Basic Income Tax 2015-2016 William Kratzke
Chapter 10: Character of Income and Computation of Tax
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- I. Capital Gain
Chapter 10: Character of Income and Computation of TaxRecall that there are three principles that guide us through every question of income tax. See chapter 1. The first of these principles is that “[w]e tax income of a particular taxpayer once and only once.” A good bit of our study to this point has been to identify inconsistencies or anomalies with this principle, i.e., exclusions from gross income and certain deductions. In this chapter, we refine the notion of taxing all income once by adding this caveat: not all income is taxed the same. Taxable income has a “character” that determines the tax burden to which it is subject. Under § 1(h), an individual’s tax liability is actually the sum of the taxes of different rates on income of several different characters. The Tax Formula: (gross income) MINUS deductions named in § 62 EQUALS (adjusted gross income (AGI)) MINUS (standard deduction or itemized deductions) MINUS (personal exemptions) EQUALS (taxable income) ➔Compute income tax liability from tables in § 1 (indexed for inflation) MINUS (credits against tax) We have also seen that the Code states rules whose effect is to match income and expenses over time. See Idaho Power, Encyclopaedia Britannica, supra. We now find that the Code requires taxpayers – with only quite limited exceptions – to match income, gains, losses, and expenses with respect to character. Taxpayers who perceive these points may try to manipulate the character of income and associated expenses, and the Code addresses these efforts. Generally, a taxpayer prefers gains to be subject to a lower rate of tax, and deductions to be taken against income subject to a higher rate of tax. We consider here incomes of the following characters: long-term capital gain (and its variations), short-term capital gain, depreciation recapture, § 1231 gain, dividends, and passive income. I. Capital GainWe have already seen that § 61(a)(3) includes within the scope of “gross income” “gains derived from dealings in property.” Section 1001(a) informed us that taxpayer measures such gains (and losses) by subtracting “adjusted basis” from “amount realized.” Gains from the sale or exchange of “capital assets” might be subject to tax rates lower than those applicable to “ordinary income.” So we begin with a definition of “capital asset.” A. “Capital Asset:” Property Held by the Taxpayer Read § 1221(a). Notice the structure of the definition, i.e., all property except ... Do not the first two lines of this section imply that “capital asset” is a broad concept? Is there a common theme to the exceptions – at least to some of them? In Corn Products Refining Co. v. Commissioner, 350 U.S. 46 (1955), taxpayer was a manufacturer of products made from corn. Its profitability was vulnerable to price increases for corn. In order to protect itself against price increases and potential shortages, taxpayer “took a long position in corn futures[188]” at harvest time when prices were “favorable.” Id. at 48. If no shortage appeared when taxpayer needed corn, it would take delivery on as much corn as it needed and sell the unneeded futures. However, if there were a shortage, it would sell the futures only as it was able to purchase corn on the spot market. In this manner, taxpayer protected itself against seasonal increases in the price of corn. Taxpayer was concerned only with losses resulting from price increases, not from price decreases. It evidently purchased futures to cover (much) more than the corn it would actually need. See id. at 49 n.5. Hence, taxpayer sold corn futures at a profit or loss. Over a period when its gains far exceeded its losses, taxpayer treated these sales as sales of capital assets. This would subject its gains to tax rates lower than the tax rate on its ordinary income. At the time, the Code did not expressly exclude transactions of this nature from property constituting a capital asset. The Commissioner argued that taxpayer’s transactions in corn futures were hedges that protected taxpayer from price increases of a commodity that was “‘integral to its manufacturing business[.]’” Id. at 51. The Tax Court agreed with the Commissioner as did the United States Court of Appeals for the Second Circuit. The United States Supreme Court affirmed. The Court said: Admittedly, [taxpayer’s] corn futures do not come within the literal language of the exclusions set out in that section. They were not stock in trade, actual inventory, property held for sale to customers or depreciable property used in a trade or business. But the capital-asset provision ... must not be so broadly applied as to defeat rather than further the purpose of Congress. [citation omitted]. Congress intended that profits and losses arising from the everyday operation of a business be considered as ordinary income or loss rather than capital gain or loss. The [Code’s] preferential treatment [of capital gains] applies to transactions in property which are not the normal source of business income. It was intended ‘to relieve the taxpayer from * * * excessive tax burdens on gains resulting from a conversion of capital investments, and to remove the deterrent effect of those burdens on such conversions.’ [citation omitted]. Since this section is an exception from the normal tax requirements of the Internal Revenue Code, the definition of a capital asset must be narrowly applied and its exclusions interpreted broadly. This is necessary to effectuate the basic congressional purpose. Id. at 51-52. Subsequent to this case, Congress amended § 1221 by adding what is now § 1221(a)(7). A “capital asset” does not include “any hedging transaction which is clearly identified as such before the close of the day on which it was acquired, originated, or entered into ...” In other cases, taxpayers successfully argued that a futures transaction that proved profitable involved a “capital asset,” whereas a futures transaction that proved unprofitable was a hedge against price fluctuations in a commodity that was definitionally not a “capital asset.” Losses therefore could offset ordinary income. This “head-I-win-tails-you-lose” whipsaw of the Commissioner should have ended with the holding in Corn Products. The Commissioner won in Corn Products. Should the Commissioner be happy about that? Do you think that hedge transactions of the sort described in Corn Products more often produce profit or loss? •The statutory embodiment of the Corn Products rule creates the presumption that a hedge is a capital asset transaction unless the taxpayer identifies it as an “ordinary income transaction” at the time taxpayer enters the transaction. How does this scheme prevent the whipsaw of the Commissioner? Corn Products is also important for its statements concerning how to construe § 1221. While the structure of § 1221 implies that “capital asset” is a broad concept, i.e., “all property except ...”, the Court stated that the exceptions were to be construed broadly – thereby eroding the scope of the phrase “capital asset.” Furthermore, we might surmise that a major point of Corn Products is that a transaction that is a “surrogate” for a “non-capital” transaction is in fact a non-capital transaction. In Arkansas Best Corp. v. Commissioner, 485 U.S. 212 (1988), taxpayer was a diversified holding company that purchased approximately 65% of the stock of a Dallas bank. The bank needed more capital and so over the course of five years, taxpayer tripled its investment in the bank without increasing its percentage interest. During that time, the financial health of the bank declined significantly. Taxpayer sold the bulk of its stock, retaining only a 14.7% interest. It claimed an ordinary loss on the sale of this stock, arguing that its ownership of the stock was for business purposes rather than investment purposes. The Commissioner argued that the loss was a capital loss. Taxpayer argued that Corn Products supported the position that property purchased with a business motive was not a capital asset. The Tax Court agreed with this analysis and applied it to the individual blocks of stock that taxpayer had purchased, evidently finding that the motivation for different purchases was different. The United States Court of Appeals for the Eighth Circuit reversed, finding that the bank stock was clearly a capital asset. The Supreme Court affirmed. The Court refused to define “capital asset” so as to exclude the entire class of assets purchased for a business purpose. “The broad definition of the term ‘capital asset’ explicitly makes irrelevant any consideration of the property’s connection with the taxpayer’s business ...” Id. at 217. The Court held that the list of exceptions to § 1221's broad definition of “capital asset” is exclusive. Id. at 217-18. The Court (perhaps) narrowed its approach to “capital asset” questions in Corn Products to a broad application of the inventory exception rather than a narrow reading of the phrase “property held by the taxpayer[.]” Id. at 220. The corn futures in Corn Products were surrogates for inventory. •Thus, “capital asset” is indeed “all property” except for the items – broadly defined – specifically named in § 1221(a). •Read § 1221(a)’s list of exceptions to “capital assets” again. Is (are) there a general theme(s) to these exceptions? •Read again the excerpt from Corn Products, above. •The phrase “capital asset” certainly includes personal use property. Thus if a taxpayer sells his/her personal automobile for a gain, the gain is subject to tax as capital gain.
Do the CALI Lesson Basic Federal Income Taxation: Property Transactions: Capital Asset Identification B. Other Terms Relating to Capital Gains and Losses: Long Term and Short Term Gains and Losses Read § 1222. You will see that the Code distinguishes between sales or exchanges of capital assets held for one year or less, and sales or exchanges of capital assets held for more than one year.189 Sections 1221(1, 2, 3 and 4) inform us that every single sale or exchange of a capital asset gives rise to one of the following: •short-term capital gain (STCG); •short-term capital loss (STCL); •long-term capital gain (LTCG); •long-term capital loss (LTCL).
•net short-term capital gain (NSTCG) = STCG − STCL, but not less than zero; •net short-term capital loss (NSTCL) = STCL − STCG, but not less than zero; •net long-term capital gain (NLTCG) = LTCG − LTCL, but not less than zero; •net long-term capital loss (NLTCL) = LTCL − LTCG, but not less than zero.
NLTCG − NSTCL We defer for the moment the definition of “net capital loss” to the discussion of capital loss carryovers.190 Notice that the definitions of § 1222 implement, at least initially, a matching principle to gains and losses. Short-term losses offset only short-term gains. Long-term losses offset only long-term gains. Net short-term capital loss offsets net long-term capital gain. Section 1222 does not allow any other mismatching. The matching principle is very important because only the LTCG that remains after allowable offsets (LTCL and NSTCL) is subject to tax at reduced rates; other income is subject to tax at higher “ordinary income” rates. C. Deductibility of Capital Losses and Capital Loss Carryforwards Section 1211(b) provides that a taxpayer other than a corporation191 may claim capital losses only to the extent of capital gains plus the lesser of $3000 or the excess of such losses over gains. This is one of very few places in the Code where taxpayer may mismatch what might be NLTCL against income subject to ordinary income rates, whether STCG or otherwise. In the event taxpayer incurred losses greater than those allowed by § 1211(b), i.e., a “net capital loss, § 1222(10), taxpayer may carry them forward until he/she dies. § 1212(b). Section 1212(b) treats a capital loss-carryover as if it were one of the transactions described in §§ 1222(2 or 4) in the next succeeding year. •The Code creates a pecking order of capital loss carryovers by requiring taxpayer – before calculating his/her capital loss carryovers – to add a (hypothetical) STCG equal to the lesser of taxpayer’s § 1211(b) deduction or taxpayer’s “adjusted taxable income.” § 1212(b)(2)(A).192 •If the “net capital loss” results from NLTCL and NSTCL, the taxpayer first reduces the NSTCL by the amount of his/her § 1211(b) deduction, second reduces the NLTCL by the balance (if any) of his/her § 1211(b) deduction. Taxpayer carries forward all of the NLTCL and reduces the NSTCL by the amount deducted. § 1212(b)(2)(A). •If NSTCL > NLTCG, taxpayer carries forward the “net capital loss” as a STCL transaction. § 1212(b)(1)(A) and § 1212(b)(2)(A). •If NLTCL > NSTCG, taxpayer carries forward the “net capital loss” as a LTCL transaction. §§ 1212(b)(1)(B) and 1212(b)(2)(A).
•Taxpayer’s capital losses exceed his/her capital gains by $9000. Taxpayer’s § 1211(b) deduction is $3000. Taxpayer’s “net capital loss” (§ 1222(10)) is $6000. •We calculate taxpayer’s capital loss carryovers by first adding $3000 (the amount of taxpayer’s § 1211(b) deduction) to his/her NSTCL. Taxpayer’s NSTCL becomes $2000; taxpayer’s NLTCL is $4000. Taxpayer will carry these amounts forward. In the succeeding year, taxpayer will include $2000 as a STCL and include $4000 as a LTCL.
•Taxpayer’s capital losses exceed his/her capital gains by $5000. Taxpayer’s § 1211(b) deduction is $3000. Taxpayer’s “net capital loss” is $2000. Dividends: For many years, dividend income that individual taxpayers received was taxed as ordinary income. Dividend income comes from corporate profits on which the corporation pays income tax. The corporation may not deduct dividends that it pays to shareholders. Hence, dividend income that a shareholder actually receives is subject to two levels of income tax. This double tax has been subject to criticism from the beginning. Nevertheless, it is constitutional. A legislative compromise between removing one level of tax and retaining the rules taxing dividends as ordinary income is § 1(h)(11). An individual adds “qualified dividend income” to his/her net capital gain. § 1(h)(11)(A). “Qualified dividend income” includes dividends paid by domestic corporations and by “qualified foreign corporations.” § 1(h)(11)(B)(i). A “qualified foreign corporation” is one incorporated in a possession of the United States or in a country that is eligible for certain tax-treaty benefits, or one whose stock “is readily tradable on an established securities market in the United States.” § 1(h)(11)(C). The effect of treating dividend income as “net capital gain” is to subject dividend income to the reduced rates that § 1(h) imposes on “net capital gain.” However, placement of this rule in § 1(h) means that capital losses do not offset dividend income. •We calculate taxpayer’s capital loss carryover by first adding $3000 to his/her NSTCL. Taxpayer’s NSTCL becomes $4000. Subtract $2000 from $4000. § 1212(b)(1)(A). Taxpayer will carry this amount forward. In the succeeding year, taxpayer will include $4000 as a STCL. 3. Taxpayer has $100,000 of ordinary income. Taxpayer does his/her § 1222 calculations. For the year, taxpayer has $11,000 of NSTCG and $18,000 of NLTCL. •Taxpayer’s capital losses exceed his/her capital gains by $7000. Taxpayer’s § 1211(b) deduction is $3000. Taxpayer’s “net capital loss” is $4000. Taxing Ordinary Income, “Net Capital Gain,” and “Adjusted Net Capital Gain:” Not all capital gain is taxed alike, but no capital gain income should be taxed at a rate higher than the rate applicable to a taxpayer’s ordinary income. To implement this principle, § 1(h) establishes various maximum rates. The highest maximum rate is the rate on ordinary income. In the event that taxpayer’s circumstances qualify different forms of capital gain income to a lower maximum rate, then, and only then, that lower maximum rate applies. Otherwise the ordinary income rate applies. Section 1(h) distinguishes between “net capital gain” and “adjusted net capital gain.” Section 1(h)(3) defines the phrase “adjusted net capital gain” to be “net capital gain” MINUS “unrecaptured § 1250 gain,” MINUS “28-percent rate gain,” PLUS “qualified dividend income.” There are different maximum rates applicable to taxpayer’s “adjusted net capital gain” that depend on what taxpayer’s marginal bracket would be if all of his/her taxable income were subject to tax as ordinary income. Those maximum rates (0%, 10%, 20%) are applicable only if they are lower than the marginal rate otherwise applicable to taxpayer’s taxable income taxed as ordinary income. The maximum tax rates on unrecaptured § 1250 gain is 25%, and the maximum tax rate on 28% rate gain is 28%. •We calculate taxpayer’s capital loss carryover by first adding $3000 to his/her NSTCG. Taxpayer’s NSTCG becomes $14,000. Subtract $14,000 from $18,000. Taxpayer will carry forward $4000 forward to the succeeding year as a LTCL. § 1212(b)(1)(B). Matching the character of gains and losses: Aside from §§ 1211 and 1212, the Code strictly implements a matching regime with respect to ordinary gains and losses, and capital gains and losses. A taxpayer who regularly earns substantial amounts of ordinary income and incurs very large investment losses can use those losses only at the rate prescribed by § 1211(b) in the absence of investment gains.193 
Do the CALI Lesson Basic Federal Income Taxation: Property Transactions: Capital Loss Mechanics D. Computation of Tax We already know that § 1 imposes income taxes on individuals.194 Section 1(h) creates income “baskets” that are subject to different maximum rates of income tax (see text box). Once an income “basket” has been subject to a particular maximum rate of tax, the principle that we tax income once applies. Section 1(h) refers to “net capital gain,” which we determined under § 1222 by netting gains and losses from sales or exchanges of various capital assets. Section 1(h) supplies more definitions, most of which refine the concept of “net capital gain.” The importance of placing definitions in § 1(h) rather than adding another sub-section to § 1222 is that the particular definition only applies to individuals195 – not to corporations. Unrecaptured § 1250 gain and 28-percent rate gain: “Unrecaptured § 1250 gain” is the income attributable to recapture of depreciation that taxpayer has claimed on real property. It will be included in taxpayer’s net § 1231 gain. “28-percent rate gain” property is the net of collectibles gains and losses PLUS § 1202 gain, i.e., half of the gain from the sale of certain small business stock held for more than five years. § 1(h)(4). Temporarily, none of the gain from the sale of such stock was included in “28-percent rate gain.” A “collectible” is essentially any work of art, rug or antique, metal or gem, stamps or certain coins, an alcoholic beverage, and anything else that the Secretary of the Treasury designates. § 408(m)(2). Sections 1(h)(1)(B, C, D, E, and F) impose different maximum rates of tax on different forms of “net capital gain.” These rates are dependent on the rate of tax imposed on a taxpayer’s ordinary income – viz., they increase when a taxpayer’s marginal rate on ordinary income reaches 25% and increase again when a taxpayer’s marginal rate on ordinary income reaches 39.6%. In addition, there is a medicare “contribution” of 3.8% on the unearned income of (relatively196) high income earners. § 1411. [Thus the net of federal taxes on the long-term capital gains of some taxpayers is 18.8% or 23.8%, not 15% of 20%.] Section 1(h)(1)(A) isolates “ordinary income”197 and subjects it to the progressive tax brackets of § 1(a).198 Section 1(h)(1)(A) also assures that the “net capital gain” of a taxpayer is subject to the lower rates of tax on only so much of the gain otherwise necessary for a taxpayer’s total taxable income to reach the 25% bracket. The next “basket” of income is “adjusted net capital gain” (see accompanying box). Section 1(h)(1)(B) subjects the “adjusted net capital gain” of a taxpayer whose marginal rate on ordinary income is less than 25% to a 0% tax. If a taxpayer’s ordinary income plus “adjusted net capital gain” is less than the 25% bracket threshold, to that extent the elements that distinguish “adjusted net capital gain” from “net capital gain” (see accompanying box) are subject to tax at ordinary income rates. Section 1(h)(1)(C) subjects the “adjusted net capital gain” of taxpayers whose marginal rate on ordinary income is 25% or more to a tax rate of 15%. Section 1(h)(1)(D) subjects the “adjusted net capital gain” of taxpayers whose marginal rate on ordinary income is 39.6% to a tax rate of 20%. Section 1(h)(1)(E) subjects unrecaptured depreciation on real property up to the amount of net § 1231 gain to a maximum rate of 25%. Section 1(h)(1)(F) subjects “28-percent rate gain” property to a maximum rate of (surprise) 28%. Taxpayer’s tax liability is the sum of the taxes imposed on these income baskets.
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