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Gross Income

  • 651. 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) unless specifically excluded by the Internal Revenue Code. The most common items included in gross income are salary, fees, commissions, business profits, interest and dividends, rents, alimony received prior to 2019, and gains from the sale of property – but not the mere return of capital.1

      Some of the specifically excluded items from gross income that are received tax-free by an individual taxpayer are: gifts and inheritances;2 gain (subject to limitation) from the sale of a personal residence (see Q 7846); at least 50 percent of gain (subject to limitation) from the sale of certain qualified small business stock held for more than five years (see Q 7521 and Q 7522); interest on certain state, city or other political subdivision bonds (see Q 7660); Social Security and railroad retirement benefits (subject to limitations – see Q ); veterans’ benefits in any form specifically covering personal injuries or sickness from active service in the armed forces (but not including retirement pay);3 Workers’ Compensation Act payments (subject to limitation);4 death proceeds of life insurance;5 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;6 contributions to a “Medicare Advantage MSA” by the Department of Health and Human Services;7 exempt-interest dividends from mutual funds (see Q 7932); interest on certain U.S. savings bonds purchased after 1989 and used to pay higher education expenses (within limits – see Q 7686);8 contributions paid by an employer to Health Savings Accounts;9 distributions from Health Savings Accounts used to pay qualified medical expenses;10 and federal subsidies for prescription drug plans.11


      1 .IRC Sec. 61(a).

      2 .IRC Sec. 102.

      3 .IRC Sec. 104(a)(4).

      4 .IRC Sec. 104(a)(1).

      5 .IRC Secs. 101(a), but see IRC Sec. 101(j) as to EOLI.

      6 .IRC Sec. 137.

      7 .IRC Sec. 138.

      8 .See IRC Sec. 135.

      9 .IRC Sec. 106(d).

      10 .IRC Sec. 223(f)(1).

      11 .IRC Sec. 139A.

  • 652. How are the commissions, including insurance 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, or whether the taxpayer has a contingent obligation to repay them. Commissions on insurance premiums, however, are subject to special rules. (See Q 3519 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 the agent reports depends upon the contract with the company. In a technical advice memorandum, the IRS determined that cash advances made to an insurance sales agent were income in the year of receipt where there was no unconditional obligation to repay the advances, and any excess in advances over commissions earned were recoverable by the insurance company only by crediting earned commissions and renewals against such advances.1 This position is consistent with other IRS rulings and prior case law.2

      On the other hand, if the drawing account is a loan repayable by the agent (or upon which the agent remains personally liable) if the agent leaves, only commissions actually received are treated as income. To this point, in a Tax Court memorandum opinion, the Tax Court held that advance commissions received by an agent that were repayable on demand, bore interest and were secured by earned commissions, as well as by the personal liability of the agent, were not taxable compensation to the agent.3

      Conversely, in several Tax Court cases, a salesman discharged from the obligation to repay advance commissions received in previous years was required to recognize income in the year of discharge.4 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 received gross income at the time any pre-existing deficiency in her commission account was offset even though she never received an actual check.5

      If the drawing account is guaranteed compensation, however, it is treated as income in addition to any commissions received in excess of the amount that offsets the agent’s draw. This rule applies even if the agent uses the accrual method of accounting.6

      Since 2005, deferral of commissions, including renewals, will generally create “nonqualified deferred compensation” and be subject to IRC Section 409A and other prior rules governing deferral of income, unless the plan qualifies for a 409A exemption or an exception, like the short-term deferral exception. Section 409A treats categorizes commissions as either sales commissions or  investment commissions.7

      Other Tax Court Cases Involving Insurance Commissions. In several cases, the Tax Court held that amounts received by a district manager upon termination of his agency contract is ordinary income rather than capital gain 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.8 The Tax Court also held that termination payments received by a retiring insurance agent who did not own any company assets he returned to the insurance company was not capital gain from a sale of capital assets, but instead were ordinary income.9

      Finally, from the prospective of the insurance company, for cash advances treated as loans, 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 from (1) deducting a cash advance in the taxable year paid to the agent to (2) deducting a cash advance in the taxable year earned by the agent is set forth in Revenue Procedure 2001-24.10


      1 .TAM 9519002.

      2 .See Rev. Rul. 83-12, 1983-1 CB 99 (also released as IR 82-150); Geo. Blood Enter., Inc. v. Comm., TC Memo 1976-102. (See Rev. Proc. 83-4, 1983-1 CB 577 for guidance in complying with these rules.)

      3 .Gales v. Comm., TC Memo 1999-27; acq. in result, 1999-2 CB 3.

      4 .McIsaac v. Comm., TC Memo 1989-307. See also Cox v. Comm., TC Memo 1996-241; Diers v. Comm., TC Memo 2003-229.

      5 .Harper v. Comm., TC Summary Op. 2007-133.

      6 .See Rev. Rul. 75-541, 1975-2 CB 195; Security Assoc. Agency Ins. Corp. v. Comm., TC Memo 1987-317; Dennis v. Comm., TC Memo 1997-275.

      7.Treas. Reg. § 1.409A-2 (b)(12)(i)-(iii); also see 1.409A-2(b)(9), Examples 7-9.

      7 .Clark v. Comm., TC Memo 1994-278. See also Farnsworth v. Comm., TC Memo 2002-29, Parker v. Comm., TC Memo 2002-305.

      8 .Baker v. Comm., 118 TC 452 (2002), aff’d, 2003 U.S. App. LEXIS 15509 (7th Cir. 2003). See also Trantina. v. United States, 512 F. 3d 567, 2008-1 USTC ¶50,138 (9th Cir. 2008).

      9 .2001-10 IRB 788.

  • 653. How are the commissions on policies purchased by an insurance agent taxed?

    • Commissions on a life insurance policy purchased by the agent, on the agent’s own life or on the life of another, are taxable to the agent as ordinary income. Such commissions are considered compensation, not a reduction in the cost of the underlying policy.1 This rule applies to brokers as well as to other life insurance salesmen.2


      1 .Ostheimer v. U.S., 264 F.2d 789 (3rd Cir. 1959); Rev. Rul. 55-273, 1955-1 CB 221.

      2 .Comm. v. Minzer, 279 F.2d 338 (5th Cir. 1960); Bailey v. Comm., 41 TC 663 (1964); Mensik v. Comm., 37 TC 703 (1962), aff’d, 328 F.2d 147 (7th Cir. 1964).

  • 654. How are an insurance agent’s commissions taxed if they are received pursuant to a deferred income plan?

    • If, before retiring, an insurance agent enters into an irrevocable agreement with the insurance company to receive renewal commissions in level installments over a period of years, only the amount of the annual installment will be taxable each year – instead of the full amount of commissions as they accrue.1 Although the Oates case and Revenue Ruling 60-31 concern deferred compensation arrangements during retirement years, the same principle should apply if the agent, during the agent’s lifetime, elects a level commission arrangement for payments after death.

      In a private letter ruling, 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.2 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.3 However, the IRS did not acquiesce to the Olmsted decision.4

      However, since 2005 Code section 409A specifically covers commission compensation of agents as employees and brokers as independent contractors (both of which are referred to as “service providers”) if there is a “deferral of compensation” with the creation of a “nonqualified deferred compensation plan” (even for a single individual).  Although additive constructive receipt income tax law that does not replace prior income law and doctrines, Section 409A requires nearly all mandatory and voluntary deferral arrangements for commissions to comply with both the Section 409A written form and operational requirements to achieve and defer income taxation of commissions and other compensation connected to the sale and placement of life insurance and other investments.

      Under the regulations to Section 409A, the initial elections to defer such compensation must specifically be made irrevocable prior to January 1 of the calendar year in which bona fide sales/renewal commissions are earned in the case of sales commissions.  In the case of investment commissions based upon the value of assets under management, an irrevocable initial election must be made prior to January 1 of the calendar year in which the date for each 12-month measuring period begins.5


      1 .Comm. v. Oates, 207 F.2d 711 (7th Cir. 1953); Rev. Rul. 60-31, 1960-1 CB 174; Let. Ruls. 9540033, 9245015.

      2 .Let. Rul. 9609011.

      3 .Comm. v. Olmsted Inc. Life Agency, 35 TC 429 (1960), aff’d, 304 F.2d 16 (8th Cir. 1962).

      4 .Non-acq., 1961-2 CB 6.

      5.See specifically, Treas. Reg. §§ 1.409A-2(a)(12)(i)-(iii), and 1.409A-2(b)(9), Examples 7-9.  See Keels v. Comm., TC Memo  2020-25 (Feb. 19, 2020) in which the deferred compensation plan of State Farm Insurance Company for deferred commissions  forms part of the basis of the opinion on a broker’s disputed  tax liability.  Also see generally IRC Sec. 409A and the regulations thereto.

  • 655. What are the tax consequences if an insurance agent sells or assigns the agent’s right to receive renewal commissions?

    • Assignment of renewal commissions. If the agent assigns the right to renewal commissions as a gift, they are included in the agent’s gross income as they are received by the donee (who does not report them as gross income).1 In a Tax Court memorandum decision, the Tax Court held that an insurance agent was taxable on his commission income despite assigning it to his S corporation. The Tax Court noted that the agent was the true earner of the income and made no valid assignment of the employment agreement with the insurance company to the S corporation.2 In Zaal, a 1998 memorandum decision, the Tax Court held that an agent’s transfer of the right to receive renewal commissions was not valid for tax purposes because it was essentially an anticipatory assignment of income rather than a sale of property. Citing Helvering v. Eubank, the Tax Court held that the commission income was taxable to the agent rather than the corporation to which the rights were assigned.3

      Sale of renewal commissions. In a bona fide, arm’s length sale of a right to receive renewal commissions, as to the selling agent, the Second Circuit held that the consideration for the sale of the right to renewal commissions is ordinary income to the agent in the year received.4 In Cotlow, the Second Circuit also determined that the renewals received by the purchaser are tax-free until the purchaser recovers the cost (i.e., the amount of consideration paid). Thereafter, the excess is fully taxable as it is received. Other cases have held that the purchaser must amortize the cost. In other words, the purchaser can recover (tax-free) that portion of the purchase price that the renewals received in that year bear to the total anticipated renewals.5


      1 .Helvering v. Eubank, 311 U.S. 122 (1940); Hall v. U.S., 242 F.2d 412 (7th Cir. 1957).

      2 .Isom v. Comm., TC Memo 1995-383.

      3 .Zaal v. Comm., TC Memo 1998-222. See also McManus v. Comm., TC Summ. Op. 2006-68.

      4 .Cotlow v. Comm., 228 F.2d 186 (2nd Cir. 1955); see also, Turner v. Comm., 38 TC 304 (1962).

      5 .Latendresse v. Comm., 243 F.2d 577 (7th Cir. 1957); Hill v. Comm., 3 BTA 761 (1926).

  • 656. How are commissions received after the death of the insurance agent taxed?

    • Renewal commissions payable after the death of an insurance agent are “income in respect of a decedent” for income tax purposes. Additionally, the value of the right to the commissions is includable in the agent’s gross estate for estate tax purposes. As income in respect of a decedent, the renewal commissions are taxable to the ultimate recipient of the commissions (e.g., the agent’s estate, beneficiaries, or a trust) in the year in which they are received.1 However, the person who reports such commissions as income is entitled to an income tax deduction (an itemized deduction) for the portion of federal estate taxes and generation-skipping transfer taxes attributable to their inclusion in the decedent’s gross estate. 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 death.2

      If prior to receipt of the renewal commissions, the recipient sells or otherwise disposes of the right to commissions, all income is accelerated as the recipient must include the entire fair market value of the right to the commissions in the year of sale or other disposition (e.g., the recipient gifted the right to another person). On the other hand, if the recipient dies prior to receiving the commissions, the fair market value of the right to commissions will not be included on the final income tax return. In that case, the person who receives the income right from the second decedent by will or inheritance must include such commissions in gross income (as income in respect of a decedent) as they are received.3


      1 .Latendresse v. Comm., above; Est. of Goldstein v. Comm., 33 TC 1032 (1960), aff’d, 340 F.2d 24 (2nd Cir. 1965); Est. of Remington v. Comm., 9 TC 99 (1947).

      2 .Latendresse v. Comm., above.

      3 .IRC Sec. 691(a); Treas. Reg. §1.691(a)-1.

  • 657. How are an insurance agent’s commissions treated for self-employment tax purposes?

    • Termination payments (as distinguished from renewal commissions) received by a former insurance salesman are not treated as 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 one-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).1 For termination payments that do not fall within the above description, earlier case law and rulings may apply.

      In a Tax Court summary opinion, the Tax Court distinguished the self-employment tax treatment of renewal commissions as compared to termination payments. In that case, the Tax Court found that the insurance agent’s renewal commissions were self-employment income subject to self-employment tax because they were tied to the quantity and quality of the taxpayer’s prior labor, and derived from the carrying on of the taxpayer’s business as an independent insurance agent.2 Additionally, the Tax Court held that the insurance agent was subject to self-employment tax because he was not a statutory employee, but instead engaged in a self-employed trade or business activity.3

      Finally, the Eleventh Circuit held that the FICA statute requiring an employer to pay a portion of the FICA tax on behalf of an “employee” 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.4


      1 .IRC Sec. 1402(k).

      2 .Gilbert v. Comm., TC Summary Op. 2005-176.

      3 .Byer v. Comm., TC Summary Op. 2006-125.

      4 .See McDonald v. Southern Farm Bureau Life Ins. Co., 291 F. 3d 718, 2002 U.S. App. LEXIS 9110 (11th Cir. 2002).

  • 658. What is an insurance premium rebate?

    • An insurance premium rebate, which is illegal in most states, is a transaction in which a life insurance agent returns all or a portion of a commission to the purchaser, or simply pays the policy’s first-year premium without contribution from the purchaser. The transaction is economically feasible to the insurance agent because 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. As a result, the purchaser may ultimately receive free or less expensive life insurance coverage. See Q 659 and Q 660 for the tax consequences of insurance premium rebating to the insurance agent and the purchaser, respectively.

  • 659. What are the income tax consequences of rebating premiums to the insurance agent?

    • As discussed in Q 658, most 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 agent’s state of residence, as well as the position of the circuit court in that jurisdiction. In Alex v. Commissioner,a Ninth Circuit case, an insurance agent in a state with an anti-rebating statute rebated a portion of his premium to the purchaser. The agent argued that the rebated portion of the premium was not taxable because it was in essence a price adjustment (as if the cost of the insurance had been adjusted downward by the amount of the rebate).1 The Ninth Circuit disagreed with this characterization and held that the entire commission earned was taxable.2

      Furthermore, in the Alex case, the court decided that the agent could not offset his commission income by deducting the rebate as a business expense deduction because the Code disallows deductions for illegal payments that under a generally enforced state law subjects the payor to a criminal penalty or loss of a license or privilege to engage in a trade or business.3 Compare that decision to Custis v. Commissioner, a Tax Court memorandum opinion in which the Tax Court allowed an agent to deduct the amount of rebated premiums as a business expense under IRC Section 162 because his state’s anti-rebating statute was not generally enforced.

      Conversely, in a Tenth Circuit decision, the court held that an insurance agent who expressly waived the right to receive basis commissions from clients was not required to include the waived commission in gross income. In this case, the agent was obligated to pay only the net premiums due on the policies he sold to the insurance company. By waiving his right to basic commissions that were never paid to him, the agent was not in actual or constructive receipt of those commissions that would result in taxable income. However, the court did not address the issue of whether the agent’s waiver violated the state’s anti-rebating laws.4


      1 .Alex v. Comm., 628 F.2d 1222 (9th Cir. 1980), aff’g 70 TC 322 (1978).

      2 .See also Custis v. Comm., TC Memo 1982-296; Kreisberg v. Comm., TC Memo 1979-420.

      3 .IRC Sec. 162(c)(2). See Kreisberg, above.

      4 .Worden v. Comm., 2 F.3d 359 (10th Cir. 1993).

  • 660. What are the income tax consequences of rebating premiums for 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.1 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.

      In a technical advice memorandum, the Service 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.2 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 4019 and Q 3944 for an explanation of how employer-provided life insurance coverage is valued under split dollar arrangements and qualified retirement plans, respectively.)


      1 .Woodbury v. U.S., 93-2 USTC ¶50,528 (D. N.D. 1993), aff’d per curium, 27 F.3d 572 (8th Cir. 1994); Wentz v. Comm., 105 TC 1 (1995); Haderlie v. Comm., TC Memo 1997-525.

      2 .TAMs 9214008, 9214007, 9214006.

  • 661. 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 (such as trust income) of most children under age 19 (age 24, if the child is a full-time student), different rules may apply.

      Prior to 2018 and after 2019, the unearned income taxable to the child generally is taxed at the parents’ marginal rate when it exceeds $2,100 (in 2015 to 2021, as adjusted for inflation).[1]


      Planning Point: Taxpayers had the option of applying a different set of rules in 2018 and 2019 under the 2017 tax reform legislation. If the election was made, earned income of minors would be taxed according to the individual income tax rates prescribed for single filers,[2] and unearned income of minors would be taxed according to the applicable tax bracket that would apply if the income was that of a trust or estate (for both income that is subject to ordinary income tax rates and in determining the capital gains rate that will apply if long-term capital gains treatment is appropriate).[3]


      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.[4] 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.[5]

      The 2017 Tax Act aimed to simplify the treatment of unearned income of minors by applying the tax rates that apply to trusts and estates to this income. The SECURE Act[6] repealed this rule for tax years beginning in 2020 and thereafter. For 2018 and 2019, taxpayers have the option of electing which set of rules to apply, and may apply for refunds if appropriate for these tax years.

      [1].      Rev. Proc. 2015-53, Rev. Proc. 2016-55.

      [2].      IRC Sec. 1(j)(4)(B).

      [3].      IRC Sec. 1(j)(4).

      [4].     Rev. Rul. 56-484, 1956-2 CB 23; Rev. Rul. 59-357, 1959-2 CB 212.

      [5].     IRC Sec. 677(b).

      [6].      PL 116-94, 133 Stat. 2534 (12-20-2019)

  • 662. When is a cash basis taxpayer deemed to “receive” income? How is the doctrine of constructive receipt applicable?

    • Generally, the inclusion of gross income (the first step in the computation of taxable income) must be determined pursuant to the taxpayer’s regular method of accounting.1 The two commonly accepted methods of accounting are the cash basis method and the accrual basis method.2

      Under the cash basis method, all items deemed to be gross income (whether in the form of cash, property or services) are generally includable in the taxable year in which they are actually or constructively received.3 For example, a taxpayer who receives a salary check in December of 2021 but does not cash or deposit it until January of 2022 must include the wage income in 2021. However, this would not be the result if substantial restrictions on the check made it non-negotiable in 2021 or if the issuer was insolvent.4

      For cash method taxpayers, the doctrine of constructive receipt of income goes beyond actual receipt of income in determining the timing of the inclusion of items of gross income. Under this doctrine, a cash method taxpayer is deemed to receive (and, thus must report) income that has been credited to the account or set apart in such a way that the taxpayer has free access to it at any time – even though it has not actually been received by the taxpayer.5 For example, a cash method taxpayer must report the interest credited to a bank savings account in the taxable year it is credited without regard to whether the interest is withdrawn or remains in the account (see Q 7916). On the other hand, in a private letter ruling, the IRS ruled that a cash method employee who has the mere right to make an election to cash out future vacation leave under the employer’s plan would not be in constructive receipt of the vacation pay if the employee chose not to make such an election.6

      Significantly, constructive receipt occurs only if the taxpayer’s control or access to 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 , or subject to a substantial risk of forfeiture. If a taxpayer’s access to income is subject to the surrender of a valuable right, such as the surrender of a death benefit in order to be entitled to income generated by the underlying insurance policy, the Tax Court has held that the constructive receipt doctrine does not apply under those circumstances.7


      1 .IRC Sec. 446(a).

      2 .IRC Sec. 446(c).

      3 .IRC Sec. 451(a); Treas. Reg. §1.451-2(a).

      4 .Chapman v. Comm., TC Memo 1982-307; Baxter v. Comm., 816 F.2d 493 (9th Cir. 1987), rev’g in part TC Memo 1985-378.

      5 .Treas. Reg. §1.451-2. See, e.g., Visco v. Comm, 281 F.3d 101 (3rd Cir. 2002), aff’g, TC Memo 2000-77 (employment-related dispute).

      6 .Let. Rul. 200130015.

      7 .See Cohen v. Comm., 39 TC 1055 (1963); Nesbitt v. Commissioner, 43 TC 629 (1965).

  • 663. What is a below-market loan?

    • 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.1 IRC Section 7872 essentially recasts a below-market loan into two phantom transactions (meaning they are deemed to have occurred, even though they did not actually occur): (1) an arm’s-length loan pursuant to which the borrower paid (but obviously did not) interest to the lender at the applicable federal rate, and (2) a deemed transfer of interest to the lender that the borrower should have (but did not) pay to the lender (“imputed transfer”).2

      In other words, in (1) above, it is as if the lender transferred to the borrower the amount of interest at the applicable federal rate the borrower should have paid the lender less the amount of interest, if any, that the borrower actually did pay to the lender; and, subsequently in (2) above, the borrower is treated as paying the amount of foregone interest to the lender as interest. Generally, the lender must report the imputed transfer of the foregone interest as interest income. Conversely, depending on the relationship of the borrower to the lender, the borrower may or may not be required to include the foregone interest in income (for example if the loan was between family members the foregone interest that is deemed to have been received may be treated as an income tax-free gift). Additionally, depending on the nature of the borrowing, the borrower may or may not be entitled to an interest deduction (i.e., used the borrowed funds for a vacation).

      Example: On January 1, 2021, Samuel loans Asher $100,000 (interest free) payable on demand. As of December 31, 2021, the loan remains outstanding. Obviously, because the loan bears no interest, it is a below-market loan. Since the 2019 blended annual rate is 0.13 percent (see below), IRC Section 7872 would recast the below-market loan into the following two transactions:

      1) For tax year 2021, Samuel is deemed to have transferred $130 of foregone interest to Asher, the amount Asher should have paid Samuel (even though this not actually occur).

      2) In turn, Asher is deemed to have paid the $130 of foregone interest to Samuel (even though Asher did not make the payment).

      The tax consequences of below-market loans are determined by the relationship between the borrower and the lender. Therefore, in the example above, (1) if Asher and Samuel were brothers, the below-market low could be a gift loan (see Q 664) or (2) if Asher was an employee of Samuel, a compensation-related loan or (3) if Asher is a shareholder of Samuel, Inc., a corporation-shareholder loan (see Q 665).

      Additionally, the below-market loan rules apply to any below-market loan 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. (see Q 666.)3 Provided one of the principal purposes is not tax avoidance, the Service has determined that the interest arrangements of certain loans (including, for example, tax-exempt obligations, obligations of the U.S. government, life insurance policy loans, etc.) will not be considered as having a significant effect on the federal tax liability of either party.4

      Applicable Federal Rate

      The applicable federal rates are determined by the Secretary on a monthly basis.5 The Secretary may by regulation permit a rate that is lower than the applicable federal rate to be used under certain circumstances.6

      The applicable federal rate (see Q 676) for demand loans is the short-term rate (compounded semiannually) in effect during the period for which the foregone interest is being determined.7 If the principal amount of such loan remains outstanding for the entire calendar year, foregone interest is equal to the excess of the “blended annual rate” for that calendar year multiplied by the outstanding principal balance 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.8

      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.9

      Reporting Requirements

      In any taxable year in which the lender has imputed interest income or the borrower either has imputed income and/or claims an interest deduction in the amount of the forgone interest, he or she is required to:

      •attach a statement to Form 1040 explaining that it relates to the amount includable in income or is deductible by reason of the below-market loan rules;

      •provide the name, address and taxpayer identification number of the other party; and

      • specify the amount includable or deductible and the mathematical assumptions and method used in computing the amounts imputed.10


      1 .IRC Secs. 7872(e), 7872(f).

      2 .Prop. Treas. Reg. §1.7872-1(a).

      3 .IRC Sec. 7872(c)(1).

      4 .Temp. Treas. Reg. §1.7872-5T.

      5 .IRC Sec. 1274(d).

      6 .See IRC Sec. 1274(d)(1)(D).

      7 .IRC Sec. 7872(f)(2)(B).

      8 .Rev. Rul. 86-17, 1986-1 CB 377.

      9 .IRC Sec. 7872(f)(2)(A).

      10 .Prop. Treas. Reg. §1.7872-11(g).

  • 664. What are the income tax consequences of a below-market loan that is categorized as a gift loan?

    • A below-market demand or term loan is a gift loan if the foregone interest is in the nature of a gift.1 As explained in Q 663, the foregone interest is the difference between the interest computed at the applicable federal rate that should have been paid to the lender less the amount actually paid by the borrower to the lender. In two phantom transactions, (1) the lender is deemed to have transferred the foregone interest to the borrower that (2) the borrower is deemed to have paid the lender as interest.2 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.3 So, if the borrower and lender were related (i.e., parent and child) or had a close personal relationship (friends), the amount of foregone interest the borrower “received” from the lender is a gift. Since gifts are not included in the gross income of the recipient, it is not taxable. Conversely, the foregone interest the borrower is deemed to have transferred to the lender is taxable to the lender as interest income. Finally, the deductibility of the deemed interest payment to the lender depends on how the borrower used the borrowed funds (similar to the way the deductibility of interest actually paid is determined, i.e., whether the borrowed funds were used for personal or investment purposes, etc. – see Q 8030).

      Example: On January 1, 2021, Samuel loans his brother, Asher $100,000 (interest free) payable on demand. Asher uses the borrowed funds to buy investment securities. As of December 31, 2021, the loan remains outstanding. Obviously, because the loan bears no interest, it is a below-market loan. Since the 2021 blended annual rate is 2.42 percent (see Q 663), IRC Section 7872 would recast the below-market loan into the following two transactions:

      For tax year 2021, Samuel is deemed to have transferred $130 of foregone interest to Asher, the amount Asher should have paid Samuel (even though this did not actually occur).

      In turn, Asher is deemed to have paid the $130 of foregone interest to Samuel (even though Asher did not make the payment).

      Since Asher is Samuel’s brother, Samuel is deemed to have made a gift of the foregone interest to Asher (not taxable to Asher). In turn, the interest payment of that same amount Asher is deemed to have made to Samuel is interest income to Samuel (taxable to Samuel). Finally, because Asher used the borrowed funds to purchase investment securities, the phantom interest payment Asher is deemed to have made is deductible as investment interest.4

      There is, however, a de minimis exception to the application of the below-market gift loan rules. In other words, if applicable, there would be no tax consequences to either the borrower or the lender. Pursuant to this de minimis exception, the 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 (spouses are treated as one person) does not exceed $10,000. This de minimis exception, however, does not apply to any gift loan directly attributable to the purchase or carrying of income-producing assets.5

      Also applicable to below-market gift loans, a special rule limits the amount of the lender’s taxable interest 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 the 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.6 Net investment income equals the excess of investment income that includes, for this purpose, any amount that would be includable as interest on all deferred payment obligations were the original issue discount over investment expenses. Deferred payment obligations include annuities, U.S. savings bonds and short-term obligations. In any year in which the borrower’s net investment income does not exceed $1,000, the amount of the lender’s taxable interest income will be treated as zero.7

      For the gift tax consequences of below-market gift loans, see Q 892.


      1 .IRC Sec. 7872(f)(3).

      2 .IRC Sec. 7872(a)(1).

      3 .IRC Sec. 7872(a)(2); Prop. Treas. Reg. §1.7872-6(b)(3).

      4 .IRC Sec. 163(d).

      5 .IRC Sec. 7872(c)(2); Prop. Treas. Reg. §1.7872-8(b)(3).

      6 .IRC Sec. 7872(d)(1); Prop. Treas. Reg. §§1.7872-8(c), 1.7872-11(g)(3).

      7 .IRC Sec. 7872(d)(1)(E).

  • 665. What are the income tax consequences of a below-market loan treated as a compensation-related loan or a corporation-shareholder loan?

    • 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 in the case of gift loans (see Q 664).1 In a compensation-related loan, the amount of the foregone interest deemed to be transferred from the lender/employer to the borrower/employee will be treated as compensation paid from the former to the latter. Conversely, the foregone interest deemed to be paid from the borrower/employee will be treated as interest on the loan.

      Example: On January 1, 2021, Samuel loans his employee, Asher $100,000 (interest free) payable on demand. Asher uses the borrowed funds to buy investment securities. As of December 31, 2021, the loan remains outstanding. Obviously, because the loan bears no interest, it is a below-market loan. Since the 2019 blended annual rate is 0.13 percent (see Q 663), IRC Section 7872 would recast the below-market loan into the following two transactions:

      For tax year 2021, Samuel is deemed to have transferred $130 of foregone interest to Asher, the amount Asher should have paid Samuel (even though this did not actually occur).

      In turn, Asher is deemed to have paid the $130 of foregone interest to Samuel (even though Asher did not make the payment).

      Since Asher is Samuel’s employee, Samuel is deemed to have paid compensation in the amount of the foregone interest to Asher (taxable to Asher as wage income2). In turn, Asher is deemed to have made an interest payment of that same amount to Samuel (taxable to Samuel as interest income). Also, because Asher used the borrowed funds to purchase investment securities, the phantom interest payment is deductible as investment interest subject to the limitations on interest deductions (see Q 8027).3 Finally, Samuel is entitled to a deduction for the compensation (assuming it is reasonable) he is deemed to have paid to Asher.4

      Similar consequences result in the case of a corporation-shareholder loan (i.e., a below-market loan from the corporation to the shareholder). In that case, the foregone interest transferred from the corporation to the shareholder is treated as a taxable dividend (subject to the rules dealing with distributions from a corporation to shareholders).5 Also, depending on the purpose of the borrowing, the shareholder may be entitled to an interest deduction. The corporation/lender is required to report taxable interest income. There will, however, be no deduction because a corporation is not allowed a deduction for dividends paid to shareholders.

      In the case of compensation-related or corporation-shareholder below-market term 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.6 The excess is treated as original issue discount and, generally, treated as transferred on the day the loan was made. In compensation-related loans, the lender/employer will be entitled to a compensation deduction for the amount treated as original issue discount interest and will include such amount as interest income as it accrues over the term of the loan. The borrower will have taxable compensation on the day the loan is made, but deductions (if allowed – see Q 8027) 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.

      Similar to a gift loan, demand (or term) compensation-related loans and corporation-shareholder loans, 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.7 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 $10,000.8

      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.9


      1 .IRC Secs. 7872(c)(1)(B), 7872(c)(1)(C); Prop. Treas. Reg. §1.7872-4(c).

      2 .IRC Sec. 61(a)(1).

      3 .IRC Sec. 163(d).

      4 .IRC Sec. 162.

      5 .IRC Sec. 61(a)(7).

      6 .IRC Sec. 7872(b)(1).

      7 .IRC Sec. 7872(c)(3).

      8 .IRC Sec. 7872(f)(10).

      9 .Rountree Cotton, Inc. v. Comm., 113 TC 422 (1999), aff’d per curiam, 87 AFTR 2d ¶2001-718 (10th Cir. 2001).

  • 666. Can securities law restrictions apply to a below-market loan?

    • Section 402 of the Sarbanes-Oxley Act of 2002 (P.L. 107-204) amended Section 13 of the Securities and Exchange Act of 19341 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. 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.

      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.

      So, since the narrow restrictions require loans to directors or executive officers to be made on market terms, it is unlikely that any of those loans would be below-market loans. On the other hand, it is possible that a loan that did not bear market interest would be a below-market loan for income tax purposes (because the rate might be less than the applicable federal rate) as well as being prohibited under section 402 of the Sarbanes-Oxley Act.

      The question of whether there is a prohibited below market loan comes up most frequently with regard to collateral assignment (loan regime) split dollar life insurance arrangements for executives and directors of publicly traded companies (Q 4022 to Q 4031).


      1.  15 USC 78m.

  • 667. What is an installment sale? How is the gain taxed?

    • Editor’s Note: Under the 2017 Tax Act, in 2022, the following changes apply:

      The 0 percent capital gains rate will apply to joint filers who earn less than $83,350 (half of that amount for married taxpayers filing separately), heads of households who earn less than $55,800, single filers who earn less than $41,675, and trusts and estates with less than $2,800 in income.

      The 15 percent rate will apply to joint filers who earn more than $83,350 but less than $517,200 (half of these amounts for married taxpayers filing separately), heads of households who earn more than $55,800 but less than $488,500, single filers who earn more than $41,675 but less than $459,750, and trusts and estates with more than $2,800 but less than $13,700 in income.

      The 20 percent rate will apply to joint filers who earn more than $517,200 (half of that amount for married taxpayers filing separately), heads of households who earn more than $488,500, single filers who earn more than $459,750, and trusts and estates with more than $13,700 in income.1 For the tax treatment of installment payments, see Q 702.

      Gain resulting from an installment sale is reported using the installment method. Generally, dealers may not report their sales under the installment method (with exceptions for farm property and certain timeshares and residential lots).2 See Q 7517 for the treatment of gain from the sale of publicly-traded stock. An installment sale is a sale or 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.3 It is not necessary that there be more than one payment.

      Example: On December 31, 2022, Asher transfers land to Samuel for $100,000. There is only one payment due on January 2, 2023. In spite of the fact that only one payment is required, the transaction qualifies as an installment sale because that payment is due at the end of the taxable year.

      As explained below, installment reporting requires the taxpayer to report gain resulting from the underlying transaction (it does not apply to loss4) ratably over the term of the installment period. The taxpayer must use the installment method 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.5 For many taxpayers, reporting gain on the installment method is beneficial because without it, the taxpayer would have to report the entire gain in the year of disposition (even though it may take years for the taxpayer to receive the installment payments). Thus, the installment method provides for the ratable reporting of income over the term of years in which payments are due. On the other hand, a taxpayer with a significant capital loss (deductible to the extent of capital gains plus $3,000) may find it beneficial to report all the gain in one year so as to offset such capital loss. For such a taxpayer, electing out of installment reporting (discussed below) is an option.

      Example: In 2022, Asher transfers land to Samuel for $100,000. The terms of the sale call for annual payments of $10,000 (plus interest) to Asher over a 19-year period. Asher’s total capital gain on the transaction is $90,000. If Asher were to report the sale on the installment method, he would report $9,000 of capital gain in each year of the 10-year term over which the transaction took place. However, Asher has a $90,000 capital loss from another transaction. Thus, if Asher elects out of installment reporting, the entire $90,000 of capital gain would be includible in gross income in a single year to offset the $90,000 of capital loss. This would allow Asher to account for the 2022 gain in a single year (essentially tax-free) by using it to offset capital loss.

      If the taxpayer fails to make a timely election out of installment reporting, the IRS may nonetheless approve the election upon a showing that the taxpayer’s failure to make a timely election was due to good cause.6 As illustrated by Revenue Ruling 90-46, what constitutes “good cause” is very narrow. A change in the law that would cause electing out to be more tax advantageous or a change of mind by the taxpayer would not constitute good cause. On the other hand, a well-documented mistake (inadvertent failure to make a timely election due to an accountant’s error) would constitute good cause.

      Similarly, once an election out of installment reporting is made, it cannot be revoked without the permission of the IRS. In granting such permission, a showing of good cause (as illustrated by Revenue Ruling 90-46) is also the standard considered by the IRS. Good cause will not be found if the purpose of a late election out is tax avoidance.7 Generally, what constitutes good cause is determined on a case by case basis. Examples of IRS determinations of good faith can be found in private letter rulings.8

      Be mindful, however, that a determination in a private letter ruling applies only to the taxpayer who requested the ruling.

      Basic Mechanics of Installment Reporting

      As illustrated below, reportable gain for each installment payment is determined by multiplying the gross profit ratio by each payment. The gross profit ratio is “gross profit” divided by the total contract price.9 Gross profit is the selling price minus selling expenses minus the seller’s adjusted basis in the transferred property. The total contract price is the selling price minus qualified indebtedness (generally, secured debt on the property assumed by the buyer).10

      Example: On December 30, 2022, Asher sells a parcel of land (not subject to a mortgage or lien) to Samuel for $100,000 (there are no selling expenses). Asher’s basis in the land is $10,000. Pursuant to a note, for a period of 10 years, beginning January 1, 2023, Samuel is required to make an annual installment payment of $10,000 (plus interest). If Asher were to elect out of installment reporting, he would report a gain of $90,000 ($100,000 selling price minus $10,000 basis). Asher, however, does not elect out of installment reporting.

      The computation of Asher’s reportable gain is as follows:

      Step 1 – Compute the gross profit ratio.

      Gross Profit: $90,000 ($100,000 selling price minus $10,000 basis)

      Total Contract Price: $100,000

      Or

      90 percent

      Step 2 – Multiply the gross profit ratio by the principal payment amount.

      90 percent * $10,000 = $9,000.

      Step 3 – Determine the amount of the principal payment that is the tax-free recovery of basis.

      $10,000 minus $9,000 = $1,000

      Thus, with respect to each $10,000 principal payment, $9,000 is capital gain and $1,000 is the tax-free recovery of basis. As a result, over the 10-year installment payment term, Asher will report $90,000 of capital gain and $10,000 recovery of basis.


      1 .IRC Sec. 1(j)(5); Rev. Proc. 2021-45.

      2 .IRC Secs. 453(b)(2)(A), 453(l)(2).

      3 .IRC Sec. 453(b).

      4 .See IRC Sec. 453.

      5 .IRC Secs. 453(a), 453(d); Bolton v. Comm., 92 TC 303 (1989).

      6 .Treas. Reg. §15A.453-1(d); Rev. Rul. 90-46, 1990-1 CB 107.

      7 .Let. Rul. 9230003.

      8 .Let. Rul. 9218012. See also Let. Rul. 200226039. Let. Ruls. 9419012, 9345027.

      9 .IRC Sec. 453(c).

      10 .Treas. Reg. §15A.453-1(b)(2)(v), (b(3)(ii) and (b)(2)(iii). With respect to qualified indebtedness, Treas. Reg. §15A.453-1. See, however, Professional Equities, Inc. v. Comm., 89 TC 165 (1987).

  • 668. Does the installment method of reporting apply to depreciation recapture?

    • The installment method of reporting deferral of gain does not apply to depreciation recapture. Therefore, the portion of gain attributable to depreciation recapture must be reported in the year of sale. Once depreciation has been recaptured, any adjusted net capital gain (the balance of the gain, see Q 702) is computed by adding the amount of depreciation recaptured to the seller’s basis.

      Example: On December 30, 2022, Asher sells a tractor used in his trade or business to Samuel for $10,000. Asher’s adjusted basis in the tractor is $2,000. Of Asher’s $8,000 overall gain ($10,000 minus $2,000), $2,000 of it is attributable to depreciation recapture. For that reason, the $2,000 of depreciation recapture must be included in Asher’s gross income in the year of sale (meaning it is not subject to ratable inclusion). Pursuant to a note, for a period of five years, beginning January 1, 2023, Samuel is required to make an annual installment payment of $2,000 (plus interest).

      The computation of Asher’s reportable gain is as follows:

      Step 1 – Compute the gross profit ratio.

      Gross Profit:

      6,000 ($10,000 SP – $2,000 basis + $2,000 depreciation recapture)

      TCP: $10,000

      Or

      60 percent

      Step 2 – Multiply the gross profit ratio by the principal payment amount.

      60 percent * $2,000 = $1,200.

      Step 3 – Determine the amount of the principal payment that is the tax-free recovery of basis.

      $2,000 minus $1,200 = $800

      Thus, with respect to each $2,000 principal payment, $1,200 is capital gain and $800 is the tax-free recovery of basis. Over the five-year installment payment term, Asher will report $6,000 of capital gain and $4,000 recovery of basis. The $4,000 basis recovery includes $2,000 of adjusted basis plus the $2,000 of depreciation recapture Asher recognized in the year of sale.

  • 669. How is unrecaptured Section 1250 gain treated when a taxpayer recognizes gain using the installment method of reporting?

    • 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),1 the unrecaptured IRC Section 1250 gain (which is generally taxed at a maximum marginal rate of 25 percent – see Q 702) must be taken into account before any adjusted net capital gain (taxed at a maximum of 20 percent/15 percent/0 percent – see Q 702).2 This means the recognition of unrecaptured IRC Section 1250 gain is not prorated over the term of the installment agreement, but instead recognized first to the extent of each year’s recognized gain. The remaining capital gain is recognized only after all unrecaptured 1250 gain is recognized.


      1 .See IRC Sec. 1250(c).

      2 .Treas. Reg. §1.453-12(a).

  • 670. How is interest on the unpaid balance of an installment obligation treated?

    • All interest received by the taxpayer is ordinary income.1 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” accruing 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 seller and buyer, respectively.

      Imputed interest rules also apply to installment sales. In general, if the sales price of the property exceeds $3,000 and any payment is deferred for more than one year, interest must be charged on payments due more than six months following the sale at a rate that is equal to 100 percent of the “applicable federal rate,” compounded semiannually. If not, interest will be imputed at that rate.2 The applicable federal rate (see Q 676) is lowest of the AFRs in effect for any month in the three-month period ending with the first calendar month in which there is a binding written contract for sale.3

      However, the following are exceptions to this general rule:

      (1) if the interest charged is less than 100 percent of the AFR, a rate of no greater than 9 percent, 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 $6,289,500 in 2022, $6,099,500 in 2021, $6,039,100 in 2020, or $5,944,600 in 2019;4

      (2) if the rate charged is less than 100 percent of the AFR, a rate of no greater than 6 percent, compounded semiannually, is imputed on aggregate sales of land during a calendar year between an individual and a family member (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 percent of the AFR, compounded semiannually, applies to the excess);5 and

      (3) a rate of 110 percent 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 back to the seller (“sale-leaseback” transactions).6


      1. Treas. Reg. §1.483-1.

      2. IRC Sec. 483.

      3. IRC Sec. 1274(d)(2)(B).

      4. IRC Sec. 1274A, Rev. Rul. 2016-30, Rev. Rul. 2018-11, Rev. Proc. 2018-57, Rev. Proc. 2019-44, Rev. Proc. 2020-45.

      5. IRC Sec. 483(e)(3).

      6. IRC Sec. 1274(e).

  • 671. How are installment sales between related parties taxed?

    • Installment sales between “related” parties are subject to strict rules. Except as noted below, “related” persons include the following: (1) family members (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 percent 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 percent 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 percent of the stock of the corporation, and has more than a 50 percent interest in the partnership; (10) two S corporations if the same persons actually or constructively own more than 50 percent of the stock of each; (11) an S corporation and a C corporation, if the same persons actually or constructively own more than 50 percent of the stock of each; or (12) generally, an executor and a beneficiary of an estate.1

      There are attribution rules that apply to determine the ownership of stock. For example, an individual is treated as though he or she owns stock that is actually owned by family members (see above) and stock owned by a corporation, partnership, estate, or trust in proportion to the interest in the entity owned by the individual, family member, or a partner owning stock in the same corporation in which the individual owns stock.2 As explained in Q 674, in the case of installment sales of depreciable property between related parties, a different definition of “related” is applied.3


      1 .IRC Secs. 453(f)(1), 318(a), 267(b).

      2 .IRC Secs. 453(f)(1), 318(a), 267(c).

      3 .See IRC Sec. 453(g).

  • 672. What are the results if a purchaser in an installment sale between related parties disposes of the property before the seller receives the entire selling price (i.e., a second disposition)?

    • If a related installment sale purchaser disposes of the property before the related seller has received the entire selling price, such disposition is treated as a “second disposition” subject to a special rule. 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 the related party had received that amount on the date of the second disposition. In other words, since installment payments are taxed upon receipt (see Q 667), the related seller would have to report the gain computed as if he or she had actually received it (even though this did not occur). It may be difficult for the related seller to pay the tax on this gain since the seller did not actually receive that amount. However, this rule generally does not apply if:

      (1)the second disposition occurs more than two years after the first disposition;

      (2)the second disposition is an involuntary conversion, the threat of which did not exist at the time of the first disposition;

      (3)the second disposition occurs after the death of either of the related parties; or

      (4)neither disposition had as one of its principal purposes the avoidance of income tax.1


      1 .IRC Sec. 453(e).

  • 673. What are the results if an installment sale between related parties is cancelled or payment is forgiven?

    • 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.1 The seller’s basis in the obligation is the difference between the face value of the obligation less the amount of income that would be includible in gross income had the obligation been actually satisfied.2

      Example: Asher sells a tractor to Samuel for $10,000 with an adjusted basis of $2,000. In exchange, Samuel conveys five installment notes ($2,000 each). Asher’s gross profit ratio would be 80 percent (see Q 666) meaning that 80 percent of each payment would be included in gross income ($1,600) and 20 percent ($400) would be tax-free return of basis. Therefore, each note would have a basis of $400 ($2,000 face value less $1,600 income). So, if Asher were to forgive a $2,000 installment note, he would recognize a gain of $1,600 (the difference between the face amount of the note and his basis in the note). In other words, a forgiven note is essentially taxed in the same way as it would have been had the seller actually received payment.


      1 .IRC Sec. 453B(f).

      2 .IRC Sec. 453B(b).

  • 674. Can a sale of depreciable property between related parties be reported using the installment method?

    • 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.1


      1 .IRC Sec. 453(g).

  • 675. What is an interest surcharge with respect to outstanding installment obligations?

    • Generally, an interest surcharge is an interest charge payable by the seller to the IRS with respect to a portion of a tax liability that is deferred as a result of installment reporting. In other words, installment reporting allows the taxpayer to defer the gain realized from the installment over time rather than in the year of sale. The tax on that gain is considered a deferred tax liability. The interest surcharge applies to all installment obligations held by the taxpayer (meaning it applies to multiple installment sales) in which deferred payments for sales during the taxable year exceed $5,000,000. There is an exception to the surcharge with respect to: (1) property used or produced in the trade or business of farming, (2) timeshares and residential lots, and (3) personal use property.1

      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 (with respect to tax deficiencies). 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.2 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.3

      Planning Point: This interest surcharge on installment sales with deferred payments can be minimized by splitting the sale between two spouses and spreading it over 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.


      1 .IRC Sec. 453A(b).

      2 .IRC Sec. 453A(c).

      3 .IRC Sec. 453A(d)(1). See Revenue Act of 1987 Conf. Rept., at pages 22-23.

  • 676. What is the applicable federal rate and under what circumstances is it employed?

    • The applicable federal rate (AFR) is used in determining the amount of imputed interest with respect to certain below-market loans for both income and gift tax purposes (see Q 663, Q 892), in imputing interest on debt instruments given on the sale or exchange of property (see Q 667, Q 7838), and for determining interest and present values in connection with deferred payments for the use of property or services (see Q 7831).

      The applicable federal rates are determined monthly by the IRS (and published in a revenue ruling). The various 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, respectively.1

      To determine the appropriate AFR applicable with respect to below-market loans, see Q 663 and Q 892. To determine the appropriate AFR with respect to deferred rent, see Q 7831.

      In the case of any sale or exchange in which a debt instrument is involved, the applicable federal rate will be the lowest three-month rate in effect for any month in the three-month period ending with the first calendar month in which there is a binding written contract.2

      By regulation, the IRS may permit a rate that is lower than the applicable federal rate to be used under certain circumstances.3


      1 .IRC Sec. 1274(d)(1).

      2 .IRC Sec. 1274(d)(2).

      3 .See IRC Sec. 1274(d)(1)(D).

  • 677. Are Social Security and railroad retirement benefits taxable?

    • Under certain circumstances, a portion of Social Security benefits and tier 1 railroad retirement benefits may be 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 are includible in gross income as ordinary income. “Modified adjusted gross income” is a taxpayer’s adjusted gross income (disregarding foreign income, savings bonds, 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.1

      A taxpayer whose modified adjusted gross income plus one-half of his or her Social Security benefits exceed a base amount is required to include in gross income the lesser of (a) 50 percent of the excess of such combined income over the base amount, or (b) 50 percent of the Social Security benefits received during the taxable year.2 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.3

      In addition to the initial tier of taxation 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.4 If a taxpayer’s modified adjusted gross income plus one-half of his or her Social Security benefits exceed the adjusted base amount, his or her gross income will include the lesser of (a) 85 percent of the Social Security benefits received during the year, or (b) the sum of – (i) 85 percent 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).5

      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 + (½ 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 (½ × ($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 + (½ of $8,000) = $37,000] is greater than the applicable adjusted base amount of $34,000. Thus, $6,550 [the lesser of 85 percent of his benefits ($6,800), or 85 percent of the excess of $37,000 over the adjusted base amount (85 percent × ($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.6

      Reductions of Social Security Benefits that do not Reduce the Amount Included in the Computation of Taxable Benefits

      Workers’ compensation pay that reduced the amount of Social Security received and any amounts withheld from a taxpayer’s Social Security benefits to pay Medicare insurance premiums do not reduce the amount that are included in the computation of taxable Social Security benefits.7

      In Green v. Comm.,8 the taxpayer argued that his Social Security disability benefits were excludable from gross income9 because they had been paid in lieu of workers’ compensation. Thus, they should not be included in the computation of taxable Social Security benefits. The Tax Court determined, however, that Title II of the Social Security Act is not a form of workers’ compensation. 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.

      Similarly, 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 caused from exposure to Agent Orange during his Vietnam combat service) were includable in gross income under IRC Section 86 and 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. Eligibility for purposes of Social Security disability benefits is determined on the basis of the individual’s prior work record, not the cause of the 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 excluded from gross income under IRC Section 104(a)(4).10

      Railroad retirement benefits (other than Tier I benefits) are taxed in the same way as 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.11


      1 .IRC Sec. 86(b)(2).

      2 .IRC Sec. 86(a)(1).

      3 .IRC Sec. 86(c)(1). In a Tax Court case, the term “live apart” means living in separate residences. In that case, the taxpayer lived in the same residence as his spouse for at least thirty 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. McAdams v. Comm., 118 TC 373 (2002).

      4 .IRC Sec. 86(c)(2).

      5 .IRC Sec. 86(a)(2).

      6 .IRC Sec. 86(e).

      7 .Rev. Rul. 84-173, 1984-2 CB 16.

      8 .TC Memo 2006-39.

      9 .Under IRC Section 104(a)(1).

      10 .Reimels v. Comm., 123 TC 245 (2004), aff’d, 436 F.3d 344 (2d Cir. 2006); Haar v. Comm., 78 TC 864, 866 (1982), aff’d, 709 F.2d 1206 (8th Cir. 1983), followed.

      11 .See IRC Sec. 72(r)(1).

  • 678. How is unearned income of certain children treated for federal income tax purposes when such income is derived from property given under the Uniform Gifts to Minors Act or the Uniform Transfers to Minors Act?

    • Editor’s Note: For tax years beginning after 2017 and before 2026, the personal exemption was suspended. Under the 2017 Tax Act, the unearned income of minors was taxed according to the income tax rates that apply to trusts and estates.The SECURE Act repealed the changes made by the 2017 tax reform legislation with respect to the kiddie tax rules. The repeal of the 2017 kiddie tax changes is effective beginning in 2020.  However, taxpayers have the option of electing to have either set of rules apply retroactively, in 2018 and 2019, and seek a refund if appropriate.1

      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.2 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 $1,100 in 2019-2020 and $1,050 in 2015-2018 to offset unearned income (or, if higher, the dependent may take a standard deduction in the amount of the sum of $350 (in 2013-2021) and his earned income, as indexed for inflation – see Q 752). Prior to 2018, dependents for whom another taxpayer was allowed a personal exemption could not take a personal exemption for themselves (see Q 728).3 For the treatment of unearned income for children, see Q 679.


      1.SECURE Act, Sec. 501(c).

      2 .IRC Sec. 61; Rev. Rul. 56-484, 1956-2 CB 23; Rev. Rul. 59-357, 1959-2 CB 212.

      3 .Rev. Proc. 2014-61, 2014-47 IRB 860, Rev. Proc. 2015-53, 2015-44 IRB 615, Rev. Proc. 2016-55, Rev. Proc. 2017-58, Rev. Proc. 2018-57, Rev. Proc. 2019-44.

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

    • Editor’s Note: Under the SECURE Act, the changes made by the 2017 Tax Act with respect to the kiddie tax rules were repealed.  The repeal of the 2017 kiddie tax changes is effective beginning in 2020.  However, taxpayers have the option of electing to have either set of rules apply retroactively, in 2018 and 2019, and can seek a refund if appropriate.1

      Under certain circumstances, children under the age of 19 (age 24 for students) were required to pay tax on their unearned income above a certain amount at their parents’ marginal rate. (See Q 753 for the current tax rates.) The tax applied to all unearned income, regardless of when the assets producing the income were transferred to the child.

      The 2017 Tax Act changed the treatment of unearned income of minors by applying the tax rates that apply to trusts and estates to this income.  Under the tax reform rule, which was repealed by the SECURE Act (but see Editor’s Note, above), earned income of minors was taxed according to the individual income tax rates prescribed for single filers,2 and unearned income of minors was taxed according to the applicable tax bracket that would apply if the income was that of a trust or estate (for both income that would be subject to ordinary income tax rates and income that would receive capital gains treatment).3

      The so-called “kiddie tax” rules apply 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 $2,200 (in 2019-2021 and $2,100 in 2015-2018) of unearned income.4

      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.5

      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 $1,100 standard deduction for a dependent child in 2019-2020, plus (2) the greater of $1,100 or (if the child itemizes) the amount of allowable itemized deductions that are directly connected with the production of his unearned income.6

      “Earned income,” essentially, means all compensation for personal services actually rendered.7 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 Gifts to Minors Act, and interest on both earned and unearned income.8 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).9 Generally, the tax on accumulation distributions does not apply to domestic trusts (see Q 795). The source of the assets that produce unearned income need not be the child’s parents.10 The application of the “kiddie tax” to funds provided to a child by sources other than the child’s parents was held constitutional.11

      Example: Cole is a child who is seventeen years of age at the end of the taxable year beginning on January 1, 2021. Both of Cole’s parents are alive at the end of the taxable year. During 2021, 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 2021. Some cash gifts were received by Cole prior to 2021. Cole has no itemized deductions and is eligible to be claimed as a dependent on his parent’s return. Therefore, for the taxable year 2017, Cole’s standard deduction is $2,050, the amount of Cole’s earned income, plus $350. Of this standard deduction amount, $1,050 is allocated against unearned income, and $1,000 is allocated against earned income. Cole’s taxable unearned income is $1,350, of which $1,050 is taxed without regard to section 1(g). The remaining taxable unearned income of $300 is net unearned income and is taxed under section 1(g). 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 2021 will not affect the tax treatment of this income under section 1(g).

      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.12 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 half-blood, or from a prior marriage of either spouse.13

      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.14

      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 needed to file an accurate return.15 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.16

      Parental Election Rules

      Certain parents may elect to include their child’s unearned income over $2,100 (in 2019-2020) 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 $1,100 and less than $11,000 (in 2020), all of which is from interest and dividends.17

      The election is not 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 $2,100 in 2020 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 percent floor on miscellaneous itemized deductions (suspended from 2018 through 2025) 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 percent of the lesser of $1,100 or the excess of the gross income of such child over $1,100. If the election is made, the child will be treated as having no gross income for the year.18 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 777.


      1. SECURE Act Sec. 501(c).

      2. IRC Sec. 1(j)(4)(B).

      3. IRC Sec. 1(j)(4).

      4. Rev. Proc. 2018-57, Rev. Proc. 2019-44.

      5. IRC Sec. 1(g)(2).

      6. IRC Sec. 1(g)(4); Rev. Proc. 2019-44.

      7. IRC Secs. 911(d)(2), 1(g)(4)(A)(i).

      8. Temp. Treas. Reg. §1.1(i)-1T, A-8, A-9, A-15.

      9. Temp. Treas. Reg. §1.1(i)-1T, A-16.

      10. Temp. Treas. Reg. §1.1(i)-1T, A-8.

      11. See Butler v. U.S., 798 F. Supp. 574 (E.D. Mo. 1992).

      12. Temp. Treas. Reg. §1.1(i)-1T, A-11, A-12.

      13. Temp. Treas. Reg. §1.1(i)-1T, A-13, A-14.

      14. Temp. Treas. Reg. §1.1(i)-1T, A-17, A-19.

      15. Temp. Treas. Reg. §1.1(i)-1T, A-22.

      16. Ann. 88-70, 1988-16 IRB 37.

      17. IRC Sec. 1(g)(7); Rev. Proc. 2008-66, above, Rev. Proc. 2015-53, Rev. Proc. 2016-55, Rev. Proc. 2017-58.

      18. IRC Sec. 1(g)(7)(B).

  • 680. Can parents elect to include a child’s income on their own return?

    • Sometimes. Certain parents may elect to include their child’s unearned income over $2,100 (in 2019-2021) 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 $1,100 and less than $11,000 (in 2021), all of which is from interest and dividends.[1]

      The election is not 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 $2,100 in 2021 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 percent floor on miscellaneous itemized deductions (suspended from 2018 through 2025) 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 percent of the lesser of $1,100 or the excess of the gross income of such child over $1,100. If the election is made, the child will be treated as having no gross income for the year.[2] 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 777.

      ______________

      [1].     IRC Sec. 1(g)(7); Rev. Proc. 2008-66, above, Rev. Proc. 2015-53, Rev. Proc. 2016-55, Rev. Proc. 2017-58, Rev. Proc. 2019-44.

      [2].     IRC Sec. 1(g)(7)(B).

  • 681. What is an Education Savings Account (also known as a Coverdell Education Savings Account)?

    • An education IRA or Coverdell Education Savings Account (ESA) is a trust or custodial account created exclusively for the purpose of paying the “qualified education expenses” of the designated beneficiary of an ESA at the time it is created.1 At the time the ESA is created, the beneficiary must be under age eighteen or a special needs beneficiary. An ESA is similar to a Roth IRA in that both are funded with after-tax contributions. To the extent the distributions do not exceed the beneficiary’s adjusted education expenses for the tax year of withdrawal, they are tax-free. 2

      In addition, there must be a written ESA document meeting the following requirements:

      • The trustee or custodian must be a bank or entity approved by the IRS.
      • Contributions to the ESA must be in cash, made before the beneficiary attains the age of eighteen (unless a special needs beneficiary); contributions are capped at $2,000 per year, as reduced based upon the income limitations. The reduction range is adjusted gross income between $95,000 and $110,000 for single taxpayers or $190,000 to $220,000 for married taxpayers. This means no contribution would be allowed if adjusted gross income exceeds the higher adjusted gross income limit (see Q 682).
      • Qualified education expenses include private school (grades one through twelve) as well as higher education.

      For guidance regarding certain reporting requirements and transition rules applicable to ESAs, see Notice 2003-53.3 See Q 8555Q for the estate tax treatment and Q 8 for the gift tax treatment of ESAs.


      1 .IRC Secs. 530(b), 530(g).

      2 .IRC Sec. 530(d).

      3 .2003-33 IRB 362.

  • 682. What are the rules governing contributions to a Coverdell Education Savings Account?

    • Annual contributions to a Coverdell Education Savings Account (“ESA”) must be made in cash on or before the date on which the beneficiary attains age eighteen unless the beneficiary is a special needs beneficiary. According to the Conference Report, a special needs beneficiary includes an individual with a physical, mental, or emotional condition (including learning disabilities) that requires additional time to complete his or her education.1 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.2

      In general, the aggregate amount of contributions to an ESA on behalf of a beneficiary (except in the case of rollover contributions) cannot exceed $2,000.3 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 $15,000.4 For joint filers, the maximum contribution is reduced by the amount that bears the same ratio to such maximum amount as the contributor’s MAGI in excess of $190,000 bears to $30,000.5 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.6 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 percent excess contribution excise tax under Code section 4973(a).7 Note that any excess contributions from previous taxable years, to the extent not returned, will continue to be taxed as excess contributions in subsequent taxable years.8


      1 .IRC Sec. 530(b)(1).

      2 .IRC Sec. 530(b)(5).

      3 .IRC Sec. 530(b)(1)(A)(iii).

      4 .IRC Sec. 530(c)(1).

      5 .IRC Sec. 530(c)(1).

      6 .IRC Sec. 530(c)(2).

      7 .IRC Sec. 4973(e)(2).

      8 .IRC Sec. 4973(e).

  • 683. How are distributions from an Education Savings Account treated? What are “qualified education expenses”?

    • Distributions from an ESA are tax-free if they are used solely for the “qualified education expenses” of the designated beneficiary.1 Qualified education expenses include both “qualified higher education expenses” and “qualified elementary and secondary education expenses.”2 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.3 Room and board (up to a certain amount) is also included if the student is enrolled at least half-time.4 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 1965.5 Thus, virtually all accredited public, nonprofit, and proprietary postsecondary institutions are considered eligible educational institutions.6

      Qualified education expenses are reduced by scholarships, educational assistance provided to the individual, or any payment for such expenses (other than a gift, devise, bequest, or inheritance) excludable from gross income. These expenses are also reduced by the amount of such expenses taken into account in determining the American Opportunity Credit or the Lifetime Learning Credit.7

      Qualified elementary and secondary education expenses include tuition, fees, and costs for academic tutoring, special needs services, books, supplies, and other equipment 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 twelve) as determined under state law. Also included are expenses for room and board, uniforms, transportation, supplementary items and services (including extended day programs) 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.8

      If a designated beneficiary receives distributions from both an ESA and qualified tuition program that in the aggregate amount exceed the “qualified education expenses” of the designated beneficiary, the expenses are allocated among such distributions so as to determine the amount excludable under each.9 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.10

      Purchase of life insurance with ESA funds is not permitted.11 ESA assets may not be commingled with other property except in a common trust fund or common investment fund.12 If the beneficiary engages in a prohibited transaction, ESA status is lost 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.13

      Bankruptcy

      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.14


      1 .IRC Sec. 530(d)(2)(A).

      2 .IRC Sec. 530(b)(2).

      3 .IRC Secs. 529(e)(3), 530(b)(2).

      4 .IRC Sec. 530(b)(2).

      5 .See IRC Sec. 529(e)(5).

      6 .Notice 97-60, 1997-2 CB 310, at 16 (Sec. 3, A16).

      7 .IRC Sec. 530(d)(2)(C).

      8 .IRC Sec. 530(b)(4).

      9 .IRC Sec. 530(d)(2)(C)(ii).

      10 .IRC Sec. 530(d)(2)(D).

      11 .IRC Sec. 530(b)(1)(C).

      12 .IRC Sec. 530(b)(1)(D).

      13 .IRC Sec. 530(e).

      14 .11 USC 541(b), as amended by BAPCPA 2005.

  • 684. Is a rollover from one education savings account to another permitted?

    • A rollover from one ESA to another ESA is not treated as a distribution (that would be potentially taxable) provided the beneficiaries of both ESAs are the same, or members of the same family. The new beneficiary must be under thirty years old as of the date of such distribution or change, except in the case of a special needs beneficiary.1 The rollover contribution must be made no later than sixty 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 twelve-month period.2 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 thirty or is a special needs beneficiary.3 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.4 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.5


      1 .IRC Sec. 530(b)(1).

      2 .IRC Sec. 530(d)(5).

      3 .IRC Secs. 530(b)(1), 530(d)(6).

      4 .IRC Sec. 530(d)(7).

      5 .IRC Sec. 530(d)(7).

  • 685. What are the results when the beneficiary of an education savings account dies?

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


      1 .IRC Sec. 530(b)(1)(E).

      2 .IRC Sec. 530(d)(8).

      3 .IRC Sec. 530(d)(1).

  • 686. How are excess distributions from an education savings account treated?

    • If distributions from the ESA exceed the amount of the designated beneficiary’s “adjusted qualified education expenses” (qualified education expenses less any tax-free educational assistance) for the year, the recipient will be taxed on a portion of the excess distribution and a portion will be treated as the recovery of “basis.” This is because a portion of the ESA is comprised of after-tax contributions and a portion is comprised of earnings generated by the account. Thus, the latter amount is non-taxable and there is an amount includable in gross income. In determining the taxable portion of an ESA excess distribution, consider the following based on the example in IRS Publication 970:

      Example: In 2021, Asher receives a distribution of $850 from an ESA of which $1,500 had been contributed in 2020. Asher’s qualified education expenses for that year are $700. In 2021, there were no contributions to the account. Because the 2020 distribution was Asher’s first distribution from the account, his basis is $1,500 (the amount contributed). As of December 31, 2021, the balance in the ESA is $950. The taxable portion of Asher’s distribution is computed as follows:

      Step 1 – Determine the basis portion of the distribution. Multiply the amount distributed ($850) by a fraction, the numerator is Asher’s basis in the account at the end of 2020 ($1,500) plus the balance in the account as of December 31, 2019 ($0) and the denominator is the balance of the account as of December 31, 2020 ($950) plus the amount distributed in 2020 ($850), or

      $850 *

      $1,500

      = $708

      $1,800

      Step 2 – Determine the earnings included in the distribution. Subtract the basis portion of the distribution ($708) from the amount of the distribution ($850). $850 minus $708 = $142 (the earnings portion of the distribution),

      Step 3 – Determine the tax-free (return of basis) portion of the distribution. Multiply the earnings portion of the distribution ($142) by a fraction, the numerator is Asher’s 2021 qualified education expenses and the denominator is the total amount distributed to Asher ($850), or

      $142 *

      $700

      = $117 (tax-free earnings

      $850

      Step 4 – Determine the taxable earnings. Subtract the tax-free earnings ($117) from the earnings portion of the distribution ($142). $142 minus $117 + $25 (the taxable earnings).

      In addition to income tax, the portion of an ESA includable in gross income is subject to an additional 10 percent 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, Lifetime Learning Credit, or American Opportunity Credit.1 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.2 However, the earnings are includable in the contributor’s income for the taxable year in which such excess contribution was made.


      1 .IRC Sec. 530(d)(4).

      2 .IRC Sec. 530(d)(4)(C).

  • 687. What is a qualified tuition program (also known as a 529 plan)?

    • Editor’s Note: Under the 2017 Tax Act, Section 529 plans would be expanded to include the use of up to $10,000 per year for elementary or secondary school expenses (a provision that would have permitted Section 529 plan funds to be used for expenses incurred in connection with homeschooling was eliminated at the last minute). Per the SECURE Act,[1] up to $10,000 in expenses associated with the beneficiary’s participation in registered apprenticeship programs can also be treated as qualified education expenses for 529 plan purposes, as can up to $10,000 in student loan repayments. See below for more details.

      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” that meet certain requirements and under which a person may buy tuition credits or certificates on behalf of a designated beneficiary that entitle the beneficiary to a waiver or payment of qualified higher education expenses of the beneficiary (see below). 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.[2] 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.[3]

      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.[4]  See Q 689 for the tax treatment of distributions from qualified tuition programs. See Q 844for the estate tax treatment and Q 902 for the gift tax treatment of qualified tuition programs.

      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.[5]

      With respect to item (3), above, the IRS announced a special rule 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 Notice 2001-55, final regulations are expected to provide that 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. Until such final regulations have been issued under IRC Section 529, the IRS will allow qualified tuition programs and their participants to rely on the guidance provided in the notice.[6]

      Program Established and Maintained by One or More Eligible Educational Institutions

      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.”[7] “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.[8] 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).[9]

      Qualified Higher Education Expenses

      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.[10] 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.[11]

      Under the 2017 tax reform legislation, up to $10,000 per year that is used to pay for elementary and secondary school expenses will qualify as higher education expenses.[12]

      Under the SECURE Act, up to $10,000 in 529 plans can be used to repay the designated plan beneficiary’s student loans (or student loans of the beneficiary’s siblings).[13]  The $10,000 limits are cumulative, meaning that the amount is reduced by any distributions treated as qualified higher education expenses under the new provisions in prior years.  However, amounts treated as a qualified education expense with respect to a sibling’s student loan repayments are not counted with respect to amounts available for the designated plan beneficiary.  The available deduction for student loan interest for a taxpayer is reduced in any taxable year by the amount of distributions treated as qualified higher education expenses under Code Section 529(c)(9) with respect to loans that would be includible in gross income under Section 529(c)(3)(A) if not for the new rule.[14]

      Additionally, up to $10,000 in expenses associated with the beneficiary’s participation in registered apprenticeship programs can be treated as qualified education expenses.[15]  The SECURE Act’s expansion of 529 programs applies retroactively, for tax years beginning after December 31, 2018.

      Adequate Safeguards

      The safe harbor that provides adequate safeguards to prevent contributions in excess of those necessary to meet the beneficiary’s qualified higher education expenses is satisfied if all contributions to the account are prohibited once the account balance reaches a specified limit applicable to all beneficiaries’ accounts with the same expected year of enrollment.[16] Total 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.[17]

      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 as the IRS may require. The reports must be filed and furnished to the above individuals in the time and manner determined by the IRS.[18] In 2001, in light of the amendments to IRC Section 529 under EGTRRA 2001, the IRS released guidance regarding certain recordkeeping, reporting, and other requirements applicable to qualified tuition programs.[19] Pending the issuance of final IRC Section 529 regulations, qualified tuition programs and their participants may rely on Notice 2001-81.

      Bankruptcy

      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.[20]

       

      [1].     PL 116-94, Sec. 302

      [2].     IRC Sec. 529(b)(1); Prop. Treas. Reg. §1.529-2(b).

      [3].     IRC Sec. 529(b)(1)(A).

      [4].     IRC Sec. 529(a).

      [5].     IRC Sec. 529(b).

      [6].     Notice 2001-55, 2001-39 IRB 299.

      [7].     IRC Secs. 529(b)(1), 529(e)(5).

      [8].     See Prop. Treas. Reg. §1.529-1(c).

      [9].     IRC Sec. 529(b)(1).

      [10].   IRC Sec. 529(e)(3)(A).

      [11].   IRC Sec. 529(e)(3)(B).

      [12].    IRC Sec. 529(c)(7).

      [13].    IRC Sec. 529(c)(9).

      [14].    IRC Sec. 221(e)(1).

      [15].    IRC Sec. 529(c)(8).

      [16].   Prop. Treas. Reg. §1.529-2(i)(2).

      [17].   Prop. Treas. Reg. §1.529-2(h)(2).

      [18].   IRC Sec. 529(d); Prop. Treas. Reg. §1.529-4.

      [19].   See Notice 2001-81, 2001-52 IRB 617.

      [20].   11 USC 541(b).

  • 688. Is it permissible to contribute to a qualified tuition plan and an education savings account?

    • A taxpayer may claim an American Opportunity or Lifetime Learning Credit and exclude distributions from a Section 529 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.1 See Q 761. However, an individual must reduce total qualified higher education expenses by certain scholarships and the amount of expenses taken into account in determining the American Opportunity or Lifetime Learning credit allowable to the taxpayer (or any other person).2

      Without incurring an excise tax, it is permissible to make a contribution to a Section 529 qualified tuition program in the same taxable year as a contribution to a Coverdell Education Savings Account for the benefit of the same designated beneficiary. (See Q 681.)3 For purposes of determining the amount of the exclusion, 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 American Opportunity and Lifetime Learning credits, then the expenses must be allocated between the Coverdell Education Savings Account distributions and the Section 529 qualified tuition program distributions.4

      The total deductible amount of 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 is a tax-free return of contributions to the plan.5


      1 .See IRC Sec. 529(c)(3)(B)(v).

      2 .IRC Sec. 529(c)(3)(B)(v).

      3 .IRC Sec. 4973(e).

      4 .IRC Sec. 529(c)(3)(B)(vi).

      5 .IRC Sec. 222(c)(2)(B).

  • 689. Are certain distributions from a qualified tuition program (529 Plan) taxable?

    • Distributions from state qualified tuition programs, pre-paid tuition programs sponsored by private schools and universities are fully excludable from gross income if the distributions are used to pay “qualified higher education expenses” (see Q 687) of the designated beneficiary.1 (For the general rule governing nonqualified distributions, see below.)

      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.2 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, would constitute payment of a qualified higher education expense.3

      Nonqualified distributions (i.e., distributions that are not used to pay “qualified higher education expenses”) are includable in gross income. However, the amount of the distribution representing the amount paid or contributed to the 529 plan are not taxable. An individual receiving a distribution from a 529 plan will receive a Form 1099-Q. The gross distribution received is entered in Box 1 of the form. That amount will be divided between the earnings generated from the 529 plan (Box 2) and the basis (return of investment) (Box 3). Consider the following example based on the example in IRS Publication 970:

      Example: In 2013, Asher’s parents opened a 529 plan. Over a number of years, they contributed $18,000 to the plan. As of the date of distribution in the summer of 2022, the balance in the plan was $27,000. At that time, Asher enrolled in college and paid $8,300 of qualified education expenses for the rest of the year. Those expenses were paid from the following sources:

      Gifts from parents

      $1,600

      Partial scholarship (tax-free)

      $3,100

      529 Plan distribution

      $5,300

      Step 1 – Determine the “adjusted qualified education expenses.” Adjusted qualified education expenses (AQEE) are the amount of qualified education expenses ($8,300) less tax-free educational assistance ($3,100). Therefore, AQEE is $5,200 ($8,300 minus $3,100).

      Thus, the 529 plan distribution of $8,300 exceeds Asher’s AQEE of $5,200. For that reason, a portion of the distribution will be taxable. According to Asher’s Form 1099-Q, Box 2, $950 of the distribution is earnings.

      Step 2 – Compute the tax-free earnings. Multiply the total distributed earnings ($950) by a fraction, the numerator of which is AQEE ($5,200) and the denominator of which is the 529 plan distribution ($5,300), or:

      $950 (total earnings x

      $5,200 (AQEE)

      = $932 (tax-free earnings)

      $5,300 (distribution)

      Step 3 – Compute the taxable earnings. Subtract tax-free earnings ($932) from total earnings ($950), or $950 minus $932, which equals taxable earnings of $18 that must be included in gross income.

      Additionally, there is a 10 percent additional tax imposed on nonqualified distributions in the same manner as is imposed on certain distributions from Coverdell Education Savings Accounts (see Q 683).4 The 10 percent additional tax 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.5

      Repeal of the Aggregation Requirement

      For distributions made after December 31, 2014, the Protecting Americans from Tax Hikes Act of 2015 (PATH) eliminated the requirement that, in calculating the earnings portion of any distribution that exceeds qualified education expenses, all Section 529 plans of which an individual is a designated beneficiary will be treated as one program. Forms 1099-Q must generally be furnished to distributees on or before January 31 of the year following the year of a distribution, and to the IRS on or before February 28, or, if filing electronically, March 31. Because of the difficulties involved in adjusting 529 plan systems to comply with the retroactive repeal of the aggregation requirement, the IRS provided transition relief.  The IRS did not impose penalties for inaccurately reported earnings on 2015 Forms 1099-Q that were solely due to the repeal of the aggregation requirement.

      Guidance Provided in Notice 2001-81

      In Notice 2001-81, the IRS announced that final regulations would 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 in the computation of the earnings portion of any distribution.6 The notice also indicated that the final regulations would revise the time for determining the earnings portion of any distribution from a qualified tuition account. Specifically, for distributions made after 2002, such programs are 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.7 Finally, the notice states 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. However, the program must continue to verify whether the distribution is used for qualified higher education expenses of the beneficiary.8


      1 .IRC Sec. 529(c)(3)(B).

      2 .IRC Sec. 529(c)(3)(B).

      3 .IRC Sec. 529(c)(3)(B).

      4 .IRC Secs. 529(c)(6), 530(d)(4).

      5 .IRC Sec. 530(d)(4)(B).

      6 .Notice 2001-81, 2001-2 CB 617.

      7 .See Notice 2001-81, 2001-2 CB 617.

      8 .Notice 2001-81, above.

  • 690. Can a distribution from a qualified tuition program be rolled over into another account tax-free?

    • Editor’s Note: The 2017 Tax Act now permits Section 529 plan funds to be rolled over into an ABLE account for the designated beneficiary or the designated beneficiary’s family member in an amount up to the annual 529 plan contribution limit (rollovers would offset other contributions made to the ABLE account for the year).  Amounts rolled over in excess of the limitation are included in the distributee’s gross income.  These rules are effective for rollovers that occur after December 31, 2017 and before December 31, 2025.  See Q 396 to Q 398 for a discussion of the ABLE account rules.1

      Any portion of a distribution transferred within sixty 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 sixty days from one family member to another.)2 Additionally, if a new beneficiary is a member of the old beneficiary’s family, a change in designated beneficiaries with respect to an interest in the same qualified tuition program will not be treated as a distribution.3 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 twelve-month period can receive such rollover treatment.4

      Generally, a member of the family is 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.5 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.6


      1. Pub. Law. No. 115-97.

      2. See Prop. Treas. Reg. §§1.529-3(a) and (b); Prop. Treas. Reg. §1.529-1(c).

      3. IRC Sec. 529(c)(3)(C).

      4. IRC Sec. 529(c)(3)(C)(iii).

      5. IRC Sec. 529(e)(2); IRC Sec. 152(d).

      6. IRC Sec. 529(e)(1).

  • 691. What are the tax consequences of an educational benefit trust?

    • At one time, educational benefit trusts promised to provide funds to pay certain educational costs on a tax favored basis. Treasury Regulation Section 1.962-1 confirmed, however, that these benefits were taxed to employees when paid as compensation. Where employer contributions to an educational benefit trust are related to an employee’s service, they are taxed as compensation to the employee when they are either paid to or for the benefit of their children or no longer are subject to a substantial risk of forfeiture.1

      Amounts paid to provide benefits to children of stockholder-employees generally are treated as compensation to the employees, not dividends, where the plan is adopted for business reasons in an effort to attract and retain employees.2

      Where a bona fide debtor-creditor relationship is not intended for funds advanced to employees for this purpose, the amounts are treated as compensation even though called “loans.”3

      IRC Sections 419 and 419A generally apply to post-1985 contributions to an educational benefit trust. Prior to that time, there was some controversy regarding the timing of the employer’s deduction. For years, the position of the IRS was that benefits provided under an educational benefit trust related to the employee’s service constituted a deferral of compensation and, therefore, the employer’s deductions should be taken when the benefits are paid out under IRC Section 404(a)(5).4 The IRS has since privately ruled that an educational benefit trust was a “welfare benefit fund,” and that the deduction of contributions is controlled by IRC Section 419.5

      Educational benefit trusts cannot take advantage of the (limited) immediate deductions for advance funding under the general rule of IRC Section 419 because they do not have “qualified asset accounts.”6 Thus, an employer’s deduction generally is limited to the amount includable in income by employees that year, minus the trust’s after-tax income.

      The general rule of IRC Section 419(b), which limits the deduction of welfare benefit fund contributions to the fund’s “qualified cost,” does not apply to contributions to a collectively bargained welfare benefit fund. The IRS has ruled that such contributions could be deducted in the year contributed, provided that they constitute ordinary and necessary expenses.7 This ruling is questionable, however, because it is based on a temporary regulation (published before the current statutory text) that provides more generous treatment for collectively bargained funds than current law.

      For a more detailed treatment of welfare benefit funds, see Q 4101 and Q 4102.


      1 .Grant-Jacoby, Inc. v. Comm., 73 TC 700 (1980); Citrus Orthopedic Medical Group, Inc. v. Comm., 72 TC 461 (1979); Armantrout v. Comm., 67 TC 996 (1977), aff’d, 570 F.2d 210 (7th Cir. 1978); Treas. Reg. §1.83-3(c)(4), Ex. 2; Rev. Rul. 75-448, 1975-2 CB 55; Let. Rul. 8535002. See also Wheelerv. U.S., 768 F.2d 1333 (Fed. Cir. 1985).

      2 .Grant-Jacoby, Inc. v. Comm., supra.

      3 .Saunders v. Comm., TC Memo 1982-655, aff’d, 720 F.2d 871, 83-2 USTC ¶88,609 (5th Cir. 1983) (overly generous loan forgiveness provisions in plan indicated true loan not intended). See Let. Rul. 8137001.

      4 .See Grant-Jacoby, Inc. v. Comm., supra; Citrus Orthopedic Medical Group, Inc. v. Comm., supra; Rev. Rul. 75-448, 1975-2 CB 55.

      5 .Let. Rul. 8737022.

      6 .IRC Sec. 419A(a).

      7 .See Let. Rul. 9510048.

  • 692. What is “tax basis” and why is it significant?

    • “Tax basis” is a taxpayer’s after-tax investment in property as adjusted up or down by certain tax significant items. Tax basis serves multiple purposes including (but not limited to) the amount available for depreciation deductions (with respect to depreciable property) and in the determination of taxable gain or loss upon the sale or exchange of property.1

      When an individual acquires property, the individual also acquires an initial tax basis in such property. Depending on the manner of acquisition, the basis may be (1) its cost, (2) its fair market value as of a specified date, or (3) a substituted tax basis.2 (See Q 693 to Q 695 as to which of these applies to a given manner of acquisition.)

      As indicated above, during the taxpayer’s ownership period, the tax basis of the property may be adjusted to reflect certain additional after- tax contributions to the property, and returns of, the initial after-tax investment in the property. (For example, tax basis is increased by subsequent after-tax investment such as capital improvements; and reduced by deductions (a form of recovery of the initial after-tax investment) such as allowable depreciation or depletion.) A taxpayer’s tax basis, as adjusted, is often referred to as “adjusted tax basis.”3


      1 .IRC Sec. 1011(a).

      2 .Basis is a “substituted basis” as determined in whole or in part by reference to the property’s basis in the hands of a previous owner, or by reference to other property previously owned by the taxpayer for whom the basis is determined. IRC Sec. 7701(a)(42).

      3 .IRC Sec. 1016.

  • 693. What is the tax basis of property that is acquired by purchase or exchange?

    • A taxpayer’s tax basis in property acquired by purchase or in a taxable exchange is its cost (money paid or the fair market value exchanged).1

      Special rules apply to stock exchanges made pursuant to a plan of corporate reorganization.2 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 7517. For the rules applicable to stock received in a demutualization, see Q 7517. Proposed regulations relating to redemptions of stock in which the redemption proceeds are treated as a dividend distribution have been withdrawn.3


      1 .IRC Sec. 1012.

      2 .See IRC Sec. 354.

      3 .See 71 Fed. Reg. 20044 (4-19-2006).

  • 694. How is the tax basis of property acquired from a decedent determined?

    • General Rules

      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 747); normally the basis of such income is zero.1 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.2 If an estate tax return is filed and the executor elects the alternative valuation (see Q 916), the basis is the fair market value on the alternative valuation date instead of its value on the date of death.3

      Under IRC Section 1014(f)(1), the basis of property acquired from a decedent cannot exceed the value of the property as finally determined for estate tax purposes (or, if not yet determined, the value reported on a statement under Section 6035(a)).  Proposed regulations provide that this limitation applies whenever the taxpayer reports a taxable event to the IRS, and continues to apply until the property is sold, exchanged or disposed of in a transaction that requires recognition of gain or loss.  However, the proposed regulations clarify that the rules do not prohibit an adjustment to the basis of property resulting from post-death events that are allowable under another IRC section, and that such adjustments do not cause the taxpayer to violate Section 1014(f) or 6662(k) on the date of sale or other disposition.  Further, the regulations provide that the limitation applies only to property that would increase the eventual estate tax liability, and both define such property and provide examples of exclusions.  When the proposed regulations are made final, they will apply only to property acquired from a decedent when the return is required to be filed after July 31, 2015.4

      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 $10,000.5

      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.6 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 824) 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 824) 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.7

      Qualified terminable interest property. Upon the death of the donee spouse or surviving spouse, qualified terminable interest property (see Q 847) is considered as “acquired from or to have passed from the decedent” for purposes of receiving a new basis at death.8

      Decedents Dying in 2010 Who Elected Not To Be Subject to Estate Tax

      Modified carryover basis. For decedents dying in 2010 who elected not to be subject to estate tax, 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 making the election in 2010 will generally be equal to the lesser of (1) the adjusted basis of the decedent (i.e., carried over to the recipient from the 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.9


      1 .IRC Sec. 1014(c).

      2 .IRC Sec. 1014(e).

      3 .IRC Sec. 1014(a).

      4 .IRC Sec. 1014(f)(1); REG-127923-15, TD 9757.

      5 .Treas. Reg. §1.1014-4(a)(3).

      6 .IRC Sec. 1014(b)(9).

      7 .IRC Sec. 1014(b)(6).

      8 .IRC Sec. 1014(b)(10).

      9 .IRC Secs. 1014(f), 1022 (for decedents dying in 2010 only).

  • 695. How is the tax basis of property acquired by gift determined?

    • 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.1

      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.2 As to property acquired by gift before 1921, basis is the fair market value of the property at time of acquisition.3


      1 .IRC Sec. 1015.

      2 .IRC Sec. 1015(a).

      3 .IRC Sec. 1015(c).

  • 696. How is the tax basis of property acquired in a generation skipping transfer determined?

    • Generally, in the case of property received in a generation-skipping transfer (see Q 874), 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 Q ) before the generation-skipping transfer tax basis adjustment is made.1

      However, where property is transferred in a taxable termination (see Q 8) 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 8).2


      1 .IRC Sec. 2654(a)(1).

      2 .IRC Sec. 2654(a)(2).

  • 697. What is the tax basis of property acquired from a spouse or incident to a 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).1 These rules may apply to transfers made after 1983 if both parties elect.2 See Q 789 regarding transfers incident to divorce.


      1 .IRC Secs. 453B(g), 1041; Temp. Treas. Reg. §1.1041-1T, A-1.

      2 .Temp. Treas. Reg. §1.1041-1T, A-16.

  • 698. 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.1

      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 7796).2


      1 .IRC Sec. 1221; Treas. Reg. §1.1221-1.

      2 .See IRS Pub. 544.

  • 699. 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 gain or loss if the property was owned for one year or less.1 For an explanation of the tax treatment of capital gains and losses, see Q 702.

      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.2 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.3 According to IRS Publication 544 (released in November, 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 Publication 544 have omitted this statement.

      Example 1. Mrs. Copeland bought a capital asset on January 1, 2021. She would begin counting on January 2, 2021. The second day of each successive month would begin a new month. If Mrs. Copeland sold the asset on January 1, 2021, 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, 2022.

      Example 2. Mrs. Brim bought a capital asset on January 30, 2021. She would begin counting on January 31, 2021. 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 7587), nonequity option contracts, and foreign currency contracts (see Q 7592). Furthermore, the short sale rules (see Q 7525 ) and tax straddle rules (see Q 7593 to Q 7614) may require a tolling or recalculation of an individual’s holding period.

      Tacking of Holding Periods

      In some cases, such as when property is received as a gift or in a like-kind exchange, 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.4

      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 200131028.5

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


      1 .IRC Sec. 1222.

      2 .Rev. Rul. 70-598, 1970-2 CB 168.

      3 .Rev. Rul. 66-7, 1966-1 CB 188.

      4 .IRC Sec. 1223(2).

      5 .See SCA 200131028.

  • 700. 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 the 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.1 However, in cases involving mutual fund shares he may be permitted to use an “average basis” method to determine the tax basis and holding period in the securities transferred (see Q 7949).

      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 a broker to sell securities from another lot.2

      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.3 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.4

      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.5

      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.6


      1 .Treas. Reg. §1.1012-1(c)(1).

      2 .Treas. Reg. §1.1012-1(c)(2).

      3 .Treas. Reg. §1.1012-1(c)(3)(i).

      4 .Treas. Reg. §1.1012-1(c)(7); Rev. Rul. 71-21, 1971-1 CB 221.

      5 .Treas. Reg. §1.1012-1(c)(3)(ii).

      6 .Treas. Reg. §1.1012-1(c)(4).

  • 701. 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.1 It makes no difference that the sale was a bona fide, arm’s-length transaction.2 Neither does it matter that the sale was made indirectly through an unrelated middleman.3 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.4 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.5

      A loss realized on the exchange of properties between related persons will also be disallowed under these rules.6 Whether loss is realized in transfers between spouses during marriage or incident to divorce is explained in Q 789.

      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);7 (2) an individual and a corporation of which the individual actually or constructively owns more than 50 percent 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 percent 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 percent of the stock of the corporation, and has more than a 50 percent interest in the partnership; (10) two S corporations if the same persons actually or constructively own more than 50 percent of the stock of each; (11) an S corporation and a C corporation, if the same persons actually or constructively own more than 50 percent of the stock of each; (12) generally, an executor and a beneficiary of an estate; or (13) possibly an individual and his or her individual retirement account (IRA).8 Special rules apply for purposes of determining constructive ownership of stock.9 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.10

      Generally, loss will be disallowed on a sale between a partnership and a partner who owns more than a 50 percent interest, or between two partnerships if the same persons own more than a 50 percent interest in each.11 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.12 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.13 Loss on a sale or exchange (other than of inventory) between two corporations that are members of the same controlled group (using a 50 percent test instead of 80 percent) is generally not denied but is deferred until the property is transferred outside the controlled group.14

      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.15

      Special rules apply to installment sales between related parties (see Q 667) and to the deduction of losses (see Q 8003 to Q 8023).

      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).16 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).


      1 .IRC Sec. 267(a); Treas. Reg. §1.267(a)-1 and Rev. Rul. 2008-5.

      2 .Treas. Reg. §1.267(a)-1(c).

      3 .See Hassen v. Comm., 599 F.2d 305 (9th Cir. 1979).

      4 .McWilliams v. Comm., 331 U.S. 694 (1947).

      5 .IRC Sec. 267(a)(1).

      6 .IRC Sec. 267(a)(1).

      7 .See Let. Rul. 9017008.

      8 .IRC Sec. 267(b).

      9 .See IRC Sec. 267(c).

      10 .Let. Rul. 9017008.

      11 .IRC Sec. 707(b).

      12 .Temp. Treas. Reg. §1.267(a)-2T(c), A-2.

      13 .Treas. Reg. §1.267(b)-1(b).

      14 .IRC Sec. 267(f).

      15 .IRC Sec. 267(d); Treas. Reg. §1.267(d)-1.

      16 .Garber Industries Holding Co., Inc., v. Comm., 124 TC 1 (2005); aff’d, 435 F. 3d 555, 2006-1 USTC ¶50,109 (5th Cir. 2006).

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

    • For tax years beginning in 2018 and before 2026, the long-term capital gain brackets no longer neatly align with the ordinary income tax brackets. For 2022 with respect to adjusted net capital gain, the 0 percent rate will apply to joint filers who earn less than $83,350 (half the amount for married taxpayers filing separately), heads of households who earn less than $55,800, single filers who earn less than $41,675 and trusts and estates with less than $2,800 in income.

      The 15 percent capital gains rate will apply to joint filers who earn more than $83,350 but less than $517,200 (half the amount for married taxpayers filing separately), heads of house­holds who earn more than $55,800 but less than $488,500, single filers who earn more than $41,675 but less than $459,750, and trusts and estates with more than $2,800 but less than $13,700 in income.

      The 20 percent capital gains rate will apply to joint filers who earn more than $517,200 (half that amount for married taxpayers filing separately), heads of households who earn more than $488,500, single filers who earn more than $459,750, and trusts and estates with more than $13,700 in income.1

      Aside from the changes in the income thresholds that determine the applicable rate, tax reform did not change the tax treatment of capital gains and losses and qualified dividend income.2

      For tax years beginning in 2013 and before 2018, adjusted net capital gain was generally subject to a maximum rate of 0 percent for taxpayers in the 10 and 15 percent tax brackets, a maximum rate of 15 percent for taxpayers in the 25 percent, 28 percent, 33 percent, and 35 percent tax brackets (see “Reduction in Capital Gain Rates,” Q 704), and a maximum rate of 20 percent for taxpayers in the 39.6 percent tax bracket.

      Despite these general brackets, detailed rules as to the exact calculation of the capital gains tax result in some exceptions.3

      “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 percent rate gain (both defined below); plus (3) “qualified dividend income” (as defined in IRC Section 1(h)(11)(B)).4

      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 692. The amount realized includes both money and the fair market value of any property received.5 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 699.

      Generally, taxpayers may elect to treat a portion of net capital gain as investment income.6 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.”7 See Q 8040.

      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.8 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.9 See Q 8040.

      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 six 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 the income tax rate that applies based on the taxpayer’s income with respect to the income thresholds described above (see Appendix B), or (II) taxable income reduced by the adjusted net capital gain;

      (B)0 percent 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 the income tax rate that applies based on the taxpayer’s income with respect to the income thresholds described above (see Appendix B) over (ii) the taxable income reduced by the adjusted net capital gain;

      (C)15 percent of the lesser of (i) so much of the taxpayer’s adjusted net capital gain (or, if less, taxable income) as exceeds the amount on which a tax is determined under (B), above, or (ii) the excess of (I) the amount of taxable income which would be taxed at below the income tax rate that applies based on the taxpayer’s income with respect to the income thresholds described above over (II) the sum of the amounts on which a tax is determined under (A) and (B), above;

      (D)20 percent of the taxpayer’s adjusted net capital gain (or, if less, taxable income) in excess of the sum of the amounts on which tax is determined under (B) and (C), above;

      (E)25 percent 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

      (F)28 percent of the amount of taxable income in excess of the sum of the amounts on which tax is determined under (A) through (E) above.10

      It is important to note that as a result of this complex formula, generally, the maximum capital gains rate on adjusted net capital gain for 2013-2017 will be 20 percent to the extent an individual is taxed at the 39.6 percent income tax rate, 15 percent to the extent an individual is taxed at the 25, 28, 33 or 35 percent income tax rates (see Q 753), and 0 percent to the extent the individual is taxed at the 15 percent or 10 percent income tax rates.11 For 2018-2025, the maximum capital gains rate will be determined based on the income thresholds discussed above, which do not neatly align with the individual income tax brackets that will apply beginning in 2018 (however, the 0, 15, and 20 percent capital gains rates continue to apply).

      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 percent; 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.12

      “28 percent 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).13

      “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.14 Examples of collectibles include artwork, gems and coins.15 For additional details, see Q 7713 and Q 7714.

      “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 percent exclusion for certain qualified small business stock).16 See Q 7521 and Q 7522 for details. (JGTRRA 2003 provides that for alternative minimum tax purposes, an amount equal to 7 percent of the amount excluded from gross income for the taxable year under IRC Section 1202 will be treated as a preference item.17 See Q 7522.)

      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.18

      Special rules apply in the case of wash sales (see Q 7537), short sales (see Q 7525), and IRC Section 1256 contracts (see Q 7592).

      NOTE: Beginning in 2013, taxpayers may also have to account for the 3.8 percent tax on investment-type income and gains under IRC Section 1411. This tax was not impacted by tax reform.


      1. IRC Sec. 1(j)(5), Rev. Proc. 2021-45.

      2. IRC Sec. 1(h), as amended by ATRA.

      3. IRC Sec. 1(h), as amended by ATRA.

      4. IRC Sec. 1(h)(3).

      5. IRC Sec. 1001.

      6. See IRC Secs. 163(d)(4)(B), 1(h)(2).

      7. Treas. Reg. §1.163(d)-1.

      8. IRC Sec. 1222(11).

      9. IRC Secs. 163(d)(4)(B)(iii), 1(h)(2).

      10. IRC Secs. 1(h)(1)(D); 1(h)(1)(A), 1(h)(1)(B), IRC Secs. 1(h)(1)(C), 1(h)(1)(E), as amended by ATRA 2012.

      11. IRC Sec. 1(h).

      12. IRC Sec. 1(h)(6).

      13. IRC Sec. 1(h)(4).

      14. IRC Sec. 1(h)(5).

      15. See IRC Sec. 408(m)(2).

      16. IRC Sec. 1(h)(7).

      17. IRC Sec. 57(a)(7).

      18. See TD 8902, 2000-2 CB 323.