Law and the Multiverse Mailbag IX

In today’s mailbag we have a question about Superman, diamonds, and taxes.  As always, if you have questions or post suggestions, please send them to james@lawandthemultiverse.com and ryan@lawandthemultiverse.com or leave them in the comments.

Martin asks “if Superman crushes carbon and makes diamonds, is that taxable income?  I would think if he made it into a ring and gave it to Lois the government might want a percentage.”

There are two questions here.  First, are the diamonds taxable income for Superman (or Clark Kent) and second, are they taxable income for a recipient such as Lois Lane?

The answer to the first question is “probably not.”  A traditional, almost fundamental principle of income tax is that a gain in value must be realized before it can be taxed, although the definition of “realized” has expanded over the years, somewhat eroding the principle.  The Internal Revenue Code provides that one example of income is “gains derived from dealings in property.” 26 USC 61(a)(3).  ‘Dealings’ are not defined in the statute, but § 1001(a) defines the computation of “the gain from the sale or other disposition of property.”  It seems clear that improving the value of the carbon is not such a taxable event, since there is neither a sale nor disposition of the property of any kind.  An analogy might be made to a painting that appreciates in value; the increase in value is not taxed until the painting is sold, given away, etc.

If the diamonds are given to Lois Lane, however, that is obviously a gift, which has its own set of special rules.  In the US, gifts are generally not taxable income for the recipient.  26 USC 102(a).  But there is a gift tax that is ordinarily paid by the giver.  26 USC 2501(a)(1) and 26 USC 2502(c).  However, there is a significant exclusion for gifts that currently stands at $13,000 per-recipient per-year.  Thus the question is, presuming the diamonds were given as a gift today, would they exceed the exclusion?

Obviously this depends on the size and quality of the diamond and the state of the diamond market, but for example the diamond given to Lana Lang in Superman III appears to be about 3.5 to 4 carats and of very good quality.  Looking at stones for sale on Blue Nile, a similar diamond would cost somewhere between $150,000 and $400,000, depending on the particulars, which is far beyond the gift exclusion.  So how much would Superman be on the hook for?  The answer is “a lot.”  For example, if the ring were valued between $150,000 and $250,000, then the gift tax would be $38,800 plus 32% of the excess beyond $150,000, so potentially as much as $70,800.

But is the fair market value of the diamond simply that of an ordinary diamond of like size and quality?   The general rule for computing the value of gift of property is given in 26 C.F.R. § 25.2512-1: “The value of the property is the price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts.”  The unusual origin of the diamond is almost certainly a relevant fact, and if diamonds created by Superman are rare, which seems to be the case, then this particular diamond would command a significant premium, and the tax would be correspondingly higher.

This is a problem, since Clark Kent probably doesn’t make enough money to pay the tax, and Superman probably doesn’t want to get tangled up with the IRS.  It is possible to perform a “net gift” for which the recipient pays the tax, but it is unlikely that Lana has the money for that either.  She could sell the ring to pay the tax, of course, but that would defeat the purpose of the gift.  Alternatively, Superman could give her several diamonds with the intention that she keep one as a ring and sell the others to pay the taxes on all of the diamonds.  As complicated as that would be, it might be the only way to keep things above-board.

Note: No discussion of gift tax is complete without mentioning the unified credit of 26 USC 2505. It may not solve the problem here, however.  First, the value of the diamond may easily exceed the credit, especially if Superman gives them out on a regular basis.  Second, Superman may have made other gifts that already used up the credit; he has certainly been around long enough to have done so.

That’s all for this week!  Keep your questions coming in!