[I]f Superman crushes carbon and makes diamonds, is that taxable income? ... 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. ...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.” ...
Superman could theoretically avoid gift tax liability by performing the
gratuitous service of crushing coal into diamonds rather than giving a
finished diamond. Although it is true that gratuitous services are not taxed, it is also
true that the IRS and the courts frown on tax avoidance schemes that
attempt to exalt form over substance. Gregory v. Helvering, 293 U.S. 465
(1935). So a scheme by which Superman handed someone a piece of coal,
fully intending to turn it into a diamond, then did so, would be
tantamount to simply giving them a diamond. The IRS would focus on the
substance of the transaction, not the form, and consider it a taxable
gift of property.
But if, for example, Superman were at someone’s house for a barbecue
and decided to thank them for dinner by crushing a lump of their own
charcoal into a diamond, that would be different. In that case Superman
really would be performing a gratuitous service. ...
Superman has crushed coal into diamonds for various reasons, but one of the best known was his gift of a ring to Lana Lang in Superman III.
This raises an interesting question: is an engagement ring subject to
gift tax? There is, subject to certain qualifications, an unlimited
marital deduction for gifts between spouses, but what about an
engagement ring, which is given in anticipation of marriage?
The law surrounding engagement rings and other pre-nuptial gifts has a
long and complex history, dating back to at least the Romans. Most of
the law has to do with who owns such gifts, particularly if the marriage
is called off. But it turns out that none of that matters for tax
purposes. If the donor and donee aren’t married at the time of the
gift, then the marital deduction doesn’t apply. 26 U.S.C. § 2523(a). So an engagement ring is subject to gift tax, even if the donor and donee get married later that same year. In practice I suspect
that few people actually report such gifts, even in the rare case where
it would make a difference in their ultimate tax liability, but maybe
Superman would actually be moral enough to do so.
Crushing coal into diamonds still doesn’t create tax liability for
Superman, and he still has some ways to avoid liability if he crushes
coal into diamonds for other people, but he has to be careful about it.
And strictly speaking he probably should have reported that ring he
gave to Lana.