Freezing dad: taxing potential human capital.

Chambers, Valrie ; Armandi, Barry

CASE DESCRIPTION

The primary purpose of this case is to encourage students to derive a plausible, well-supported answer to a novel tax situation (in which virtually no direction currently exists) using critical thinking skills. This case is important because practitioners inevitably face situations without finite, predetermined answers. The secondary purposes of this case are to utilize broad-based research skills and familiarize the student with Reg. Sec.1.6694-2(b) of the Internal Revenue Code of 1986, as amended) which states that to protect the preparer from penalties, a tax solution must have a better than 1 in 3 chance of being sustained on its own merits. The level of case difficulty is a 5/6 (graduate level), and is designed to be taught in 3 class hours with 6 hours of outside student preparation, or alternatively assigned as an out-of-class report with a 1-hour in-class discussion.

CASE SYNOPSIS

"Joan, we can be very wealthy in a few years, as long as the technology keeps advancing," said Jim Andrews to his sister. "I don't know, Jim, it sounds kind of eerie and science fiction-ish. And even if the technology is there and we make millions, how much is the government going to grab?" replied Joan. "Good point!" answered Jim. "Let's talk to our accountant."

Most business cases presented to students have a fixed answer either as the result of past investigation in a formal (e.g. legislation or litigation) or informal (academically studied and expert-recommended) environment. However, many problems in life contain novel elements for which no existing answer has been published. Thus it is critical that students be able to think independently of a known, existing answer, while simultaneously relying on similar existing research or tenets. The need for critical thought required to analyze such a situation and derive a tentative solution is as timeless as changes in business environment that precede legislation and litigation. Previous examples of where practitioners have faced novel situations include: the time period where equipment became increasingly more computerized (should the estimated useful life of hybrid equipment be that of the computer elements, or that of the other underlying asset?) and the estimated useful life of software (where tax software, for example was essentially good for a year, but other applications had longer operational lives but faced acute obsolescence before they actually stopped functioning). This case, which is based on the death and subsequent litigation on the disposal of the remains of Ted Williams, has no definitive answer, and requires tax speculation supported by general logic and broad-based research.

INSTRUCTORS' NOTES

Most business cases presented to students have a fixed answer either as the result of past investigation in a formal (e.g. legislation or litigation) or informal (academically studied and expert-recommended) environment. However, many problems in life contain novel elements for which no existing answer has been published. Thus it is critical that students be able to think independently of a known, existing answer, while simultaneously relying on similar existing research or tenets. The need for critical thought required to analyze such a situation and derive a tentative solution is as timeless as changes in business environment that precede legislation and litigation. Previous examples of where practitioners have faced novel situations include: the time period where equipment became increasingly more computerized (should the estimated useful life of hybrid equipment be that of the computer elements, or that of the other underlying asset?) and the estimated useful life of software (where tax software, for example was essentially good for a year, but other applications had longer operational lives but faced acute obsolescence before they actually stopped functioning). This case is important because practitioners inevitably face situations without finite, predetermined answers. This case had no definitive answer, and required quite a bit of tax speculation.

When faced with a novel situation, practitioners must use a variety of sources to fashion a plausible, supported solution. To protect the preparer from penalties, that solution must have a better than 1 in 3 chance of being sustained on its own merits. (Reg. Sec. 1.6694-2(b) of the Internal Revenue Code of 1986, as amended.)

INSTRUCTIONAL AUDIENCE

Because solutions for this situation would fall primarily to practitioners, this case was presented to a master's level tax research and planning class. Students of this class had already had basic federal income tax, and often had a second course in income tax and for a class in estate tax planning. The prerequisites to this class provided basic exposure to the CCH database, and students had some general web-based skills. This case in this context would be inappropriate for students unexposed to basic tax concepts and those lacking basic web skills. A version of this case was presented on an extra-credit basis to two undergraduate Federal Income Tax I classes who were also presented with a brief structured format in class lecture for addressing the issues. While a few results showed promise, in general, undergraduate results were unimpressive.

LEARNING OBJECTIVES

The learning objectives for this case are:

* Identify estate tax issues

* Identify federal income tax issues

* Provide proposed estate tax treatment

* Provide proposed federal income tax treatment

* Understand the interplay between these two types of taxes

* Demonstrate broad, general research skills

* Demonstrate critical thinking skills

LITERATURE REVIEW

Angelini et al. (1999) show that in a tax context, teaching with the use of cases leads to a greater learning experience over lecturing alone. This case stresses student development of a plausible, supported solution in an environment where a solution has yet to be adopted. In a dynamic world with emerging technological innovations, new and novel accounting applications of established theories is probable. Those wishing to become leaders in the accounting field must be able to supply plausible applications using critical thinking skills. Albrecht (2002) values different stages of accounting: Stage 1 (bookkeeping) worth no more than $10 per hour, Stage 2 (summarizing transactions) worth no more than $30 per hour, Stage 3 (manipulating data into useful information) worth no more than $100 per hour, Stage 4 (converting information into knowledge helpful to decision making) worth no more than $300 per hour, and Stage 5 (making value-added decisions using Stage 4 knowledge), worth $1,000 per hour.

Dewey (1933) asserts that reflective and critical thinking involves multiple steps, including problem recognition in an environment of uncertainty/doubt, search for potential solutions, evaluation of alternative solutions, judgment of best decision, and reformulation of the solution as necessary. Piaget (1974) notes that learning to think critically is achieved in developmental stages. Bloom's (1956) taxonomy lists several stages of critical thinking. Fischer (1980) asserts that these stages begin as concrete knowing (knowing of facts), and progress to systems of facts, abstracts of those systems of facts, and how the multiple abstracted systems of facts relate to one another. King and Kitchener (1994) assert seven developmental stages of critical thinking, also beginning with concrete knowing based on personal observation. This stage is followed by: concrete knowing based on authoritative decree, then introducing stages of uncertainty and content-specific justification, followed by a comparison of issue aspects across contexts, followed by knowledge that is the product of reasonable inquiry and is consistent across domains.

Wolcott and Lynch (2002) also approach critical thinking, applying critical thinking skill development directly to business situations using an Issues-Theory-Analysis-Conclusions (ITAC) model. Assuming an implicit foundation of concrete knowledge and skills, Wolcott and Lynch simplify critical thinking into four additional steps: 1) identify problems, relevant information, and uncertainties, 2) explore interpretations and connections, 3) prioritize alternatives and implement a solution, and 4) envision and direct strategic innovation. This structure provides a directly relevant structure for formulating a solution for this case.

CASE DEVELOPMENT

In the summer of 2002, a media and court dispute arose pertaining to the disposition of the remains of the famous baseball player, Ted Williams. His daughter pursued a burial, while his son pursued freezing the remains, allegedly allowing for the possibility of selling his DNA. This case raised many ethical issues, but to a tax instructor it also raised many estate and income tax issues that have not been previously legislated or litigated. Because this case garnered high media attention, the students could identify with the possibility that they might have to answer tax questions in a novel situation as opposed to only finding a previously determined solution buried in the authoritative literature. Thus, this issue produced fertile ground for a short tax research case which required not only a look at the authoritative literature, but also a broad search for relevant historical and scientific context in which to interpret that (lack of) authoritative literature.

RECOMMENDATIONS FOR TEACHING APPROACHES

This type of venture is new and attributable in part to emerging technology. There is no predetermined answer to these questions, rather the student is being asked to come up with answers where no definitive answers (in Code, regulations, or case law) exist, but at least preliminary accounting treatment is needed.

Background

Shown in movies featuring the character Austin Powers, cryogenics is a method of preservation whereby tissues are generally treated then placed in liquid nitrogen and stored at temperatures well below zero degrees Fahrenheit. The hope is that the DNA, body, or tissue, when unfrozen unharmed at a later date will be as useful as the DNA, body or tissue was prior to death and/or freezing.

Cloning is the reproduction of a set of cells using the DNA of one cell. Cloning can be divided into three types: recombinant DNA technology (DNA cloning), reproductive cloning, and therapeutic cloning (Human Genome Project, 2003). Reproductive cloning most commonly results from "somatic cell nuclear transfer," where genetic material from a donor cell is inserted into an egg cell where the original DNA has been removed. The altered egg cell is then inserted into the uterus of the mother for the duration of a "normal" pregnancy. While scientists have celebrated successful cloning of mammals, the stripping of the nucleus from the egg cell is risky, expensive, and inefficient. More than 90% of the attempts fail, and of the viable clones, many have compromised immune functions.

Even where cloning is successful, the specific talents one wishes to purchase in selecting a DNA donor might not be realized due to environmental (including chemical) factors. For example, Jose Conseco has a distinguished career in major league baseball, hitting an impressive number of home runs. His identical twin brother, Ozzie, (who would be similar to a natural clone) had a very short major league baseball career, hitting no home runs.

Alternative Presentation Formats

This case was designed for students to provide a short (1-2) page memo answering the case questions, with research sources attached to the back of the memo. Alternatively, this case could require that the students format their answers in the form of a recommended revenue ruling, present hypothetical courtroom arguments for a particular point of view (e.g. depreciating v. currently expensing cryogenic expenses, or capital v. ordinary income), or as an in-class discussion.

Additional Thought Questions for In-Class Discussion

What are some non-tax issues that can affect this plan? For example:

1. Sale of organ donations is illegal in the United States; sale of sperm or eggs is not. Currently, what is the legality of cloning human beings in the United States? How are the sale of sperm, the sale of eggs, and the donations of organs currently handled under the tax code?

Currently, bills have been introduced to ban the cloning individuals in the United States. (See for example, "Human Cloning Ban and Stem Cell Research Protection Act of 2003," Senate bill 303, 108th Congress, 1st Session, and "The Human Cloning Prohibition Act of 2003," House Report 234, 108th Congress, 1st Session.) If found guilty, criminal penalties would include imprisonment for up to ten years and fines of up to the greater of $1,000,000 or three times the gross pecuniary gain from the violation. Australia and the United Kingdom, however, have allowed (limited) cloning. Therefore, serious consideration should be given to having a portion of this business overseas. Geographical diversification might significantly limit the clients' business risk.

In 1984, the National Organ Transplant Act prohibited the sale of human organs in the U.S. Illegal black markets for organs exist, and it is conceivable that one would spring up for DNA also. For example, Congress has investigated human rights violations in China pertaining to the removal and sale of prisoners' organs before execution (Parmly, 2001). Still, certain forms of quid pro quo arise even in the U.S. BBC News (2001) reports that an "American hospital is encouraging people to donate their kidneys to strangers by promising early operations for their relatives as a reward." Similarly, the organs4life website (2003) answers the question of whether one can sell his organs to another person by saying, no; but "IT IS ENTIRELY POSSIBLE to ask for and receive money and/or other things of value, in return for the HARDSHIPS ASSOCIATED WITH giving up and Organ! (sic)"

Also, selling DNA from the deceased could arguably violate state "abuse of corpse" rules. For example, the Texas Penal Code Sec. 42.08 says, "a person commits an offense if, not authorized by law, he intentionally ... dissects, in whole or in part ... or treats in a seriously offensive manner a human corpse ... [or] sells or buys a human corpse or in any way traffics in a human corpse." If the donor is indeed a willing donor, it seems markedly simpler to obtain a DNA sample from the living donor and forego the posthumous cryogenics.

Selling of tissues or fluids that are regenerated by the body (e.g. blood and semen) have been treated by the courts as legal sale of property held for sale to customers in the ordinary course of business (M.C. Green v. Commr., 74 TC 1229, Dec. 37,229 (1980)). The distinction between blood and organs rests on the ability of the donor to regenerate the removed part. Sale of blood, sperm, and eggs are currently allowed under U.S. law. Often, payments for these materials are labeled as donor stipends or incentive fees, and channeled through non-profit organizations that are overseen by the National Institute of Health.

2. If one child is reproduced from the DNA, and that child's DNA is subsequently sold (at a lower price) to others wishing to have children with celebrity DNA, how are your client's rights protected?

The answer to this rests in the form a legal protection that DNA can have. U.S. common law only recognizes limited tangible property rights for the human body. For instance, the next-of-kin has the right to control the disposition of a human body. Also, the Uniform Anatomical Gift Act controls the treatment of human organs as property for the purpose of facilitating their donation to others.

DNA would likely be protected by a patent. A patent grants the inventor the right to exclude others from using the inventor's discovery for a limited period of time (generally 17 years from the date of patent application; see U.S. Constitution, Article I, Section 8). Currently, DNA for individuals is not patented. However, genes, cell lines, and genetically modified single-cell organisms are patentable per Diamond v. Chakrabary (S Ct. 1980), because that material did not naturally occur in nature. Per Cohen (2001), the DNA Copyright Institute is trying to persuade famous people to copyright their DNA to protect it against DNA theft, misappropriation, cloning, and other unauthorized activities. DNA becomes patentable when it is isolated, purified, or modified to produce a new form (Human Genome Project, 2003). In Moore v. Regents of the University of California, 202 Cal. App. Sd. 12S0, 249 Cal. Rptr. 494 (1988), the California Court of Appeals ruled on property rights of human body parts where physicians removed the spleen of Moore, and then found that the cells of Moore's spleen possessed commercially exploitable characteristics. Without Moore's knowledge, the physicians developed, patented and sold a cell line utilizing the tissue from his spleen.

Patents would likely have limitations similar to those found in animal husbandry law. A royalty or "stud" fee is paid to have the animal bred, but no payments are due from the breeding of the subsequent offspring. Even if a patent violation could be proven however, it is unlikely that all resultant DNA could be successfully recovered.

3. Would the treatment markedly differ if DNA were taken from live donors, frozen, and sold for reproduction purposes? If so, how?

If DNA were taken from living donors, advantages exist beyond reproduction. Tissue samples can be used to identify individuals, establish evidence in court cases, and in testing for genetic disease.

Also, the donor would clearly have no basis in the DNA, and no need for estate planning due to posthumous DNA collection. Remittances for donations would be taxed as earned income (subject to self-employment taxes) in the year(s) received. (Whereas, it would be a daunting task to argue that a deceased person was self-employed when his/her DNA was sold.)

Group Versus Individual Effort

Because novel business situations are often solved after extensive public and private debate, students were actively encouraged to talk with one another about the issues, research findings, applications of those findings, and conclusions. In addition to short class discussions, students had access to one another's email address and to an electronic chat room and discussion board. The final, written solution however had to be uniquely his or hers. Evidence of talking before class, and during break was evident, but each written exercise was unique, and demonstrated varying levels and quality of critical thinking skills.

In lieu of individual problems, this case is conducive to group projects using either instructor-assigned groups or student-formed groups. The instructor could assign group grades using one project grade for everyone in the group. Alternatively, the instructor could assign the project a grade, and ask each participant to allocate that grade among group members. Each student would then receive the average of the allocated group grades. For example, if the group contained three members, and the project grade were a ninety, each group member would have (3 * 90 =) 270 points to allocate among the three group members. Group members who contributed more than average would receive more points (and possibly more than 100 points), with the compensating points coming from the grades of group members who were perceived to be slackers (See Masselli et al, 2001:15 for an example of this grading.) In either case, it is important to clearly outline the grading procedures at the assignment of the case.

INSTRUCTOR ANSWERS WITH STUDENT COMMENTS

As indicated above, the CPA partner suggested several tax issues following the case. The written issues suggested with the case are in italics. Following are the case responses expected by the instructor. This case was tested in a graduate tax course for accounting and tax majors. Therefore, after the instructor's suggested answers student responses follow that enhanced the instructor's response or surprised the instructor.

Under Either Plan (Effect to the Estate):

1. What is the value to the estate of a celebrity's DNA?

Definition of Gross Estate is found in IRC Sec. 2031. (All remaining cited code sections are for the Internal Revenue Code of 1986, as amended, except as specifically noted otherwise.) In general, the value of the gross estate is determined to be the fair market value at the time of death of "all property, real or personal, tangible or intangible, wherever situated." Currently, gross estates of less than 1.5 million dollars (2005; 2 million dollars for 2006-2008) are not subject to estate tax.

DeCode Genetics paid the government of Iceland $14 billion for the population's DNA, or about $50,000/person (Santosuosso, 2000). Both Iceland and Tonga have sold the commercial rights to the DNA information of their citizenry to for-profit companies, and Bear (2001) assesses the profitability of the information gained at about $100,000/person. Dividing the profits equally between donor and researcher, the rights to DNA are valued at $50,000 for the donor.

In the United States, there is no established value for the DNA of a cadaver (celebrity or otherwise) used for reproduction purposes. While organs are sometimes donated at death, Public Law 98-507, Title III Sec. 301 says, "it shall be unlawful for any human to knowingly acquire, receive, or otherwise transfer any human organ for valuable consideration." DNA might eventually be subject to the "no sale" rule. However, medical schools have bartered for cadavers and additional tuition fees for courses with cadaver dissection range from $30 to $1,200, depending on transportation, embalming, registration, cremation, and burial costs (AACA, 1998).

Arguably, the body has zero value because all costs expended on the body to-date were personal expenses to at best increase the quality or quantity of life, not value at death. However, the processing, freezing, and maintenance costs could constitute "improvements" that establish a basis in the remains. Alternatively, these "improvements" could be considered burial expenses (to be deducted from the estate on the estate tax return) instead of allocated against the income that the DNA generates. Using any of these approaches, the remains alone are insufficient to trigger estate tax.

If a market for DNA eventually emerges, the value would likely vary as influenced by such economic factors as supply, demand, and ease of substitution. One could then also approach the valuation by discounting the expected future cash flows of the project.

Student comments (paraphrased): The fair market value of a "non-operating" human body is $0. At one point this famous athlete was worth millions of dollars at the prime performance of his body, however when his contract with the athletic organization was completed they did not renew his contract because they recognized that the decedent's body (property) was no longer as valuable as when he signed the last contract. After he had reached his prime condition, his body began to depreciate in value until his death, at which point a non-operating body was worth nothing to the decedent. The client therefore "inherited" property that has a fair market value of $0.

2. Is the value of the remains of a celebrity sufficient enough to prompt estate tax?

Assuming the student concluded the FMV of the remains was zero, or relatively low, the remains alone would be too low to trigger estate tax. However, if a high value was assigned, or Bob were considered wealthy enough to pay estate tax anyway, estate tax on the remains might arguably be imposed. In 2005, estate tax rates on taxable transfers are 47% above the $2 million (IRC Secs. 2001, 2501). Generally, where the value of the remains is indeterminable, it would be better to use the low end (e.g. zero) as a basis for estate tax purposes. While this will result in a higher income tax rate if DNA is ultimately sold for a profit, the highest income tax rate is substantially lower than the highest estate tax rate, and the income tax liability would likely be deferred to future years, garnering the advantage of the time value of money.

3. Are the costs of cryogenics deductible by the estate? Currently (or must the costs be depreciated, depleted, or amortized)?

Alcor, the firm that froze Ted Williams, offers head-only cryogenics for $50,000, and full-body cryogenics for $120,000. The Cryonics Institute will freeze smaller pieces of tissue (hair, skin, inner cheek, saliva, or blood) for $1,250 plus $98 for a DNA sample kit and preparation procedures. Freezing of animal tissue, which is relatively common, tends to be less expensive. For example, Lazaron BioTechnologies will freeze pet tissue for $500 plus a monthly storage fee (Lazaron, 2003).

Per Reg. Sec. 20.2053-2, reasonable amounts paid for funeral expenses are allowed to the extent that they are: allowable by local law, and must be paid out of the decedent's estate, as reduced by social security and veterans administration death benefits. Examples of allowable expenses are: tombstone, monument, mausoleum, burial lot, mortuary care, embalming, cremation, casket, hearse, limousine, florists, and a reasonable amount for any kind of future care of the remains. Cryogenics are not specifically mentioned, nor are they specifically excluded. Therefore, to the extent that it is the executor's (executrix') choice for post-mortem care, both the initial cost of cryogenics and the ongoing maintenance costs would likely be deductible from the gross estate for estate tax purposes. (Note: In community property states, deductibility depends on whether the funeral expenses are deemed to be community expenses or expenses of the decedent's estate. In the first case, only one-half of the amounts expended are deductible.)

To the extent that these costs can be planned for, it is preferable that the estate, if subject to estate taxes, deducts these costs as funeral expenses because the maximum marginal estate tax rate is currently 48%, whereas the maximum corporate and individual tax rates on the highest-income taxpayers are 35%.

4. What is the estimated useful life of dad's remains?

The estimated useful life to the estate is largely irrelevant, because any sale of DNA will occur under plans 1 and 2, discussed below. Neither plan will likely result in sales immediately (before the settlement of the estate), correspondingly, it is the heirs, not the estate that must determine estimated useful life.

5. Would this plan, if profitable, produce ordinary income, capital gains, or other income (type--e.g. passive)?

To the extent that the DNA (property) is held for the primary use of sale to customers, any income would be ordinary, not capital or portfolio income. But again, it is not the estate that will hold the DNA for resale, but the heirs or their assigns, so this question is not pertinent to the estate, but rather it is pertinent to the heirs.

Under Plan 1 (Effect If Jim & Joan Absorb Costs and Sell DNA):

1. What is the heirs' basis in the celebrity's DNA?

Sec. 1014(a) (1) of the Internal Revenue Code of 1986, as amended, states that the basis of any property, real or personal, acquired by an heir from a decedent is its fair market value of the date of the decedent's death. Fair market value can be defined as the price for which a willing seller would agree to sell and a willing buyer would agree to buy. The heirs' basis in the DNA is likely equal to fair market value as of the date of death, because no current market exists and future value is speculative at best. Further, if no value were allocated to the estate, then the basis would be zero.

2. Is the heirs' basis in the celebrity's DNA deductible against any proceeds received from DNA sales?

If the cryogenic expenses were deducted as funeral expenses, then they could not also be deducted against the sales of DNA. If, however, the heirs incurred and paid the fees, the heirs could likely allocate the cost of cryogenics against the revenue it generates (Code Sec. 162).

3. Are the costs of cryogenics deductible? Currently or must they be depreciated, depleted, or amortized?

To the extent DNA sales are legal, the ordinary and necessary expenses incurred to produce revenue from cloning would be deductible under IRC Sec. 162. Costs used up currently are generally deducted currently. If the cost is expended for a long-term exhaustible resource, it should be pro-rated, either through depreciation (Sec. 167, generally pertaining to fixed assets), depletion (Sec. 611, generally pertaining to renewable natural resources), or amortization (Sec. 197 et al., generally pertaining to intangible assets). Non-exhaustible resources (e.g. land) on the other hand generally cannot be deducted per Sec. 263.

The largest cost of preserving DNA might be overhead, in which case the client must carefully avoid triggering IRC Sec. 263A uniform capitalization rules. Stringent overhead rules apply to all manufacturers and to retailers and wholesalers whose annual gross receipts for the last three years exceed $10 million Because of the potential for exceptionally long DNA "inventory" life, the IRS might assert under Sec. 263A that overhead be capitalized into inventory--essentially suspending the costs of cryogenics indefinitely while taxing the revenues immediately. Further, many of the expenses incurred might be deemed personal (that is, not entered into for a profit) and therefore non-deductible.

Note that cloning is illegal in some states (e.g. Iowa Code, Chapter 707B) and might become illegal nationwide. Still, the income is taxable and expenses related to a (an illegal) business are deductible (see Max Cohen v. Comm. 49-3 USTC 9358, 176F.2d 394 (CA-10, 1949), and Neil Sullivan v. Comm., 58-1 USTC 9368, AFTR2d 1158, 356 U.S. 27 (78 SCt 512, 1958)) unless the expense itself constitutes an illegal payment (such as a kickback, or bribe), or is a court assessed fine for an illegal activity (e.g. speeding ticket), (IRC Secs. 162 (c) and (f)). Although DNA is not yet classified as a "controlled substance," a law change could eventually invoke a statute similar to IRC Sec. 280E, which prohibits the deduction of any expenses related to the trafficking in controlled substances, other than cost of goods sold (W.H. Sundel v. Commr, 75 TCM 1853, Dec. 52,589(M), TC Memo. 1998-78, aff'd per curiam, CA-1 (unpublished opinion), 99-2 USTC Par. 50,635).

Student comments: Sec. 1.263(a)--1(b) denies deductions for expenditures that would substantially prolong the property's useful life, adapt the property to a new or different use, or materially adding to the value of the property. The client is promoting to do all three; therefore, cryogenic expenses for preserving the asset for income generating purposes are not deductible.

In Green vs. Commissioner, 74 T. C. 1229 (1980), the court ruled that taxpayer's bodies are not among the natural deposits considered by Congress as eligible for depletion. In this case, the petitioner's main source of income was the sale of her blood, for which she claimed a depletion deduction for the loss of her blood's mineral content and ability to regenerate. The court did not allow depletion in this case.

Sec. 482 defines an intangible asset as an asset that comprises of any of the following items: patents, inventions, formulae, processes, designs, patterns and know-how. DNA has some of these characteristics, so it may be an intangible asset. Sec. 197 allows amortization of intangibles, generally over a 15-year period. In this case, the father or the parents of the father would be considered the inventor, not the client. With the piecemeal sale of the asset, perhaps the client should sell licenses for the use of DNA.

4. What is the estimated useful life of a celebrity's remains?

For cloning, the estimated useful life is uncertain, and depends on how the remains are ultimately classified. If the remains were held for resale, then useful life would be irrelevant because the DNA would in essence be "inventory."

Some applicants have received patents for DNA, indicating that DNA might be an intangible asset as opposed to tangible, personal property. If the DNA is patented, patent costs would be amortized over the estimated useful life (generally the legal life) of the patent. Sale of patents does receive long-term capital gain treatment under IRC Sec. 1235. Currently, the long-term capital gains tax rate is 15%, making the sale of a patent an attractive option.

If costs are to be depreciated, only a portion of the costs offset the revenue in any given year. IRC Sec. 168 governs depreciation and assigns the estimated useful life for tax depreciation. Currently, cadavers are not directly assigned an estimated useful life. However, if the remains were to be depreciated, Sec. 168(e)(3)(c) states that property that does not have an assigned class life would receive a default class life of 7 years.

If it is argued that the remains are a natural, depletable resource, then IRC Sec. 611 would apply. However, these sections were passed to promote exploration and development of primarily geological (mines, wells, and timberland) resources. DNA might not qualify.

To the extent the DNA will be sold piecemeal, the estimated useful life might best be expressed in terms of number of original DNA samples. An expert in the DNA field, taking into account past experience, present conditions, and probable future developments, best determines this total number.

Student comments: More than 100 individuals have been frozen since the first suspension in 1967. The assumption is they can still be revived when a technology permits. Based on that information, the useful life of dad's remains of the client is at least 35 years.

Scientists have successfully collected DNA samples from a thousands-year old Egyptian mummy (CNN, 2000). The tax life however is the lesser of the real life (which is unlimited) or 40 years (the longest time for a tangible to be depreciated).

5. Would this plan, if profitable, produce ordinary income, capital gains, or other income (type--e.g. passive)?

IRC Sec. 64 defines ordinary income as any gain from sale of property that is not a capital asset. The definition of a capital asset (IRC Sec. 1221) specifically excludes property held primarily for sale to customers in the ordinary course of a trade or business. No laws, regulations, or case laws exist to specifically determine the nature of income received from cloning. However, case law exists regarding the sale of one's own blood. Per M.C. Green v. Commr., 74 TC 1229, Dec. 17,229 (1980), the income from the sale of blood is ordinary and subject to self-employment tax; the basis in one's own blood is zero. Likely, DNA would fall under the broad provisions of IRC Sec. 64 and Green v. Commr. above.

An aggressive taxpayer might try to claim IRC Sec. 1231 capital gains treatment for depreciable property used in a trade or business. However, if DNA is inventoried (and thus not depreciated), it would not qualify for Sec. 1231 treatment.

IRC Sec. 469, passive activities, restricts losses to individual passive investors. Your client, by forming a corporation, would not be affected. The heirs may be subject to passive activity loss limitations for any trade or business in which the taxpayer does not materially participate. The limitations state that all passive activity losses in excess of passive activity gains are suspended until the year that the passive activity loss property is completely disposed of.

Alternatively, the client might be able to place at least some of the proceeds received from the estate into a cemetery perpetual care fund trust. This approach would be, if sustained, beneficial for tax purposes; because per Revenue Ruling 58-190, a cemetery company can currently exclude the portion of the sales price received that is required to be placed in trust for the perpetual care of the grave site.

Under Plan 2:

1. Assuming the celebrity is interred in your facilities for further reproductive opportunities, have you purchased an asset? 2. If so, what kind of asset is it (how do you classify it)? If not, against what do you charge expenses (e.g. cost to transport the body in, etc.)? 3. What is your basis in the celebrity's DNA? 4. Is your client's basis in the celebrity's DNA deductible against any proceeds received from DNA sales? 5. Are the costs of cryogenics deductible by the clients? Currently (or must the costs be depreciated, depleted, or amortized)?

The sale of a human body is generally illegal in the United States, so the remains would likely be held "on consignment," as opposed to purchased. IRC Sec. 162 expenses (and basis) would be deducted against consignment revenue similar to Plan 1 above. Restrictions on cloning are easing internationally, with one company in London being issued a license to clone human embryos for medical research (CNN 2005), so the implications of operating internationally should be explored.

Other Accounting Issues

1. Would the cryogenics fall under start up costs?

Under IRC Sec. 195, the costs of investigation of a new business are capitalized until business commences (often measured by when the first sale takes place), and then amortized over not less than 60 months. The exception to this rule says that when a taxpayer is in the same or similar business as the new, beginning business, the costs of investigation and startup are wholly deductible in the year paid or incurred, regardless of whether the taxpayer undertakes the business (Sec. 195(c)(1)(B)). Arguably, if DNA is yet another fertility method, the costs could be currently deductible.

2. Would the recipient of the fertilized DNA be able to deduct the procedure as a medical expense?

Currently, artificial insemination, in vitro fertilization, and medical expenses for the donor sperm/egg are deductible as medical expenses. Other payments to the donor and payments to a surrogate mother are not (Reid and Main, 2000.)

STUDENT REACTIONS

Initially, several students did not like being assigned an exercise without a known, finite answer. Others found the case intriguing and/or challenging. Some mentioned that attempting to answer a tax question without a known or nearly known answer was nearly impossible. Their source of discomfort seemed to be that they did not know where to "find" an answer if it could not be looked up on the web or in the authoritative literature. That is, they were uncomfortable having to find an answer from logic and general knowledge (including general tax knowledge) alone. When the assignment was not altered to accommodate the discomfort of the students, nearly all produced a reasonably strong case. Students were allowed to discuss ideas and issues amongst one another out of class (similar to bouncing ideas off colleagues in a practitioner setting), but their final answer had to be their own. Scores ranged from a low of 81 to a high of 100. While instructor prepared answers were expected from students, alternate answers were also counted for full credit if well supported. In this sense, the grading for this case differed from those cases that had a finite answer.

Students were given a total of nine cases throughout the semester. Three came from the PricewaterhouseCoopers (2002) series, three came from their Scholes et al. (2002) textbook, and three were instructor-developed cases. A short, relative student evaluation of these cases was made during the last week of class. Subsequent evaluations comparing this case to the other eight cases presented throughout the semester are shown in Table 1.

On the final, departmentally administered teacher evaluations, there is no specific evidence to indicate that this case hurt instructor evaluations, and instructor evaluations in general were quite high for this course.

CONCLUSIONS

The point of this case is to get students to be able to create a reasonable solution to a new accounting problem using general research skills where no such solution currently exists. This case provides a colorful, futuristic scenario where such critical thinking and research skills would be needed. The case is both significantly difficult and significantly engaging to prompt learning and entertaining class discussion.

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Valrie Chambers, Texas A & M University-Corpus Christi

Barry Armandi, SUNY-Old Westbury

TABLE 1: RELATIVE STUDENT EVALUATIONS OF THIS EXERCISE

 # Students
 Chose This
Compared to 8 other cases given..? Case % Rank Order

Easiest (n = 7) 0 0 9 (last)
Hardest (n = 7) 1 14 3-way tie: 2nd
Learned the Most (n = 8) 3 37 1
Most Fun (n = 9) 200% 22 2