Taxing A 5-Hour Energy Drink

 

I am skimming a decision from the Appeals Court for the District of Columbia. I am surprised that it is only 15 pages long, as it involves a gnarly intersection of partnership tax and the taxation of nonresident aliens.

Let’s talk about it.

In general, partnerships are not treated as a taxable entity. A partnership is a reporting entity; it reports income and expenses and then allocates the same to its partners for reporting on their tax returns. Mind you, this can get mind-numbing, as a partner in a partnership can itself be another partnership. Keep this going a few iterations and being a tax professional begins to lose its charm.

A partner will - again, in general - report the income as if the partner received the income directly rather than through the partnership. If it was ordinary income or capital gain to the partnership, it will likewise be ordinary income or capital gain to the partner.

Let’s introduce a nonresident alien partner.

We have another tranche of tax law to wade through.

A nonresident alien is fancy talk for someone who does not live in the United States. That person could still have U.S. income and U.S. tax, though.

How?

Well, through a partnership, for example.

Say the partnership operates exclusively in the United States. A nonresident alien generally pays tax on income received from sources within the United States. Let’s look at one type of income: business income. We will get to nonbusiness income in a moment.

The tax Code wants to know if that business income is “effectively connected” with a U.S. trade or business.

The business income in our example is effectively connected, as the partnership operates exclusively in the United States. One cannot be any more connected than that.

The partnership will issue Schedules K-1 to its partners, including its nonresident alien partner who will file a U.S. nonresident tax return (Form 1040-NR).

Question: Will any nonbusiness income on the K-1 be reportable on the nonresident?

The tax Code separates business and nonbusiness income because they might be taxed differently for nonresidents. Nonbusiness income can go from having 30% withholding at the source (think dividends) to not being taxed at all (think most types of interest income).

What if the Schedule K-1 reports capital gains?

I normally think of capital gains as nonbusiness income.

But they do not have to be.

There is a test:

If the income is derived from assets used or held for use in the conduct of an effectively connected business – and business activities were a material factor in generating the income  – then the income will taxable to a nonresident alien.

Think capital gain from the sale of farm assets. Held for use in farming? Check. Material factor in generating farm income? Check. This capital gain will be taxable to a nonresident.

Forget the K-1. Say that the nonresident alien sold his/her partnership interest altogether.

On first impression, I am not seeing capital gain from the sale of the partnership interest (rather than assets inside the partnership) as meeting the “held for use/material factor” test.

Problem: partnership taxation has something called the “hot asset” rule. The purpose is to disallow capital gains treatment to the extent any gain is attributable to certain no-no assets – that is, the “hot assets.”

An example of a hot asset is inventory.

The Code does not want the partnership to load up on inventory with substantial markup and then have a partner sell his/her partnership interest rather than wait for the partnership to sell the inventory. This would be a flip between ordinary and capital gain income, and the IRS is having none of it.

Question: have you ever had a 5-hour Energy drink?

That is the company we are talking about today.

Indu Rawat was a 29.2% partner in a Michigan partnership which sells 5-hour Energy. She sold her stake in 2008 for $438 million.

I can only wish.

At the time of sale, the company had inventory with a cost of $6.4 million and a sales price of $22.4 million. Her slice of the profit pending in that inventory was $6.5 million.

A hot asset.

The IRS wanted tax on the $6.5 million.

Mind you, Indu Rawat did not sell inventory. She sold a partnership interest in a business that owned inventory. That would be enough to catch you or me, but could the hot asset rule catch a nonresident alien?

The Tax Court agreed with the IRS that the hot asset gain was taxable to her.

That decision was appealed.

The Appeals Court reversed the Tax Court.

The Appeals Court noted that there had to be a taxable gain before the hot asset rule could kick in. The rule recharacterizes – but does not create – capital gain.

This capital gain does not appear to meet the “held for use/material factor test” we talked about above. You can recharacterize all you want, but when you start at zero, the amount recharacterized cannot be more than zero.

Indu Rawat won on Appeal.

By the way, tax law in this area has changed since Rawat’s sale. New law would tax Rawat on her share of effectively connected gain as if the partnership had sold all its assets at fair market value. Congress made a statement, and that statement was “no more.”

Our case this time was  Indu Rawat v Commissioner, No 23-1142 (D.C. Cir. July 23, 2024).

Section 1244 Stock: An Exception To Capital Loss

I was looking at a case involving Section 1244 stock.

I remember studying Section 1244 in school. On first impression one could have expected it a common quiver in tax practice. It has not been.

What sets up the issue is the limitation on the use of capital losses. An easy example of a capital asset is stock. Buy and sell stock and you have capital gains and losses (exempting those people who are dealers in stocks and securities). You then net capital gains against capital losses.

·      If the result is net capital gain, you pay tax.

·      If the result is net capital loss, the Code allows you to deduct up to $3,000 of net loss against your other types of income.

QUESTION: What if the net loss is sizeable – say $60 grand?

ANSWER: The Code will allow you to offset that loss dollar-for-dollar against any future capital gains.

QUESTION: What if the experience left a mark? You have no intention of buying and selling stocks ever again.

ANSWER: Then we are back to the $3,000 per year.

Mind you, that $3,000 entered the Code back in 1978. A 1978 dollar is comparable to $4.82 in 2024 dollars. Just to keep pace, the capital loss limit should have been cumulatively raised to $14,460 by now. It has not, of course, and is a classroom example of structural anti-taxpayer Code bias. 

Section 1244 is there to relieve some of the pressure. It is specialized, however, and geared toward small businesses.

What it does is allow one to deduct (up to) $50 grand ($100 grand for joint returns) as an ordinary loss rather than a capital loss.

There is a downside: to get there likely means the business failed. Still, it is something. Better $50 grand at one time than $3 grand over umpteen years.

What does it take to qualify?

(1)  First, there must be stock. Being a partner in a partnership will not get you there. This means that you organized as a corporation. Mind you, it can be either a C or an S corporation, but it must be a corporation.

(2)  The corporation must be organized in the United States.

(3)  The total amount of capital contributions to the corporation (stock, additional capital, whatever) must not exceed $1 million. If you are the unfortunate who puts the number above $1 million, then some of your stock will qualify and some will not.

(4)  The capital contribution must be in cash or other property (excluding stocks and securities). This would exclude stock issued as compensation, for example.

(5)  You must be the original owner of the stock. There are minimal exceptions (such as inheriting the stock because someone died).

(6)  You must be an individual. Corporations, trusts, estates, trustees in bankruptcy and so on do not qualify.

(7)  There used to be a prohibition on preferred stock, but that went out in 1985. I suppose there could still be instances involving 1984-or-earlier preferred stock, but it would be a dwindling crowd.

(8)  The company must meet a gross receipts test the year the stock is issued.

a.    For the preceding five years (or life of the company, if less), more than 50% of aggregate gross receipts must be from active business operations.

b.    Another way to say this is that passive income (think interest, dividends, rents, royalties, sales or exchanges of stocks and securities) had better be less than 50% of aggregate gross receipts. This Code section is not for mutual funds.

An interesting feature is that no formal election is required. Corporate records do not need to reference Section 1244.  Board minutes do not need to approve Section 1244.  Nothing needs to go with the tax return. The corporation must however retain records to prove the stock’s qualification under Section 1244.

And therein can be the rub.

Let’s look at the Ushio case.

In 2009 David Ushio acquired $50,000 of common stock in PCHG.

PCHG in turn had invested in LifeGrid Solutions LLC (LGS), which in turn was seeking to acquire rights in certain alternative energy technology.

PCHG never had revenues. It ceased business in 2012 and was administratively dissolved by South Carolina in 2013.

The IRS selected the Ushio’s joint individual return for 2012 and 2013. The audit had nothing to do with Section 1244, but the IRS saw the PCHG transaction and allowed a $3,000 capital loss in 2012.

Mind you, the Ushios had not claimed a deduction for PCHG stock on either their 2012 or 2013 return.

Mr. Ushio said “wait a minute …”

Some quick tax research and Ushio came back with a counter: he wanted a $50,000 ordinary loss deduction rather than the puny $3,000 capital loss. He insisted PCHG qualified under Section 1244.

The IRS had an easy response: prove it.

Ushio was at a disadvantage. He had invested in PCHG, but he did not have inside records, assuming those records even existed.

He presented a document listing “Cash Input” and “Deferred Pay,” noting that the deferred amount was never paid. Sure enough, the amount paid-in was less than $1 million.

The IRS looked at the document and noted there was no date. They wanted some provenance for the document - who prepared it? what records were used? could it be corroborated?

No, no and no.

In addition, PCHG never reported any gross receipts. It is hard to prove more-than-50% of something when that something is stuck at zero. Ushio pushed back: PCHG was to be an operating company via its investment in LGS.

The IRS could do this all day: prove it.

Ushio could not.

Meaning there was no Section 1244 stock.

Our case this time was Ushio v Commissioner, T.C. Summary Opinion 2021-27.

 

Using A Fancy Trust Without An Advisor

 

I am a fan of charitable remainder trusts. These are (sometimes) also referred to as split interest trusts.

What is an interest in a trust and how can you split it?

In a generic situation, an interest in a trust is straightforward:

(1) Someone may have a right to or is otherwise permitted to receive an income distribution from a trust. This is what it sounds like: if the trust has income, then someone might receive all, some or none of it – depending on what the trust is designed to do. This person is referred to as an “income” beneficiary.

(2) When there are no more income beneficiaries, the trust will likely terminate. Any assets remaining in the trust will go to the remaining beneficiaries. This person(s) is referred to as a “remainder” beneficiary.

Sounds complicated, but it does not have to be. Let me give you an example.

(1)  I set up a trust.

(2)  My wife has exclusive rights to the income for the rest of her life. My wife is the income beneficiary.

(3)  Upon my wife’s death, the assets remaining in the trust go to our kids. Our kids are the remainder beneficiaries.

(4)  BTW the above set-up is referred to as a “family trust” in the literature.

Back to it: what is a split interest trust?

Easy. Make one of those interests a 501(c)(3) charity.

If the charity is the income beneficiary, we are likely talking a charitable lead trust.

If the charity is the remainder beneficiary, then we are likely talking a charitable remainder trust.

Let’s focus solely on a charity as a remainder interest.

You want to donate to your alma mater – Michigan, let’s say. You are not made of money, so you want to donate when you pass away, just in case you need the money in life. One way is to include the University of Michigan in your will.

Another way would be to form a split interest trust, with Michigan as the charity. You retain all the income for life, and whatever is left over goes to Michigan when you pass away. In truth, I would bet a box of donuts that Michigan would even help you with setting up the trust, as they have a personal stake in the matter.

That’s it. You have a CRT.

Oh, one more thing.

You also have a charitable donation.

Of course, you say. You have a donation when you die, as that is when the remaining trust assets go to Michigan.

No, no. You have a donation when the trust is formed, even though Michigan will not see the money (hopefully) for (many) years.

Why? Because that is the way the tax law is written. Mind you, there is crazy math involved in calculating the charitable deduction.

Let’s look at the Furrer case.

The Furrers were farmers. They formed two CRATs, one in 2015 and another in 2016.

COMMENT: A CRAT is a flavor of CRT. Let’s leave it alone for this discussion.

In 2015 they transferred 100,000 bushels of corn and 10,000 bushels of soybeans to the CRAT. The CRAT bought an annuity from a life insurance company, the distributions from which were in turn used to pay the Fullers their annuity from the CRT.

They did the same thing with the 2016 CRT, but we’ll look only at the 2015 CRT. The tax issue is the same in both trusts.

The CRT is an oddball trust, as it delays - but does not eliminate – taxable income and paying taxes. Instead, the income beneficiary pays taxes as distributions are received.

EXAMPLE: Say the trust is funded with stock, which it then sells at a $500,000 gain. The annual distribution to the income beneficiary is $100,000. The taxes on the $500,000 gain will be spread over 5 years, as the income beneficiary receives $100,000 annually.

Think of a CRT as an installment sale and you get the idea.

OK, we know that the Furrers had income coming their way.

Next question: what was the amount of the charitable contribution?

Look at this tangle of words:

§ 170 Charitable, etc., contributions and gifts.

           (e)  Certain contributions of ordinary income and capital gain property.

(1)  General rule.

The amount of any charitable contribution of property otherwise taken into account under this section shall be reduced by the sum of-

(A)  the amount of gain which would not have been long-term capital gain (determined without regard to section 1221(b)(3)) if the property contributed had been sold by the taxpayer at its fair market value (determined at the time of such contribution),

This incoherence is sometimes referred to as the “reduce to basis” rule.

The Code will generally allow a charitable contribution for the fair market value of donated property. Say you bought Apple stock in 1997. Your cost (that is, your “basis”) in the stock is minimal, whereas the stock is now worth a fortune. Will the Code allow you to deduct what Apple stock is worth, even though your actual cost in the stock is (maybe) a dime on the dollar?

Yep, with some exceptions.

Exceptions like what?

Like the above “amount of gain which would not have been long-term capital gain.”

Not a problem with Apple stock, as that thing is capital gain all day long.

How about crops to a farmer?

Not so much. Crops to a farmer are like yoga pants to Lululemon. That is inventory - ordinary income in nerdspeak - as what a farmer ordinarily does is raise and sell crops. No capital gain there.

Meaning?

The Furrers must reduce their charitable deduction by the amount of income that would not be capital gain.

Well, we just said that none of the crop income would be capital gain.

I see income minus (the same) income = zero.

There is no charitable deduction.

Worst … case … scenario.

I found myself wondering how the tax planning blew up.

In July 2015, after seeing an advertisement in a farming magazine, petitioners formed the Donald & Rita Furrer Charitable Remainder Annuity Trust of 2015 (CRAT I), of which their son was named trustee. The trust instrument designated petitioners as life beneficiaries and three eligible section 501(c)(3) charities as remaindermen.”

The Furrers should have used a tax advisor. A pro may not be necessary for routine circumstances: a couple of W-2s, a little interest income, interest expense and taxes on a mortgage, for example.

This was not that. This was a charitable remainder trust, something that many accountants might not see throughout a career.

Yep, don’t do this.

Our case this time is Furrer v Commissioner, T.C. Memo 2022-100.

The Obamacare Subsidy Cliff

 

I am looking at a case involving the premium tax credit.

We are talking about the Affordable Care Act, also known as Obamacare.

Obamacare uses mathematical tripwires in its definitions. That is not surprising, as one must define “affordable,” determine a “subsidy,” and - for our discussion – calculate a subsidy phase-out. Affordable is defined as cost remaining below a certain percentage of household income. Think of someone with extremely high income - Elon Musk, for example. I anticipate that just about everything is affordable to him.

COMMENT: Technically the subsidy is referred to as the “advance premium tax credit.” For brevity, we will call it the subsidy.

There is a particular calculation, however, that is brutal. It is referred to as the “cliff,” and you do not want to be anywhere near it.

One approaches the cliff by receiving the subsidy. Let’s say that your premium would be $1,400 monthly but based on expected income you qualify for a subsidy of $1,000. Based on those numbers your out-of-pocket cost would be $400 a month.

Notice that I used the word “expected.” When determining your 2022 subsidy, for example, you would use your 2022 income. That creates a problem, as you will not know your 2022 income until 2023, when you file your tax return. A rational alternative would be to use the prior year’s (that is, 2021’s) income, but that was a bridge too far for Congress. Instead, you are to estimate your 2022 income. What if you estimate too high or too low? There would be an accounting (that is, a “true up”) when you file your 2022 tax return.

I get it. If you guessed too high, you should have been entitled to a larger subsidy. That true-up would go on your return and increase your refund. Good times.

What if it went the other way, however? You guessed too low and should have received a smaller subsidy. Again, the true-up would go on your tax return. It would reduce your refund. You might even owe. Bad times.

Let’s introduce another concept.

ACA posited that health insurance was affordable if one made enough money. While a priori truth, that generalization was unworkable. “Enough money” was defined as 400% of the poverty level.

Below 400% one could receive a subsidy (of some amount). Above 400% one would receive no subsidy.

Let’s recap:

(1)  One could receive a subsidy if one’s income was below 400% of the poverty level.

(2)  One guessed one’s income when the subsidy amount was initially determined.

(3)  One would true-up the subsidy when filing one’s tax return.

Let’s set the trap:

(1)  You estimated your income too low and received a subsidy.

(2)  Your actual income was above 400% of the poverty level.

(3)  You therefore were not entitled to any subsidy.

Trap: you must repay the excess subsidy.

That 400% - as you can guess – is the cliff we mentioned earlier.

Let’s look at the Powell case.

Robert Powell and Svetlana Iakovenko (the Powells) received a subsidy for 2017.

They also claimed a long-term capital loss deduction of $123,822.

Taking that big loss into account, they thought they were entitled to an additional subsidy of $636.

Problem.

Capital losses do not work that way. Capital losses are allowed to offset capital losses dollar-for-dollar. Once that happens, capital losses can only offset another $3,000 of other income.

COMMENT: That $3,000 limit has been in the tax Code since before I started college. Considering that I am close to 40 years of practice, that number is laughably obsolete.

The IRS caught the error and sent the Powells a notice.

The IRS notice increased their income to over 400% and resulted in a subsidy overpayment of $17,652. The IRS wanted to know how the Powells preferred to repay that amount.

The Powells – understandably stunned – played one of the best gambits I have ever read. Let’s read the instructions to the tax form:

We then turn to the text of Schedule D, line 21, for the 2017 tax year, which states as follows:

         If line 16 is a loss, enter ... the smaller of:

·      The loss on line 16 or

·      $3,000

So?

The Powells pointed out that a loss of $123,822 is (technically) smaller than a loss of $3,000. Following the literal instructions, they were entitled to the $123,822 loss.

It is an incorrect reading, of course, and the Powells did not have a chance of winning. Still, the thinking is so outside-the-box that I give them kudos.

Yep, the Powells went over the cliff. It hurt.

Note that the Powell’s year was 2017.

Let’s go forward.

The American Rescue Plan eliminated any subsidy repayment for 2020.

COVID year. I understand.

The subsidy was reinstated for 2021 and 2022, but there was a twist. The cliff was replaced with a gradual slope; that is, the subsidy would decline as income increased. Yes, you would have to repay, but it would not be that in-your-face 100% repayment because you hit the cliff.

Makes sense.

What about 2023?

Let’s go to new tax law. The ironically named Inflation Reduction Act extended the slope-versus-cliff relief through 2025.

OK.

Congress of course just kicked the can down the road, as the cliff will return in 2026.

Our case this time was Robert Lester Powell and Svetlana Alekseevna Iakovenko v Commissioner, T.C. Summary Opinion 2002-19.

Qualifying For Stock Loss Under Section 1244

 

I am looking at a case having to do with Section 1244 stock.

And I am thinking: it has been a while since I have seen a Section 1244.

Mind you; that is not a bad thing, as Section 1244 requires losses. The most recent corporate exit I have seen was a very sweet rollup of a professional practice for approximately $10 million. No loss = no Section 1244.

Let’s set up the issue.

We are talking about corporations. They can be either C or S corporations, but this is a corporate tax thing. BTW there is a technical issue with Section 1244 and S corporations, but let’s skip it for this discussion.

The corporation has gone out of business.

A corporation has stock. When the corporation goes out of business, that stock is worthless. This means that the shareholder has incurred a loss on that stock. If he/she acquired the stock for $5,000, then there is a loss of $5,000 when the corporation closes.

Next: that loss is – unless something else kicks-in – a capital loss.

Capital losses offset capital gains dollar-for-dollar.

Let’s say taxpayer has no capital gains.

Capital losses are then allowed to offset (up to) $3,000 of other income.

It will take this person a couple of years to use up that $5,000 loss.

Section 1244 is a pressure valve, of sorts, in this situation.

A shareholder can claim up to $50,000 of ordinary loss ($100,000 if married filing joint) upon the sale, liquidation or worthlessness of stock if:

 

(1)  The stock is be either common or preferred, voting or nonvoting, but stock acquired via convertible securities will not qualify;

(2)  The stock was initially issued to an individual or partnership;

(3)  The initial capitalization of the corporation did not exceed $1 million;

(4)  The initial capitalization was done with stock and property (other than stock and securities);

(5)  Only persons acquiring stock directly from the corporation will qualify; and

(6)  For the five tax years preceding the loss, the corporation received more than 50% of its aggregate gross receipts from sources other than interest, dividends, rents, royalties, and the sale or exchange of stocks or securities.

The advantage is that the ordinary loss can offset other income and will probably be used right away, as opposed to that $3,000 year-by-year capital loss thing.

Mind you, there can also be part Section 1244/part capital loss.

Say a married couple lost $130,000 on the bankruptcy of their corporation.

Seems to me you have:

                      Section 1244                     100,000

                      Capital loss                         30,000

Let’s look at the Ushio case.

Mr Ushio acquired the stock of PCHG, a South Carolina corporation, for $50,000.

PCHG intended to was looking to get involved with alternative energy. It made agreements with a Nevada company and other efforts, but nothing ever came of it. PCHG folded in 2012.

Ushio claimed a $50,000 Section 1244 loss.

The IRS denied it.

There were a couple of reasons:

(1)  Mr. Ushio still had to prove that $1 million limit.

 

The issue here was the number at the corporate level: was the corporation initially capitalized (for cash and property other than stock and securities) for $1 million or less? If yes, then all the issued stock qualified. If no, the corporation must identify which shares qualified and which shares did not.

        

It is possible that PCHG was not even close to $1 million in capitalization, in which a copy of its initial tax return might be sufficient. Alternatively, PCHG’s attorney or accountant might/should have records to document this requirement.        

 

(2)  PCHG never had gross receipts.

 

This means that PHGC could not meet the 50% of gross receipts requirement, as it had no gross receipts at all.

 

Note that opening a savings or money market account would not have helped. PCHG might then have had gross receipts, but 100% of its gross receipts would have been interest income – the wrong kind of income.

Mr Ushio did not have a Section 1244 loss, as PCHG did not qualify due to the gross-receipts requirement. You cannot do percentages off a denominator of zero.

My first thought when reviewing the case was the long odds of the IRS even looking at the return, much less disallowing a Section 1244 loss on said return. That is not what happened. The IRS was initially looking at other areas of the Ushio return. In fact, Ushio had not even claimed a capital loss – much less a Section 1244 loss – on the original return. The issue came up during the examination, making it easy for the IRS to say “prove it.”

How would a tax advisor deal with this gross-receipts hurdle in practice?

Well, the initial and planned activity of PCHG failed to produce any revenues. It seems to me that an advisor would look to parachute-in another activity that would produce some – any – revenues, in order to meet the Section 1244 requirement. The tax Code wants to see an operating business, and it uses gross receipts as its screen for operations.

Could the IRS challenge such effort as failing to rise to the level of a trade or business or otherwise lacking economic substance? Well, yes, but consider the alternative: a slam-dunk failure to qualify under Section 1244.

Our case this time was Ushio v Commissioner, TC Summary Opinion 2021-27.

Income, Clearly Realized

 

What is income?

Believe it or not, there is a line of cases over decades developing the tax concept of income.

Some instances are clear-cut: if you receive wages or salary, for example, then you have income.

Some instances may not be so clear-cut.

For example, let’s say that you receive a stock dividend. The company has a good year, and you receive – as an example – 1 additional share for every 5 shares you own.  

Do you have income?

Let’s talk this out. Let’s say that the company is worth $25 million before the stock dividend and has 1 million shares outstanding. After the stock dividend it will have 1.2 million shares outstanding. What are those extra 200,000 shares worth?

This is an actual case – Eisner v Macomber - that the Supreme Court decided in 1920. Congress had changed the tax law to tax this stock dividend, and someone (Myrtle Macomber) brought suit arguing that the law was unconstitutional.

Her argument:

·      The company was worth $25 million before the dividend

·      The company was worth $25 million after the dividend

·      She may have more shares, but her shares represent the same proportional ownership of the company.

·      She did not have any more money than she had before.

She had a point.

The Bureau of Internal Revenue (that is, the IRS) came at it from a different angle:

There was income – the income generated by the company.  The company was “distributing” said income by means of a stock dividend.

The Court reasoned that one could have income from labor or from capital. The first did not apply, and it could find nothing to support the second had happened to Mrs Macomber.

The Court decided that she did not have income.

Let’s continue.

The Glenshaw Glass Company sued the Hartford-Empire Company for damages stemming from fraud and for treble damages for business injury.

The two companies settled, and Hartford was paid approximately $325 thousand in punitive damages.

Glenshaw had no intention of paying tax on that $325 grand. That money was not paid because of labor or because of capital. It was paid because of injury to its business - returning Glenshaw to where it should have been if not for the tortious behavior.

Not labor, not capital. Glenshaw was draped all over that earlier Eisner v Macomber decision.

But the IRS had a point – in fact, 325 thousand points.

Here is the Court:

Here we have instances of undeniable accessions to wealth, clearly realized, and over which taxpayers have complete dominion. The mere fact that the payments were extracted from the wrongdoers as punishment for unlawful conduct cannot detract from their character as taxable income.”

The Court levered away from its earlier labor/capital impasse and clarified income to be:

·      An increase in wealth

·      Clearly realized, and

·      Over which one has (temporary or permanent) discretion or control

In time Glenshaw has come to mean that everything is taxable unless Congress says that it is not taxable. While not mathematically precise, it is precise enough for day-to-day use.

I have a question, though.

At a conceptual level, what are the limits on the “clearly realized” requirement?

I get it when someone receive a paycheck.

I also get it when someone sells a mutual fund.

But what if your IRA has gone up in value, but you haven’t taken a distribution?

Or the house in which you raised your family has appreciated in value?

Do you have an increase in wealth?

Do you have discretion or control over said increase in wealth?

Do you have “income” that Congress can tax under Glenshaw?

ProShares Bitcoin ETF and Futures Taxation

 

This week something happened that made me think of a friend who passed away last year.

I remember him laboring me on the benefits of CBD oil and the need to invest in Bitcoin.

When he and I last left it (before COVID last year), Bitcoin was around $10 grand. It is over $60 grand presently.

Missed the boat and the harbor on that one.

This past week ProShares came out with a Bitcoin ETF (BITO). I read that it tripped the billion-dollar mark after two or three days of trading.

With that level of market acceptance, I suspect we will see a number of these in the near future.

This ETF does not hold Bitcoin itself (whatever that means). It instead will hold futures in Bitcoin.

Let’s talk about the taxation of futures.

First, what are futures and what purpose do they serve?

Let’s say that you are The Hershey Company and you want to lock-in prices for next year’s cacao and sugar. These commodities are a significant part of your costs of production, and you want to have some control over the price you will pay. You are a buyer of futures commodity contracts – in cacao and sugar – locking in volume, price and date of delivery.

Whereas you do not own the cacao and sugar yet, if their price goes up, you would have made a profit on the contract. The reverse is true, of course, if the price goes down. Granted, the price swing on the futures contract will likely be different than the swing in spot price for the commodity, as there is the element of time in the contract.  

That said, there is always someone looking to make a profit. Problem: if commodity traders had to actually receive or deliver the commodity, few people would do it. Solution: separate the contract from actual product delivery.  The contract can then be bought and sold until the delivery date; the buyers and sellers just settle-up any price swings between them upon sale.

It would be also nice to have a market that coordinates these trades. There are several, including the Chicago Mercantile Exchange. The Exchange allows the contracts to be standardized, which in turn allows traders to buy and sell them without any intent to ever receive or deliver the underlying commodity.

The ETF we are discussing (BITO) will not own any Bitcoin itself. It will instead buy and sell futures contracts in Bitcoin.

Bitcoin futures are considered “Section 1256 contracts” in tax law.

Section 1256 brings its own idiosyncrasies:

* There is a mark-to-market rule.

The term “mark” to an accountant means that something is reset to its market price. In the context of BITO, it means that – if you own it at year-end – it will be considered to have been sold. Mind you, it was not actually sold, but there will be a “let’s pretend” calculation of gain or loss as if it had been sold. Why would you care? You would care if the price went up and you had a taxable gain. You will soon be writing a very real check to the IRS for that “let’s pretend” mark.

* The 60/40 rule

This rule is nonintuitive. Whether you have capital gains or losses, those gains and losses are deemed to 60% long-term and 40% short term. The tax Code (with exceptions we will ignore for this discussion) does not care how long you actually owned the contracts. Whether one day or two years, the gain or loss will be deemed 60/40.

Mind you, this is not necessarily a bad result as long-term capital gains have favorable tax rates.

* Special carryback rule

If you have an overall Section 1256 loss for the year, you can carryback that loss to the preceding three years. There is a restriction, though: the carryback can only offset Section 1256 gains in those prior years.

This is a narrow rule, by the way. I do not remember ever seeing this carryback, and I have been in tax practice for over 35 years.

I do not know but I anticipate that BITO will be sending out Schedules K-1 rather than 1099s to its investors, as these ETFs tend to be structured as limited partnerships. That does not overly concern me, but some accountants are wary as the K-1s can be trickier to handle and sometimes present undesired state tax considerations.

Similar to my response to Bitcoin investing in early 2020, I will likely pass on this opportunity. There are unusual considerations in futures trading – google “contango” and “backwardation” for example – that you may want to look into when considering the investment.