Digging Deeper

Chapter 8 Digging Deeper

Contents:

STATUTORY EXPANSIONS

1. Court decisions play an important role in the definition of capital assets. Because the Code only lists categories of what are not capital assets, judicial interpretation is sometimes required to determine whether a specific item fits into one of those categories. The Supreme Court follows a literal interpretation of the categories. For instance, corporate stock is not mentioned in § 1221. Thus, corporate stock is usually a capital asset. However, what if corporate stock is purchased for resale to customers? Then it is inventory and not a capital asset because inventory is one of the categories in § 1221. (See the discussion of Dealers in Securities.)

A Supreme Court decision was required to distinguish between capital asset and non-capital asset status when a taxpayer who normally did not acquire stock for resale to customers acquired stock with the intention of resale.1 The Court decided that since the stock was not acquired primarily for sale to customers (the taxpayer did not sell the stock to its regular customers), the stock was a capital asset.

Often the crux of the capital asset determination hinges on whether the asset is held for investment purposes (capital asset) or business purposes (ordinary asset). The taxpayer’s use of the property often provides objective evidence.

Example: David’s business buys an expensive painting. If the painting is used to decorate David’s office and is not of investment quality, the painting is depreciable and, therefore, not a capital asset. If David’s business is buying and selling paintings, the painting is inventory and, therefore, an ordinary asset. If the painting is of investment quality and the business purchased it for investment, the painting is a capital asset, even though it serves a decorative purpose in David’s office. Investment quality generally means that the painting is expected to appreciate in value.

STATUTORY EXPANSIONS

2. Dealers in Securities.

Example: Tracy is a securities dealer. She purchases 100 shares of Swan stock. If Tracy takes no further action, the stock is inventory and an ordinary asset. If she designates in her records that the stock is held for investment, the stock is a capital asset. Tracy must designate the investment purpose by the close of business on the acquisition date. If Tracy maintains her investment purpose and later sells the stock, the gain or loss is capital gain or loss. If Tracy redesignates the stock as held for resale (inventory) and then sells it, any gain is ordinary, but any loss is a capital loss. Stock designated as held for investment and then sold at a loss always yields a capital loss.

RETIREMENT OF CORPORATE OBLIGATIONS

3. Original Issue Discount. The benefit of the sale or exchange exception that allows a capital gain from the collection of certain obligations is reduced when the obligation has original issue discount. Original issue discount (OID) arises when the issue price of a debt obligation is less than the maturity value of the obligation. OID must generally be amortized over the life of the debt obligation using the effective interest method. The OID amortization increases the basis of the bond. Most new publicly traded bond issues do not carry OID since the stated interest rate is set to make the market price on issue the same as the bond’s face amount. In addition, even if the issue price is less than the face amount, the difference is not considered to be OID if the difference is less than one-fourth of 1 percent of the redemption price at maturity multiplied by the number of years to maturity.2

In the case where OID does exist, it may or may not be amortized, depending upon the date the obligation was issued. When OID is amortized, the amount of gain upon collection, sale, or exchange of the obligation is correspondingly reduced. The obligations covered by the OID amortization rules and the method of amortization are presented in §§ 1272–1275. Similar rules for other obligations can be found in §§ 1276–1288.

Example: Jerry purchases $10,000 of newly issued White Corporation bonds for $6,000. The bonds have OID of $4,000. Jerry must amortize the discount over the life of the bonds. The OID amortization increases his interest income. (The bonds were selling at a discount because the market rate of interest was greater than the bonds’ interest rate.) After Jerry has amortized $1,800 of OID, he sells the bonds for $8,000. Jerry has a capital gain of $200 [$8,000 - ($6,000 cost + $1,800 OID amortization)]. The OID amortization rules prevent him from converting ordinary interest income into capital gain. Without the OID amortization, Jerry would have capital gain of $2,000 ($8,000 - $6,000 cost).

FRANCHISES, TRADEMARKS, AND TRADE NAMES

4. Sports Franchises. Professional sports franchises (e.g., the Detroit Tigers) are covered by
§ 1253.3 Player contracts are usually one of the major assets acquired with a sports franchise. These contracts last only for the time agreed to by the parties. By being classified as 197 intangibles, the player contracts and other intangible assets acquired in the purchase of the sports franchise are amortized over a 15-year period.

TAX CONSEQUENCES OF SHORT SALES

5. A short sale gain or loss is a capital gain or loss to the extent that the short sale property constitutes a capital asset of the taxpayer. The gain or loss is not recognized until the short sale is closed. Generally, the holding period of the short sale property is determined by how long the property used to close the short sale was held. However, if substantially identical property (e.g., other shares of the same stock) is held by the taxpayer, the short-term or long-term character of the short sale gain or loss may be affected.

· If substantially identical property has not been held for the long-term holding period on the short sale date, the short sale gain or loss is short term.

· If substantially identical property has been held for the long-term holding period on the short sale date, the short sale gain is long term if the substantially identical property is used to close the short sale and short term if it is not used to close the short sale.

· If substantially identical property has been held for the long-term holding period on the short sale date, the short sale loss is long term whether or not the substantially identical property is used to close the short sale.

· If substantially identical property is acquired after the short sale date and on or before the closing date, the short sale gain or loss is short term.

These rules are intended to prevent the conversion of short-term capital gains into long-term capital gains and long-term capital losses into short-term capital losses.

Disposition Rules for Short Sales against the Box. In a short sale against the box, the taxpayer either owns securities that are substantially identical to the securities sold short at the short sale date or acquires such securities before the closing date. To remove the taxpayer’s flexibility as to when the short sale gain must be reported, a constructive sale approach is used. If a calendar year taxpayer has not closed the short sale by delivering the short sale securities to the broker before January 31 of the year following the short sale, the short sale is deemed to have been closed on the earlier of two events.

· On the short sale date if the taxpayer owned substantially identical securities at that time.

· On the date during the year of the short sale that the taxpayer acquired substantially identical securities.

The basis of the shares in the deemed transfer of shares is used to compute the gain or loss on the short sale. Later, when shares are actually transferred to the broker to close the short sale, there may be a gain or loss because the shares transferred will have a basis equal to the short sale date price and the value at the actual short sale closing date may be different from the short sale date price.

Illustrations. The following examples illustrate the treatment of short sales and short sales against the box.

Example: On January 4, 2009, Donald purchases five shares of Osprey Corporation common stock for $100. On April 14, 2009, he engages in a short sale of five shares of the same stock for $150. On August 15, Donald closes the short sale by repaying the borrowed stock with the five shares purchased on January 4. Donald has a $50 short-term capital gain from the short sale, because he had not held substantially identical shares for the long-term holding period on the short sale date.

Example: Assume the same facts as in the previous example, except that Donald closes the short sale on January 28, 2010, by repaying the borrowed stock with five shares purchased on January 27, 2010, for $200. The stock used to close the short sale was not the property purchased on January 4, 2009, but since Donald held short-term property at the April 14, 2009 short sale date, the gain or loss from closing the short sale is short term. Donald has a $50 short-term capital loss ($200 cost of stock purchased on January 27, 2010 and a short sale selling price of $150).

Example: On January 18, 2008, Rita purchases 200 shares of Owl Corporation stock for $1,000. On November 11, 2009, she sells short for $1,300 200 shares of Owl Corporation stock that she borrows from her broker. On February 10, 2010, Rita closes the short sale by delivering the 200 shares of Owl stock that she had acquired in 2008. On that date, Owl stock had a market price of $3 per share.

Since Rita owned substantially identical stock on the date of the short sale and did not close the short sale before January 31, 2010, she is deemed to have closed the short sale on November 11, 2009 (the date of the short sale). On her 2009 tax return, she reports a $300 long-term capital gain ($1,300 short sale price - $1,000 basis). On February 10, 2010, Rita records a $700 short-term capital loss [$600 short sale closing date price (200 shares ´ $3 per share) - $1,300 basis], because the holding period of the shares used to close the short sale commences with the date of the short sale.

Example: Now assume that Rita did not own any Owl stock on the short sale date and acquired the 200 shares of Owl for $1,000 on December 12, 2009 (after the November 11, 2009 short sale date). The deemed closing of the short sale is December 12, 2009, because Rita held substantially identical shares at the end of 2009 and did not close the short sale before January 31, 2010. Her 2009 short sale gain is a short-term gain of $300 ($1,300 short sale price - $1,000 basis), and she still has a short-term capital loss of $700 on February 10, 2010.

CONCEPT SUMMARY

QUALIFIED DIVIDEND INCOME

6. Dividends paid from current or accumulated earnings and profits of domestic and certain foreign corporations are eligible to be taxed at the 0%/15% (5%/15% prior to 2008) rates if they are qualifying dividends. The question of which dividends constitute qualified dividend income is discussed more fully in Chapter 4. Here the discussion focuses on how the qualified dividend income is taxed.

After the net capital gain or loss has been determined, the qualified dividend income is added to the net long-term capital gain portion of the net capital gain and is taxed as 0%/15% gain. If there is a net capital loss, the net capital loss is still deductible for AGI up to $3,000 per year with the remainder of the loss (if any) carrying forward. In this case, the qualified dividend income is still eligible to be treated as 0%/15% gain in the alternative tax calculation (it is not offset by the net capital loss).

GOODWILL OR COVENANT NOT TO COMPETE?

7. When a business is being sold, one of the major decisions usually concerns whether a portion of the sales price is for goodwill. For the seller, goodwill generally represents the disposition of a capital asset. Goodwill has no basis and represents a residual portion of the selling price that cannot be allocated reasonably to the known assets. The amount of goodwill thus represents capital gain.

From a legal perspective, the buyer may prefer that the residual portion of the purchase price be allocated to a covenant not to compete (a promise that the seller will not compete against the buyer by conducting a business similar to the one that the buyer has purchased). Both purchased goodwill and a covenant not to compete are § 197 intangibles. Thus, both must be capitalized and can be amortized over a 15-year statutory period.

To the seller, a covenant produces ordinary income. Thus, the seller would prefer that the residual portion of the selling price be allocated to goodwill—a capital asset. If the buyer does not need the legal protection provided by a covenant, the buyer is neutral regarding whether the residual amount be allocated to a covenant or to goodwill. Since the seller would receive a tax advantage from labeling the residual amount as goodwill, the buyer should factor this into the negotiation of the purchase price.