxable year before 2004 that is includable in gross income, but used for qualified higher education expenses of the designated beneficiary. (10af) According to the Conference Committee Report, this means that the earnings portion of a distribution from a qualified tuition program of a private institution that is made in 2003, and that is used for qualified higher education expenses, is not subject to the additional tax even though the earnings portion is includable in gross income. (11af) The 10% additional tax also does not apply if the payment or distribution is (1) made to a beneficiary on or after the death of the designated beneficiary, or (2) attributable to the disability of the designated beneficiary. (1ag)

The IRS has announced that with respect to any distributions made after 2001, a qualified tuition program will no longer be required to verify how distributions are used or to collect any penalty, but the program must continue to verify whether the distribution is used for qualified higher education expenses of the beneficiary and to collect a "more than de minimis penalty" on nonqualified distributions made before 2002. (2ag)

Rollovers. Any portion of a distribution that is transferred within 60 days to the credit of a "new designated beneficiary" (see below) who is a "member of the family" (see below) of the designated beneficiary, is not includable in the gross income of the distributee. (In other words, a distribution generally can be "rolled over" within 60 days from one family member to another.) (3ag) A change in designated beneficiaries with respect to an interest in the same qualified tuition program will not be treated as a distribution provided that the new beneficiary is a member of the family of the old beneficiary. (4ag) A transfer of credits (or other amounts) for the benefit of the same designated beneficiary from one qualified tuition program to another is not considered a distribution; however, only one transfer within a 12-month period can receive such rollover treatment. (5ag) According to the Conference Committee Report, a program-to-program transfer on behalf of the same beneficiary is intended to allow a transfer between a prepaid tuition program and a savings program maintained by the same state, or a transfer between a state-sponsored plan and a prepaid private tuition program. (6ag)

Generally, member of the family means an individual's (1) spouse, (2) child or his descendant, (3) stepchild, (4) sibling or step sibling, (5) parents and their ancestors, (6) stepparents, (7) nieces or nephews, (8) aunts and uncles, or (9) in-laws, (10) the spouse of any of the individuals in (2) through (9), and (11) any first cousin of the designated beneficiary. (7cc) (However, for any contracts issued before August 20, 1996, IRC Section 529(c)(3)(C) will not require that a distribution be transferred to a member of the family or that a change in beneficiaries may be made only to a member of the family. (8ag)) A designated beneficiary is (1) the individual designated at the beginning of participation in the qualified tuition program as the beneficiary of amounts paid (or to be paid) to the program; (2) in the case of a rollover of a distribution or change in beneficiaries within a family (as described above), the new beneficiary; and (3) in the case of an interest in a qualified tuition program that is purchased by a state or local government (or its agency or instrumentality) or certain tax-exempt 501(c)(3) organizations as part of a scholarship program, the individual receiving the interest as a scholarship. (9ag)

Permanent extension of expiring provisions under PPA 2006: The tax-free treatment for qualified distributions from 529 plans (i.e., withdrawals used to pay qualified higher education expenses) under EGTRRA 2001 has been made permanent. In other words, this tax break will not end on December 31, 2010, as originally scheduled under EGTRRA 2001. (1ah) For the impact of PPA 2006 on other qualified tuition program provisions that were scheduled to expire, see Q 7517.

7519. What is "tax basis"?

"Tax basis" is the method the Internal Revenue Code employs to keep a continuous total of an individual's "investment" in a particular item of property so that when the property is sold, or otherwise transferred or disposed of, an accurate assessment of the individual's gain or loss can be made for tax purposes. (2ah)

When an individual acquires an item of property, he is considered to have also acquired an initial tax basis in that property that, depending on the manner of acquisition, may be (1) its cost, (2) its fair market value as of a specified date, or (3) a substituted tax basis. (Basis is a "substituted basis" when it is determined in whole or in part by reference to the property's basis in the hands of a prior individual, or by reference to other property held at some time by the person for whom the basis is determined. (3ah) See below as to which of these applies to a given manner of acquisition.) However, during the period of time the individual owns the property his tax basis does not necessarily remain fixed at its initial basis. Instead, it is adjusted during the period of ownership to reflect certain real or artificial additions to, and returns of, the initial "investment." (For example, tax basis is increased for such things as improvements; it is reduced for such things as allowable depreciation or depletion.) When adjusted in this manner, an individual's tax basis at a particular time is often referred to as his "adjusted tax basis." (4ah)

Property Acquired by Purchase or Exchange

With respect to property purchased or acquired in a taxable exchange on or after March 1, 1913, a taxpayer's basis is cost (the cash he paid for the property or the fair market value of the property he gave for it). (5ah) If the property was acquired by purchase before March 1, 1913, basis for determining gain is cost, or fair market value as of March 1, 1913, whichever is greater; for determining loss, the basis is cost.

Special rules apply to stock exchanges made pursuant to a plan of corporate reorganization. (6ah) For the final regulations under IRC Section 358 providing guidance regarding the determination of the basis of stock or securities received in exchange for, or with respect to, stock or securities in certain transactions, see Q 7638. For the rules applicable to stock received in a demutualization, see Q 7638. The Service and the Treasury Department have withdrawn the proposed regulations relating to redemptions of stock in which the redemption proceeds are treated as a dividend distribution. (7ah)

Property Acquired From a Decedent

Decedent Dying in Year Other Than 2010

Stepped up basis. As a general rule, the basis of property that has been acquired from a decedent is the fair market value of the property at the date of the decedent's death (i.e., the basis is "stepped up" or "stepped down," as the case may be, to the fair market value). This rule applies generally to all property includable in the decedent's gross estate for federal estate tax purposes (whether or not an estate tax return is required to be filed). It applies also to the survivor's one-half of community property where at least one-half of the value of the property was included in the decedent's gross estate. As an exception, however, the rule does not apply to "income in respect of a decedent" (see Q 7536); normally the basis of such income is zero. (1ai) As another exception, the rule does not apply to appreciated property acquired by the decedent by gift within one year of his death where the one receiving the property from the decedent is the donor or the donor's spouse; in such case the basis of the property in the hands of the donor (or spouse) is the adjusted basis of the property in the hands of the decedent immediately before his death. (2ai) If an estate tax return is filed and the executor elects the alternative valuation (see Q 7602), the basis is the fair market value on the alternative valuation date instead of its value on the date of death. (3ai)

If property in the estate of a decedent is transferred to an heir, legatee, devisee, or beneficiary in a transaction that constitutes a sale or exchange, the basis of the property in the hands of the heir, legatee, devisee, or beneficiary is the fair market value on the date of the transfer (not on the date of decedent's death). Likewise, the executor or administrator of the estate will recognize a gain or loss on the transaction. For example, if the executor of the will, to satisfy a bequest of $10,000, transfers to the heir stock worth $10,000, which had a value of $9,000 on the decedent's date of death, the estate recognizes a $1,000 gain, and the basis of the stock to the heir is $10,000. (4ai)

Jointly held property. Note that the "stepped up" basis rule applies only to property includable in the decedent's gross estate for federal estate tax purposes. (5ai) Thus, one acquiring property from a decedent who held the property jointly with another (or others) under the general rule of estate tax includability (i.e., the entire value of the property is includable in the estate of the first joint owner to die except to the extent the surviving joint owner(s) can prove contribution to the cost--see Q 7565) receives a stepped up basis in the property in accordance with that rule. By contrast, one who acquires property from a decedent spouse who with the surviving spouse had a qualified joint interest in the property (see Q 7565) receives a stepped up basis equal to one-half the value of that interest.

Community property. The stepped up basis rule applies in the case of community property both to the decedent's one-half interest and to the surviving spouse's one-half interest. (6ai)

Qualified terminable interest property. Upon the death of the donee spouse or surviving spouse, qualified terminable interest property (see Q 7572) is considered as "acquired from or to have passed from the decedent" for purposes of receiving a new basis at death. (7ai)

Decedent Dying in 2010

Modified carryover basis. In 2010, along with repeal of the estate tax for one year, a modified carryover basis regime (with limited step-up in basis) replaces the step-up in basis for property acquired from a decedent. That is, the basis of the person acquiring property from a decedent dying in 2010 will generally be equal to the lesser of (1) the adjusted basis of the decedent (i.e., carried over to recipient from decedent), or (2) the fair market value of the property at the date of the decedent's death. However, step-up in basis is retained for up to $1,300,000 of property acquired from a decedent. In the case of certain transfers to a spouse, step-up in basis will be available for an additional $3,000,000 of property acquired from a decedent. In the case of a decedent nonresident who is not a United States citizen, step-up in basis will be available for only $60,000 of property acquired from the decedent. (1aj)

Property Acquired by Gift

If the property was acquired by gift after 1920, the basis for determining gain is generally the same as in the hands of the donor. However, in the case of property acquired by gift after September 1, 1958 and before 1977, this basis may be increased by the amount of any gift tax paid, but total basis may not exceed the fair market value of the property at the time of gift. In the case of property received by gift after 1976, the donee takes the donor's basis plus a part of the gift tax paid. The added fraction is the amount of the gift tax paid that is attributable to appreciation in the value of the gift over the donor's basis. The amount of attributable gift tax bears the same ratio to the amount of gift tax paid as net appreciation bears to the value of the gift. (2aj)

For the purpose of determining loss, the basis of property acquired by gift after 1920 is the foregoing substituted basis, or the fair market value of the property at the time of gift, whichever is lower. (3aj) As to property acquired by gift before 1921, basis is the fair market value of the property at time of acquisition. (4aj)

Property Acquired in a Generation-Skipping Transfer

Generally, in the case of property received in a generation-skipping transfer (see Q 7576), the transferee takes the adjusted basis of the property immediately before the transfer plus a part of the generation-skipping transfer (GST) tax paid. The added fraction is the amount of the GST tax paid that is attributable to appreciation in the value of the transferred property over its previous adjusted basis. The amount of attributable GST tax bears the same ratio to the amount of GST tax paid as net appreciation bears to the value of the property transferred. Nevertheless, basis is not to be increased above fair market value. When property is acquired by gift in a generation-skipping transfer, the basis of the property is increased by the gift tax basis adjustment (see above) before the generation-skipping transfer tax basis adjustment is made. (5aj)

However, where property is transferred in a taxable termination (see Q 7576) that occurs at the same time and as a result of the death of an individual, the basis of such property is increased (or decreased) to fair market value, except that any increase (or decrease) in basis is limited by multiplying such increase (or decrease) by the inclusion ratio used in allocating the generation-skipping tax exemption (see Q 7577). (1ak)

Property Acquired From a Spouse or Incident to Divorce

Where property is transferred between spouses, or former spouses incident to a divorce, after July 18, 1984 pursuant to an instrument in effect after that date, the transferee's basis in the property is generally the adjusted basis of the property in the hands of the transferor immediately before the transfer and no gain or loss is recognized at the time of transfer (unless, under certain circumstances, the property is transferred in trust). (2ak) These rules may apply to transfers made after 1983 if both parties elect. (3ak) See Q 7555 regarding transfers incident to divorce.

7520. What is a "capital asset"?

For tax purposes, a "capital asset" is any property that, in the hands of the taxpayer, is not: (1) property (including inventory and stock in trade) held primarily for sale to customers; (2) real or depreciable property used in his trade or business; (3) copyrights and literary, musical, or artistic compositions (or similar properties) created by the taxpayer, or merely owned by him, if his tax basis in the property is determined (other than by reason of IRC Section 1022, which governs the basis determination of inherited property) by reference to the creator's tax basis; (4) letters, memoranda, and similar properties produced by or for the taxpayer, or merely owned by him, if his tax basis is determined by reference to the tax basis of such producer or recipient; (5) accounts or notes receivable acquired in his trade or business for services rendered or sales of property described in (1), above; (6) certain publications of the United States government; (7) any commodities derivative financial instrument held by a commodities derivatives dealer; (8) any hedging instrument that is clearly identified as such by the required time; and (9) supplies of a type regularly used or consumed by the taxpayer in the ordinary course of his trade or business. (4ak)

Generally, any property held as an investment is a capital asset, except that rental real estate is generally not a capital asset because it is treated as a trade or business asset (see Q 7813). (5ak)

7521. When is capital gain or loss short-term? When is it long-term? How is an individual's "holding period" calculated?

Generally, a capital gain or loss is long-term if the property giving rise to the gain or loss was owned for more than one year; it is short-term if the property was owned for one year or less. (6ak) For an explanation of the tax treatment of capital gains and losses, see Q 7524.

To determine how long a taxpayer has owned property (i.e., his "holding period"), begin counting on the day after the property is acquired; the same date in each successive month is the first day of a new month. The date on which the property is disposed of is included (i.e., counted) in the holding period. (1al) If property is acquired on the last day of the month, the holding period begins on the first day of the following month. Therefore, if it is sold prior to the first day of the 13th month following the acquisition, the gain or loss will be short-term. (2al) According to IRS Pub. 544 (Nov. 1982), if property is acquired near the end of the month and the holding period begins on a date that does not occur in every month (e.g., the 29th, 30th, or 31st), the last day of each month that lacks that date is considered to begin a new month; however, later editions of Pub. 544 have omitted this statement.

Example 1. Mrs. Copeland bought a capital asset on January 1, 2010. She would begin counting on January 2, 2010.The 2nd day of each successive month would begin a new month. If Mrs. Copeland sold the asset on January 1, 2011, her holding period would not be more than one year. To have a long-term capital gain or loss she would have to sell the asset on or after January 2, 2011.

Example 2. Mrs. Brim bought a capital asset on January 30, 2010. She would begin counting on January 31, 2010. Since February does not have 31 days, Mrs. Brim will start a new month on February 28. In months that have only 30 days, the 30th will begin a new month.

Special rules apply in the case of gains or losses on regulated futures contracts, single stock futures (see Q 7694), nonequity option contracts, and foreign currency contracts (see Q 7697). Furthermore, the short sale rules (see Q 7643) and tax straddle rules (see Q 7698 to Q 7705) may require a tolling or recalculation of an individual's holding period.

Tacking of Holding Periods

In some cases, the IRC allows a taxpayer to add another individual's holding period in the same property, or the taxpayer's holding period in other property, to the taxpayer's holding period. This is referred to as "tacking" of holding periods. (3al)

For an explanation of how the holding period is determined for stock received by a policyholder or annuity holder in a demutualization transaction, see SCA 200131028.

Where applicable, tacking of holding periods is discussed in the appropriate question.

7522. How are securities that are sold or transferred identified for tax purposes?

When an individual sells or otherwise transfers securities (i.e., stocks, bonds, mutual fund shares, etc.) from holdings that were purchased or acquired on different dates or at different prices (or tax bases), he must generally be able to identify the lot from which the transferred securities originated in order to determine his tax basis and holding period. If he is unable to adequately identify the lot, he will usually be deemed to have transferred the securities in the order in which they were acquired, by a "first-in, first-out" (FIFO) method. (4al) However, in cases involving mutual fund shares he may be permitted to use an "average basis" method to determine his tax basis and holding period in the securities transferred (see Q 7895).

Generally, identification is determined by the certificate delivered to the buyer or other transferee. The security represented by the certificate is deemed to be the security sold or transferred. This is true even if the taxpayer intended to sell securities from another lot, or instructed his broker to sell securities from another lot. (1am)

There are several exceptions to the general rule of adequate identification. One occurs when the securities are left in the custody of a broker or other agent. If the seller specifies to the broker which securities to sell or transfer, and if the broker or agent sends a written confirmation of the specified securities within a reasonable time, then the specified securities are the securities sold or transferred, even though different certificates are delivered to the buyer or other transferee. (2am) If the securities held are United States securities (Treasury bonds, notes, etc.) recorded by a book-entry on the books of a Federal Reserve Bank, then identification is made when the taxpayer notifies the Reserve Bank (or the person through whom the taxpayer is selling the securities) of the lot number (assigned by the taxpayer) of the securities to be sold or transferred, and when the Reserve Bank (or the person through whom the taxpayer sells the securities) provides the taxpayer with a written advice of transaction, specifying the amount and description of securities sold or transferred. (3am)

Another exception arises when the taxpayer holds a single certificate representing securities from different lots. If the taxpayer sells part of the securities represented by the certificate through a broker, adequate identification is made if the taxpayer specifies to the broker which securities to sell and if the broker sends a written confirmation of the specified securities within a reasonable time. If the taxpayer sells the securities himself, then there is adequate identification if he keeps a written record identifying the particular securities he intended to sell. (4am)

A third exception occurs when the securities are held by a trustee, or by an executor or administrator of an estate. An adequate identification is made if the trustee, executor, or administrator specifies in writing in the books or records of the trust or estate the securities to be sold, transferred or distributed. (In the case of a distribution, the trustee, executor, or administrator must also give the distributee a written document specifying the particular securities distributed.) In such a case, the specified securities are the securities sold, transferred or distributed, even though certificates from a different lot are delivered to the purchaser, transferee or distributee. (5am)

7523. How is a loss realized on a sale between related persons treated for income tax purposes?

If an individual sells property at a loss to a related person (as defined below), that loss may not be deducted or used to offset capital gains for income tax purposes. (6am) It makes no difference that the sale was a bona fide, arm's-length transaction. (7am) Neither does it matter that the sale was made indirectly through an unrelated middleman. (8am) The loss on the sale of stock will be disallowed even though the sale and purchase are made separately on a stock exchange and the stock certificates received are not the certificates sold. (1an) However, these rules will not apply to any loss of the distributing corporation (or the distributee) in the case of a distribution in complete liquidation. (2an)

A loss realized on the exchange of properties between related persons will also be disallowed under these rules. (3an) Whether loss is realized in transfers between spouses during marriage or incident to divorce is explained in Q 7555.

For this purpose, persons are related if they are: (1) members of the same family (i.e., brothers, sisters, spouses, ancestors and lineal descendants; but not if they are in-laws; (4an) (2) an individual and a corporation of which the individual actually or constructively owns more than 50% of the stock; (3) a grantor and a fiduciary of a trust; (4) fiduciaries of two trusts if the same person is the grantor of both; (5) a fiduciary and a beneficiary of the same trust; (6) a fiduciary of a trust and a beneficiary of another trust set up by the same grantor; (7) a fiduciary of a trust and a corporation of which the trust or the grantor of the trust actually or constructively owns more than 50% of the stock; (8) a person and an IRC Section 501 tax-exempt organization controlled by the person or members of his family (as described in (1) above); (9) a corporation and a partnership if the same person actually or constructively owns more than 50% of the stock of the corporation, and has more than a 50% interest in the partnership; (10) two S corporations if the same persons actually or constructively own more than 50% of the stock of each; (11) an S corporation and a C corporation, if the same persons actually or constructively own more than 50% of the stock of each; or (12) generally, an executor and a beneficiary of an estate. (5an) Special rules apply for purposes of determining constructive ownership of stock. (6an) The relationship between a grantor and fiduciary did not prevent recognition of loss on a sale of stock between them where the fiduciary purchased the stock in his individual capacity and where the sale was unrelated to the grantor-fiduciary relationship. (7an)

Generally, loss will be disallowed on a sale between a partnership and a partner who owns more than a 50% interest, or between two partnerships if the same persons own more than a 50% interest in each. (8an) Furthermore, with respect to transactions between two partnerships having one or more common partners or in which one or more of the partners in each partnership are related (as defined above), a portion of the loss will be disallowed according to the relative interests of the partners. (9an) If the transaction is between a partnership and an individual who is related to one of the partners (as defined above), any deductions for losses will be denied with respect to the related partner's distributive share, but not with respect to the relative shares of each unrelated partner. (10an) Loss on a sale or exchange (other than of inventory) between two corporations that are members of the same controlled group (using a 50% test instead of 80%) is generally not denied but is deferred until the property is transferred outside the controlled group. (11an)

If the related person to whom property was originally sold (or exchanged), sells or exchanges the same property (or property whose tax basis is determined by reference to such property) at a gain, the gain will be recognized only to the extent it exceeds the loss originally denied by reason of the related parties rules. (1ao)

Special rules apply to installment sales between related parties (see Q 7512) and to the deduction of losses (see Q 7906 to Q 7921).

In a case of first impression, the Tax Court held that IRC Section 382(l)(3)(A)(i)--which provides that an "individual" and all members of his family described in IRC Section 318(a)(1) (i.e., his spouse, children, grandchildren, and parents) are treated as one individual for purposes of applying IRC Section 382 (which limits the amount of pre-change losses that a loss corporation may use to offset taxable income in the taxable years or periods following an ownership change)--applies solely from the perspective of individuals who are shareholders (as determined under applicable attribution rules) of the loss corporation. The court further held that siblings are not treated as one individual under IRC Section 382(l)(3)(A)(i). (2ao) Accordingly, in Garber, the sale of shares by one brother to the other brother resulted in an ownership change with respect to the closely held corporation within the meaning of IRC Section 382(g).

7524. How is an individual taxed on capital gains and losses?

Adjusted net capital gain is generally subject to a maximum rate of 15%. (See "Reduction in Capital Gain Rates," below.) However, detailed rules as to the exact calculation of the capital gains tax result in some exceptions. (3ao)

"Adjusted net capital gain" is net capital gain reduced (but not below zero) by the sum of: (1) unrecaptured IRC Section 1250 gain; and (2) 28% rate gain (both defined below); plus (3) "qualified dividend income" (as defined in IRC Section 1(h)(11)(B)). (4ao)

Gain is determined by subtracting the adjusted basis of the asset sold or exchanged from the amount realized. Loss is determined by subtracting the amount realized from the adjusted basis of the asset sold or exchanged. See Q 7519. The amount realized includes both money and the fair market value of any property received. IRC Sec. 1001. Gains and losses from the sale or exchange of capital assets are either short-term or long-term. Generally, in order for gain or loss to be long-term, the asset must have been held for more than one year. See Q 7521.

Generally, taxpayers may elect to treat a portion of net capital gain as investment income. (5ao) If the election is made, any net capital gain included in investment income will be subject to the taxpayer's marginal income tax rate. The election must be made on or before the due date (including extensions) of the income tax return for the taxable year in which the net capital gain is recognized. The election is to be made on Form 4952, "Investment Interest Expense Deduction." (6ao) See Q 7925.

Net capital gain is the excess of net long term capital gain for the taxable year over net short term capital loss for such year. (1ap) However, net capital gain for any taxable year is reduced (but not below zero) by any amount the taxpayer takes into account under the investment income exception to the investment interest deduction. (2ap) See Q 7925.

The Code provides that for a taxpayer with a net capital gain for any taxable year, the tax will not exceed the sum of the following five items:

(A) the tax computed at regular rates (without regard to the rules for capital gain) on the greater of (i) taxable income reduced by the net capital gain, or (ii) the lesser of (I) the amount of taxable income taxed at a rate below 25% (See Appendix B), or (II) taxable income reduced by the adjusted net capital gain;

(B) 0% for taxable years beginning after 2007 and before 2011 (5% for 2003 through 2007) of so much of the taxpayer's adjusted net capital gain (or, if less, taxable income) as does not exceed the excess (if any) of (i) the amount of taxable income that would (without regard to this paragraph) be taxed at a rate below 25% (see Appendix B) over (ii) the taxable income reduced by the adjusted net capital gain;

(C) 15% of the taxpayer's adjusted net capital gain (or, if less, taxable income) in excess of the amount on which a tax is determined under (B) above;

(D) 25% of the excess (if any) of (i) the unrecaptured IRC Section 1250 gain (or, if less, the net capital gain (determined without regard to qualified dividend income)), over (ii) the excess (if any) of (I) the sum of the amount on which tax is determined under (A) above, plus the net capital gain, over (II) taxable income; and

(E) 28% of the amount of taxable income in excess of the sum of the amounts on which tax is determined under (A) through (D) above. (3ap)

It is important to note that as a result of this complex formula, generally, the maximum capital gains rate on adjusted net capital gain will be 15% to the extent an individual is taxed at the 25% or higher marginal rates (see Q 7539), and 0% for taxable years beginning after 2007 and before 2011 (5% for 2003 through 2007) to the extent the individual is taxed at the 15% or 10% rates. (4ap)

IRC Section 1250 provides for the recapture of gain on certain property on which accelerated depreciation has been used. "Unrecaptured IRC Section 1250 gain" means the excess, if any, of: (i) that amount of long-term capital gain (not otherwise treated as ordinary income) that would be treated as ordinary income if IRC Section 1250(b)(1) included all depreciation and the applicable percentage under IRC Section 1250(a) were 100%; over (ii) the excess, if any of (a) the sum of collectibles loss, net short-term capital loss and long-term capital loss carryovers, over (b) the sum of collectibles gain and IRC Section 1202 gain. However, at no time may the amount of unrecaptured IRC Section 1250 gain that is attributable to sales, exchanges and conversions described in IRC Section 1231(a)(3)(A) for any taxable year exceed the net IRC Section 1231 gain, as defined in IRC Section 1231(c)(3) for such year. (1aq)

"28% rate gain" means the excess, if any, of (A) the sum of collectibles gain and IRC Section 1202 gain (i.e., gain on certain small businesses), over (B) the sum of (i) collectibles loss, (ii) net short-term capital loss, and (iii) long-term capital loss carried over under IRC Section 1212(b)(1)(B) (i.e., the excess of net long-term capital loss over net short-term capital gain, carried over to the succeeding taxable year). (2aq)

"Collectibles gain or loss" is gain or loss on the sale or exchange of a collectible that is a capital asset held for more than one year, but only to the extent such gain is taken into account in computing gross income and such loss is taken into account in computing taxable income. (3aq) Examples of collectibles include artwork, gems and coins. (4aq) For additional details, see Q 7778 and Q 7779.

"IRC Section 1202 gain" means the excess of (A) the gain that would be excluded from gross income under IRC Section 1202 but for the percentage limitation in IRC Section 1202(a) over (B) the gain excluded from gross income under IRC Section 1202 (i.e., 50% exclusion for certain qualified small business stock). (5aq) See Q 7640 and Q 7641 for details. (JGTRRA 2003 provides that for alternative minimum tax purposes, an amount equal to 7% of the amount excluded from gross income for the taxable year under IRC Section 1202 will be treated as a preference item. (6aq) See Q 7641.)

The foregoing rules essentially establish four groups of capital assets (based upon pre-existing tax rates): (1) short-term capital assets, with no special tax rate; (2) 28% capital assets, generally consisting of collectibles gain or loss, and IRC Section 1202 gain; (3) 25% capital assets, consisting of assets that generate unrecaptured IRC Section 1250 gain; and (4) 15%/0% capital assets (i.e., 0% for taxable years beginning after 2007 and before 2011, and 5% for 2003 through 2007) for taxpayers in the 15%/10% ordinary income tax brackets, consisting of all other long-term capital assets.

Within each group, gains and losses are netted. The effect of this process is generally that if there is a net loss from (1), it is applied to reduce any net gain from (2), (3), or (4), in that order. If there is a net loss from (2) it is applied to reduce any net gain from (3) or (4), in that order. If there is a net loss from (4), it is applied to reduce any net gain from (2) or (3), in that order. (7aq)

After all of the netting above, if there are net losses, up to $3,000 ($1,500 in the case of married individuals filing separately) of losses can be deducted against ordinary income. (8aq) Apparently, any deducted loss would be treated as reducing net loss from (1), (2), or (4), in that order. Any remaining net losses could be carried over to other taxable years, retaining its group classifications. If there are net gains, such gains would generally be taxed as described above.

Generally, to the extent a capital loss described above exceeds the $3,000 limit ($1,500 in the case of married individuals filing separately), it may be carried over to other taxable years, but always retaining its character as long-term or short-term. However, special rules apply in determining the carryover amount from years in which a taxpayer has no taxable income. (1ar)

Collectibles gain and IRC Section 1250 gains under IRC Section 1(h) are subject to special rules when an interest in a pass-through entity (i.e., partnership, S corporation, or trust) is sold or exchanged. Regulations finalized in 2000 provide rules for dividing the holding period of an interest in a partnership. (2ar)

Special rules apply in the case of wash sales (see Q 7651), short sales (see Q 7643), and IRC Section 1256 contracts (see Q 7697).

Reduction in Capital Gain Rates for Individuals

Long-term capital gains incurred on or after May 6, 2003 are subject to lower tax rates. For taxpayers in the 25% tax bracket and higher (28%, 33% and 35% in 2010), the rate on long-term capital gains is reduced from 20% to 15% in 2003 through 2010. For taxpayers in the 15% and 10% brackets, the rate on long-term capital gains is reduced from 10% to 5% in 2003 through 2007, and all the way down to 0% in 2008 through 2010. The lower capital gain rates are effective for taxable years ending on or after May 6, 2003 and beginning before January 1, 2011. On December 31, 2010, the lower rates on long-term capital gains will "sunset" (expire), after which time the prior capital gain rates (20%, 10%) will, once again, be effective. (3ar) For the treatment of long-term capital gains incurred prior to May 6, 2003, see the "Transitional rules," below.

Collectibles gain, IRC Section 1202 gain (i.e., qualified small business stock), and unrecaptured IRC Section 1250 gain continue to be taxed at their current tax rates (i.e., 28% for collectibles gain and IRC Section 1202 gain, and 25% for unrecaptured IRC Section 1250 gain). (4ar)

Repeal of qualified 5-year gain. For tax years beginning after December 31, 2000, if certain requirements were met, the maximum rates on "qualified 5-year gain" could be reduced to 8% and 18% (in place of 10% and 20% respectively). Furthermore, a noncorporate taxpayer in the 25% bracket (or higher) who held a capital asset on January 1, 2001 could elect to treat the asset as if it had been sold and repurchased for its fair market value on January 1, 2001 (or on January 2, 2001 in the case of publicly traded stock). If a noncorporate taxpayer made this election, the holding period for the elected assets began after December 31, 2000, thereby making the asset eligible for the 18% rate if it was later sold after having been held by the taxpayer for more than five years from the date of the deemed sale and deemed reacquisition. (5ar) Under JGTRRA 2003, the 5-year holding period requirement, and the 18% and 8% tax rates for qualified 5-year gain are repealed. When the 15%/0% rates for capital gains "sunset" (expire), the 5-year holding period requirement and 18% and 8% rates will, once again, be effective. (6ar)

Lower Rates for Qualified Dividend Income

Under prior law, dividends were treated as ordinary income and, thus, were subject to ordinary income tax rates. Under JGTRRA 2003, "qualified dividend income" (see below) is treated as "net capital gain" (see below) and is, therefore, subject to new lower tax rates. For taxpayers in the 25% income tax bracket and higher), the maximum rate on qualified dividends paid by corporations to individuals is 15% in 2003 through 2010. For taxpayers in the 15% and 10% income tax brackets, the tax rate on qualified dividend income is reduced to 0% in 2008 through 2010 (5% in 2003 through 2007). The preferential treatment of qualified dividends as net capital gains will "sunset" (expire) on December 31, 2010, after which time the prior treatment of dividends will, once again, be effective. (1as) In other words, dividends will once again be taxed at ordinary income tax rates.

Qualified dividend income. Certain dividends are taxed as "net capital gain" for purposes of the reduction in the tax rates on dividends. "Net capital gain" for this purpose means net capital gain increased by "qualified dividend income" (without regard to this paragraph). (2as) "Qualified dividend income" means dividends received during the taxable year from domestic corporations and "qualified foreign corporations" (defined below). (3as)

The term qualified dividend income does not include the following:

(1) dividends paid by tax-exempt corporations;

(2) any amount allowed as a deduction under IRC Section 591 (relating to the deduction for dividends paid by mutual savings banks, etc.);

(3) dividends paid on certain employer securities as described in IRC Section 404(k);

(4) any dividend on a share (or shares) of stock that the shareholder has not held for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date (as measured under IRC Section 246(c)). For preferred stock, the holding period is more than 90 days during the 181-day period beginning 90 days before the ex-dividend date if the dividends are attributable to a period exceeding 366 days (note, however, that if the preferred dividends are attributable to a period totalling less than 367 days, the holding period stated in the preceding sentence applies). (4oo)

Special rules. Qualified dividend income does not include any amount that the taxpayer takes into account as investment income under IRC Section 163(d)(4)(B). (5as) If an individual, trust, or estate receives qualified dividend income from one or more dividends that are "extraordinary dividends" (within the meaning of IRC Section 1059(c)), any loss on the sale or exchange of such share(s) of stock will, to the extent of such dividends, be treated as long-term capital loss. (6as)

A dividend received from a mutual fund or REIT is subject to the limitations under IRC Sections 854 and 857. (1at) For the treatment of mutual fund dividends and REIT dividends under JGTRRA 2003, see Q 7886 and Q 7903, respectively.

Pass-through entities. In the case of partnerships, S corporations, common trust funds, trusts, and estates, the rule that qualified dividends are taxable as capital gains applies to taxable years ending after December 31, 2002, except that dividends received by the entity prior to January 1, 2003 are not treated as qualified dividend income. (2at)

Qualified foreign corporations .The term "qualified foreign corporation" means a foreign corporation incorporated in a possession of the United States, or a corporation that is eligible for benefits of a comprehensive income tax treaty with the United States. If a foreign corporation does not satisfy either of these requirements, it will nevertheless be treated as such with respect to any dividends paid by that corporation if its stock (or ADRs with respect to such stock) is readily tradable on an established securities market in the United States. (3at)

Common stock (or an ADR in respect of such stock) is considered "readily tradable on an established securities market in the United States" if it is listed on a national securities exchange that is registered under Section 6 of the Securities Exchange Act of 1934 (15 USC 78(f)), or on the NASDAQ Stock Market. As stated in the Securities and Exchange Commission's Annual Report for 2002, registered national exchanges include (as of September 30, 2002) the American Stock Exchange (AMEX), Boston Stock Exchange, Cincinnati Stock Exchange, Chicago Stock Exchange, New York Stock Exchange (NYSE), Philadelphia Stock Exchange, and the Pacific Stock Exchange. (4at)

In order to meet the "treaty test," the foreign corporation must be eligible for benefits of a comprehensive income tax treaty with the United States that the Treasury Secretary determines is satisfactory for these purposes, and the treaty must also provide for the exchange of tax information. For the current list of tax treaties meeting these requirements, see Notice 2006-101. (5at)

The term "qualified foreign corporation" does not include any foreign corporation if, for the taxable year of the corporation in which the dividend was paid (or the preceding taxable year), the corporation is a passive foreign investment company (as defined in section 1297). (6at)

Special rules apply in determining a taxpayer's foreign tax credit limitation under IRC Section 904 in the case of qualified dividend income. For these purposes, rules similar to the rules of IRC Section 904(b)(2)(B) (concerning adjustments to the foreign tax credit limitation to reflect any capital gain rate differential) will apply to any qualified dividend income. (7at)

For information reporting and other guidance on foreign stock dividends, see Notice 2006-3; (8at) Notice 2004-71; (9at) and Notice 2003-79. (10at)

Reporting Requirements under JGTRRA 2003

New boxes have been added to Form 1099-DIV to allow for the reporting of qualified dividends (Box 1b) and post-May 5, 2003 capital gain distributions (Box 2b). Likewise, new boxes have also been added to Form 1099-B for reporting post-May 5, 2003 profits or losses from regulated futures or currency contracts. (1au) Payments made in lieu of dividends ("substitute payments") are not eligible for the lower rates applicable to qualified dividends. (2au) For the information reporting requirements for such payments, see Notice 2003-67; (3qq) Announcement 2003-75; (4au) Treas. Reg. [section]1.6045-2(a)(3)(i); TD 9103. (5au)
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Title Annotation:TAX FACTS ON INVESTMENTS: Part 1
Publication:Tax Facts on Investments
Date:Jan 1, 2011
Words:23893
Previous Article:Abbreviations.
Next Article:Part I: Federal income taxation.
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