2. 2
The Big Picture (slide 1 of 3)
• Maurice has come to you for tax advice regarding his
investments.
– He inherited $500,000 from his Uncle Joe and, following
the advice of a financial adviser, made the following
investments 9 months ago.
• $5,000 for 100 shares of Eagle Company stock.
• $50,000 for a 50% interest in a patent that Kevin, an
unemployed inventor, had obtained for a special
battery he had developed to power ‘‘green’’ cars.
– To date, Kevin has been unable to market the battery to an auto
manufacturer or supplier.
3. 3
The Big Picture (slide 2 of 3)
• $95,000 to purchase a franchise from Orange, Inc.
• $200,000 in the stock of Purple, a publicly held bank
that does not pay dividends.
– At one time, the stock had appreciated to $300,000, but
now it is worth only $210,000.
• Maurice is considering unloading this stock.
• $50,000 in tax-exempt bonds.
– The interest rate is only 3%.
– Maurice is considering moving this money into taxable
bonds that pay 3.5%.
• $100,000 for a 10% limited partnership interest in a
real estate development.
– Lots in the development are selling well.
4. 4
The Big Picture (slide 3 of 3)
• Maurice read an article that talked about the
beneficial tax rates for capital assets and dividends.
– He really liked the part about ‘‘costless’’ capital gains,
although he did not understand it.
• Maurice has retained his job as a toll booth operator
at the municipal airport.
– His annual compensation is $35,000.
• Respond to Maurice’s inquiries.
– Read the chapter and formulate your response.
5. 5
Taxation of Capital
Gains and Losses
• Capital gains and losses must be separated
from other types of gains and losses for two
reasons:
– Long-term capital gains may be taxed at a lower
rate than ordinary gains
– A net capital loss is only deductible up to $3,000
per year
6. 6
Proper Classification of
Gains and Losses
• Depends on three characteristics:
– The tax status of the property
• Capital asset, §1231 asset, or ordinary asset
– The manner of the property’s disposition
• By sale, exchange, casualty, theft, or condemnation
– The holding period of the property
• Short term and long term
7. 7
Capital Assets
(slide 1 of 6)
• §1221 defines capital assets as everything
except:
– Inventory (stock in trade)
– Notes and accounts receivables acquired from the
sale of inventory or performance of services
– Realty and depreciable property used in a trade or
business (§1231 assets)
8. 8
Capital Assets
(slide 2 of 6)
• §1221 defines capital assets as everything except
(cont’d):
– Certain copyrights; literary, musical, or artistic
compositions; or letters, memoranda, or similar property
• Taxpayers may elect to treat a sale or exchange of certain musical
compositions or copyrights in musical works as the disposition of a
capital asset
– Certain publications of U.S. government
– Supplies of a type regularly used or consumed in the
ordinary course of a business
9. 9
Capital Assets
(slide 3 of 6)
• Thus, capital assets usually include:
– Assets held for investment (e.g., stocks, bonds,
land)
– Personal use assets (e.g., residence, car)
– Miscellaneous assets selected by Congress
10. 10
Capital Assets
(slide 4 of 6)
• Dealers in securities
– In general, securities are the inventory of securities
dealers, thus ordinary assets
– However, a dealer can identify securities as an
investment and receive capital gain treatment
• Clear identification must be made on the day of
acquisition
11. 11
Capital Assets
(slide 5 of 6)
• Real property subdivided for sale
– Taxpayer may receive capital gain treatment on the
subdivision of real estate if the following requirements are
met:
• Taxpayer is not a corporation
• Taxpayer is not a real estate dealer
• No substantial improvements made to the lots
• Taxpayer held the lots for at least 5 years
– Capital gain treatment occurs until the year in which the
6th lot is sold
• Then up to 5% of the revenue from lot sales is potential ordinary
income
• That potential ordinary income is offset by any selling expenses
from the lot sales
12. 12
Capital Assets
(slide 6 of 6)
• Nonbusiness bad debts
– A nonbusiness bad debt is treated as a short-term
capital loss in the year it becomes completely
worthless
• Even if outstanding for more than one year
13. 13
Sale or Exchange
• Recognition of capital gains and losses
generally requires a sale or exchange of assets
• Sale or exchange is not defined in the Code
• There are some exceptions to the sale or
exchange requirement
14. 14
Sale or Exchange–Worthless Securities and
§ 1244 Stock (slide 1 of 2)
• A security that becomes worthless creates a
deductible capital loss without being sold or
exchanged
– The Code sets an artificial sale date for the securities on the
last day of the year in which worthlessness occurs
• Section 1244 allows an ordinary deduction on
disposition of stock at a loss
– The stock must be that of a small business company
– The ordinary deduction is limited to $50,000 ($100,000 for
married individuals filing jointly) per year
15. 15
Sale or Exchange–Worthless Securities
(slide 2 of 2)
• Worthless securities example:
– Calendar year taxpayer purchased stock on
December 5, 2013
– The stock becomes worthless on April 5, 2014
– The loss is deemed to have occurred on December
31, 2014
• The result is a long-term capital loss
16. 16
Sale or Exchange
Retirement of Corporate Obligations
• Collection of the redemption value of
corporate obligations (e.g., bonds payable) is
treated as a sale or exchange and may result in
a capital gain or loss
– OID amortization increases basis and reduces gain
on disposition or retirement
17. 17
Sale or Exchange–Options
(slide 1 of 2)
• For the grantee of the option, if the property subject
to the option is (or would be) a capital asset in the
hands of the grantee
– Sale of an option results in capital gain or loss
– Lapse of an option is considered a sale or exchange
resulting in a capital loss
• For the grantor of an option, the lapse creates
– Short-term capital gain, if the option was on stocks,
securities, commodities or commodity futures
– Otherwise, ordinary income
18. 18
Sale or Exchange–Options
(slide 2 of 2)
• Exercise of an option by a grantee
– Increases the gain (or reduces the loss) to the
grantor from the sale of the property
– Gain is ordinary or capital depending on the tax
status of the property
• Grantee adds the cost of the option to the basis
of the property acquired
19. 19
The Big Picture - Example 13
Options (slide 1 of 4)
• Return to the facts of The Big Picture on p. 16-1.
• On February 1, 2014, Maurice purchases 100 shares
of Eagle Company stock for $5,000.
– On April 1, 2014, he writes a call option on the stock,
giving the grantee the right to buy the stock for $6,000
during the following six-month period.
– Maurice (the grantor) receives a call premium of $500 for
writing the call.
20. 20
The Big Picture - Example 13
Options (slide 2 of 4)
• Return to the facts of The Big Picture on p. 16-1.
• If the call is exercised by the grantee on August 1,
2014, Maurice has $1,500 of short-term capital gain
from the sale of the stock.
– $6,000 + $500 − $5,000 = $1,500
• The grantee has a $6,500 basis for the stock.
– $500 option premium + $6,000 purchase price
21. 21
The Big Picture - Example 13
Options (slide 3 of 4)
• Return to the facts of The Big Picture on p. 16-1.
• Assume that Maurice decides to sell his stock prior to exercise
for $6,000 and enters into a closing transaction by purchasing
a call on 100 shares of Eagle Company stock for $5,000.
– Because the Eagle stock is selling for $6,000, Maurice must pay a call
premium of $1,000.
• He recognizes a $500 short-term capital loss on the closing
transaction.
– $1,000 (call premium paid) − $500 (call premium received)
• On the actual sale of the Eagle stock, Maurice has a short-term
capital gain of $1,000
– $6,000 (selling price) − $5,000 (cost)
22. 22
The Big Picture - Example 13
Options (slide 4 of 4)
• Return to the facts of The Big Picture on p. 16-1.
• Assume that the original option expired unexercised.
– Maurice has a $500 short-term capital gain equal
to the call premium received for writing the option.
• This gain is not recognized until the option expires.
– The grantee has a loss from expiration of the
option.
• The nature of the loss will depend upon whether the
option was a capital asset or an ordinary asset.
23. 23
Sale or Exchange–Patents
• When all substantial rights to a patent are
transferred by a holder to another, the transfer
produces long-term capital gain or loss
– The holder of a patent must be an individual,
usually the creator, or an individual who purchases
the patent from the creator before the patented
invention is reduced to practice
24. 24
The Big Picture - Example 14
Patents (slide 1 of 2)
• Return to the facts of The Big Picture on p. 16-1.
• Kevin transfers his 50% rights in the battery
patent to the Green Battery Co.
– In exchange, he receives $1 million plus $.50 for
each battery sold.
25. 25
The Big Picture - Example 14
Patents (slide 2 of 2)
• Assuming Kevin has transferred all substantial rights,
Kevin automatically has a long-term capital gain.
– Both the $1 million lump-sum payment and the $.50 per
battery royalty qualify (less his basis in the patent).
– Kevin also had an automatic long-term capital gain when
he sold 50% of his rights in the patent to Maurice.
• Whether Maurice gets long-term capital gain
treatment on the transfer to Green Battery will depend
on whether he is a holder (see the discussion below
and Example 15).
26. 26
The Big Picture - Example 15
Holder Of A Patent (slide 1 of 2)
• Return to the facts of The Big Picture on p. 16-1 and
continuing with the facts of Example 14
• Kevin is clearly a holder of the patent
– He is the inventor and was not an employee when
he invented the battery.
27. 27
The Big Picture - Example 15
Holder Of A Patent (slide 2 of 2)
• When Maurice purchased a 50% interest in the patent, he
became a holder if the patent had not yet been reduced to
practice.
– Since the patent was not being manufactured at the time of the
purchase, it had not been reduced to practice.
• Consequently, Maurice is also a holder.
– He has an automatic long-term capital gain or loss if he transfers his
50% interest to Green Battery Co.
• Maurice’s basis for his share of the patent is $50,000, and his
share of the proceeds is $1 million plus $.50 for each battery
sold.
• Thus, Maurice has a long-term capital gain even though he has
not held his interest in the patent for more than one year.
28. 28
Sale or Exchange–Franchises, Trademarks, and
Trade Names (slide 1 of 3)
• The licensing of franchises, trade names,
trademarks, and other intangibles is generally
not considered a sale or exchange of a capital
asset
– Therefore, ordinary income results to transferor
• Exception: Capital gain (loss) may result if the
transferor does not retain any significant power, right,
or continuing interest
29. 29
Sale or Exchange–Franchises, Trademarks, and
Trade Names (slide 2 of 3)
• Significant powers, rights, or continuing
interests include:
– Control over assignment
– Quality of products and services
– Sale or advertising of other products or services
– The right to require that substantially all supplies
and equipment be purchased from the transferor
– The right to terminate the franchise at will, and
– The right to substantial contingent payments
30. 30
Sale or Exchange–Franchises, Trademarks, and
Trade Names (slide 3 of 3)
• When the transferor retains a significant power, right,
or continuing interest, the transferee’s noncontingent
payments are ordinary income to the transferor
– The franchisee capitalizes the payments and amortizes
them over 15 years
• Whether the transferor retains a significant power,
right, or continuing interest, contingent payments are
ordinary income for the franchisor and an ordinary
deduction for the franchisee
31. 31
The Big Picture - Example 16
Sale of Franchise
• Return to the facts of The Big Picture on p. 16-1
• Maurice sells for $210,000 to Mauve, Inc., the
franchise purchased from Orange, Inc., nine months
ago.
– The $210,000 received by Maurice is not contingent, and
all significant powers, rights, and continuing interests are
transferred.
– The $115,000 gain ($210,000 proceeds − $95,000 adjusted
basis) is a short-term capital gain because Maurice has held
the franchise for only nine months.
32. 32
Sale or Exchange
Lease Cancellation Payments
• Lessee treatment
– Treated as received in exchange for underlying leased
property
• Capital gain results if asset leased was a capital asset (e.g., personal
use )
• Ordinary income results if asset leased was an ordinary asset (e.g.,
used in lessee’s business and lease has existed for one year or less
when canceled)
• Lease could be a § 1231 asset if the property is used in lessee’s
trade or business and the lease has existed for > a year when it is
canceled
• Lessor treatment
– Payments received are ordinary income
• Considered to be in lieu of rental payments
33. 33
Holding Period
(slide 1 of 3)
• Short-term
– Asset held for 1 year or less
• Long-term
– Asset held for more than 1 year
• Holding period starts on the day after the
property is acquired and includes the day of
disposition
34. 34
Holding Period
(slide 2 of 3)
• Nontaxable Exchanges
– Holding period of property received includes holding period of former
asset if a capital or §1231 asset
• Transactions involving a carryover basis
– Former owner’s holding period tacks on to present owner’s holding
period if a nontaxable transaction and basis carries over
• Certain disallowed loss transactions
– Under several Code provisions, realized losses are disallowed.
– When a loss is disallowed, there is no carryover of holding period.
• e.g., Related party losses, sale or exchange of personal use assets
• Inherited property is always treated as long term no matter
how long it is held by the heir
35. 35
Holding Period
(slide 3 of 3)
• Short sales
– Taxpayer sells borrowed securities and then repays the
lender with substantially identical securities
– Gain or loss is not recognized until the short sale is closed
– Generally, the holding period for a short sale is determined
by how long the property used for repayment is held
• If substantially identical property (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
36. 36
The Big Picture - Example 21
Holding Period
• Return to the facts of The Big Picture on p. 16-1
• Assume that Maurice purchased the Purple
stock on January 15, 2013.
– If he sells it on January 16, 2014, Maurice’s
holding period is more than one year.
– If instead Maurice sells the stock on January 15,
2014, the holding period is exactly one year, and
the gain or loss is short term.
37. 37
Tax Treatment of Capital
Gains and Losses (slide 1 of 7)
• Noncorporate taxpayers
– Capital gains and losses must be netted by holding
period
• Short-term capital gains and losses are netted
• Long-term capital gains and losses are netted
• If possible, long-term gains or losses are then netted
with short-term gains or losses
– If the result is a loss:
– The capital loss deduction is limited to a maximum deduction
of $3,000
– Unused amounts retain their character and carryforward
indefinitely
38. 38
Tax Treatment of Capital
Gains and Losses (slide 2 of 7)
• Noncorporate taxpayers (cont’d)
– If net from capital transactions is a gain, tax
treatment depends on holding period
• Short-term (assets held 12 months or less)
– Taxed at ordinary income tax rates
• Long-term (assets held more than 12 months)
– An alternative tax calculation is available using preferential
tax rates
39. 39
Tax Treatment of Capital
Gains and Losses (slide 3 of 7)
• Noncorporate taxpayers (cont’d)
– Net long-term capital gain is eligible for one or
more of five alternative tax rates: 0%, 15%, 20%,
25%, and 28%
• The 25% rate applies to unrecaptured §1250 gain and is
related to gain from disposition of §1231 assets
• The 28% rate applies to collectibles
• The 0%/15%/20% rates apply to any remaining net
long-term capital gain
– Under the American Taxpayer Relief Act of 2012, the 20% rate
applies beginning in 2013 when the taxpayer’s regular tax
bracket is 39.6%
40. 40
Tax Treatment of Capital
Gains and Losses (slide 4 of 7)
Income Layers for Alternative Tax on Capital Gain Computation
41. 41
Tax Treatment of Capital
Gains and Losses (slide 5 of 7)
• Collectibles, even though they are held long term, are
subject to a 28% alternative tax rate
• Collectibles include any:
– Work of art
– Rug or antique
– Metal or gem
– Stamp
– Alcoholic beverage
– Historical objects (documents, clothes, etc.)
– Most coins
42. 42
Tax Treatment of Capital
Gains and Losses (slide 6 of 7)
• Qualified dividend income paid from current or acc.
E & P is eligible for the 0%/15%/20% long-term
capital gain rates
– After determining net capital gain or loss, qualified
dividend income is added to the net long-term capital gain
portion of the net capital gain and is taxed as 0%/15%/20%
gain
– If there is a net capital loss, it is still deductible for AGI
• Limited to $3,000 per year with the remainder of the loss carrying
over
• In this case, the qualified dividend income is still eligible to be
treated as 0%/15%/20% gain in the alternative tax calculation
– It is not offset by the net capital loss
43. 43
Tax Treatment of Capital
Gains and Losses (slide 7 of 7)
• The alternative tax on net capital gain applies only if
taxable income includes some net long-term capital
gain
– Net capital gain may be made up of various rate layers
• For each layer, compare the regular tax rate with the alternative tax
rate on that portion of the net capital gain
– The layers are taxed in the following order:
• 25% gain, 28% gain, the 0% portion of the 0%/15%/20% gain, the
15% portion of the 0%/15%/20% gain, and then the 20% portion of
the 0%/15%/20% gain.
• This allows the taxpayer to receive the lower of the
regular tax or the alternative tax on each layer of net
capital gain
44. 44
The Big Picture - Example 37
Qualified Dividend Income
• Return to the facts of The Big Picture on p. 16-1
• After holding the Purple stock for 10 months,
Maurice receives $350 of dividends.
– If Purple is a domestic or qualifying foreign
corporation, these are qualified dividends eligible
for the 0%/15%/20% tax rate.
45. 45
Tax Treatment of Capital
Gains and Losses - Corporate Taxpayers
• Differences in corporate capital treatment
– There is a NCG alternative tax rate of 35 %
• Since the max corporate tax rate is 35 %, the alternative
tax is not beneficial
– Net capital losses can only offset capital gains (i.e.,
no $3,000 deduction in excess of capital gains)
– Net capital losses are carried back 3 years and
carried forward 5 years as short-term losses
46. 46
Refocus On The Big Picture (slide 1 of 3)
• Maurice is correct that certain capital gains and
dividends are eligible for preferential tax treatment
– Tax rates of 0%, 15%, or 20% may apply rather than
regular tax rates.
• You then discuss the potential tax consequences of
each of his investments.
– Purple stock and Eagle stock- To qualify for the beneficial
tax rate, the holding period for the stock must be longer
than one year.
• From a tax perspective, Maurice should retain his stock
investments for at least an additional three months and a day.
• To be eligible for the ‘‘costless’’ capital gains, his taxable income
should not exceed $36,900 for 2014.
• The dividends received on the Purple stock are “qualified
dividends” eligible for the 0%/15%/20% alternative tax rate.
47. 47
Refocus On The Big Picture (slide 2 of 3)
• Patent - Since he is a ‘‘holder’’ of the patent, it will
qualify for the beneficial capital gain rate regardless
of the holding period if the patent should produce
income in excess of his $50,000 investment.
– However, if he loses money on the investment, he will be
able to deduct only $3,000 of the loss per year (assuming
no other capital gains).
• Tax-exempt bonds.
– The after-tax return on the taxable bonds would be less
than the 3% on the tax-exempt bonds.
– In addition, the interest on the taxable bonds would
increase his taxable income, possibly moving it out of the
desired 15% marginal tax rate into the 25% marginal tax
rate.
48. 48
Refocus On The Big Picture (slide 3 of 3)
• Franchise rights.
– The franchise rights purchased from Orange, Inc., probably require the
payment of a franchise fee based upon sales in the franchise business.
– Maurice should either start such a business or sell the franchise rights.
• Partnership interest.
– The tax treatment related to his partnership interest depends on whether
he is reporting
• His share of profits or losses
– Ordinary income or ordinary loss, or
• Recognized gain or loss from the sale of his partnership interest
– Capital gain or capital loss.
• You conclude your tax advice to Maurice by telling him that
his investments should make economic sense.
– There are no 100% tax rates.
– For example, disposing of the bank stock in the current market could
be the wise thing to do.
