Federal Income Tax Outline

TAX OUTLINE
 
OVERVIEW
 
I.                   Deferral:
A.                Extra income increases tax liability, so it is better to get it in the future
B.                 Deductions decrease tax liability, so I want them right now
II.                Progressive Tax System: As tax base increases, government taxes a larger percentage
A.                Example: If making $20,000, first $10,000 goes into first bracket (lowest tax) and second $10,000 into the second bracket
 
Gross Income
 
I.                   Definitions
A.                Taxable (Net) Income = Gross Income – Deductions (TI=GI-D)
B.                 Section 61:  Gross Income = Income from whatever source derived
1.                  Anything found, etc.
2.                  Taxpayer has obligation to value property and pay tax once something is determined to be income.
3.                  Test is objective not subjective. I.e. doesn’t matter that you didn’t know it was a diamond.
C.                 GI – Certain deductions = AGI , AGI – Personal Exemptions – either standard or itemized deduction = taxable income.
D.                Imputed income not gross income—FMV of taxpayer’s performance of services for himself. Consumption of use value of one’s own property.
E.                 Timing—income when received
1.                  Unless constructive receipt
2.                  Key is whether TP had “unfettered control over the date of actual receipt.” If yes then construction receipt and income when they could have received.
F.                  Bargain Purchase rule–Irrebuttable presumption in arm’s length transaction that when you buy property for CASH, you get what you pay for
G.                 
 
II.                Relevant Cases
A.                Glenshaw Glass:
1.                  Are punitive damages awarded income—yes.
2.                  Supreme Court current definition of Income is:
a.                   Accessions to wealth
b.                  Realization
c.                   Dominion and control by taxpayer
3.                  Repudiates the notion that there has to be a source. Source is not a limitation but an explanation.
4.                  Repudiates old definitions but does not provide a new clear definition. However, the three phrases in Glenshaw Glass are key and cited regularly.
 
B.                 Cesarini: When you find money in a piano, it is gross income, taxable in the year in which there was knowledge
1.                  HYPO: Diamond found in piano
a.                   Taxable when found
b.                  Law does not distinguish between cash and property because value is the translation of property into money
1)                  To tax the diamond, it must be valued
2)                  Look to what people in the marketplace are willing to pay
c.                   Fair Market Value: The value that the property would have if it was transferred from a willing seller to a willing buyer, both being reasonably aware of the circumstances
2.                  HYPO: Bought a piano for $1,000, which was really a Steinway valued at $100,000
a.                   No gain, no loss
b.                  Bargain Purchase Rule: Irrebuttable presumption in arm’s length transaction that when you buy property for CASH, you get what you pay for
c.                   Taxed on gain when sold (realized)
3.                  HYPO: Jacket
a.                   Originally cost $200, on clearance for $100
b.                  Willing buyer and willing seller; so there was no gain; the property was exchanged at it’s FMV (what someone is willing to spend)
4.                  HYPO: Do borrowers have income.
a.                   No because the obligation to pay offsets the receipt, negating any accession to wealth.
 
C.                 Old Colony Trust: Employer paid employee’s taxes. Does the employee have income? Yes
1.                  Paying a tax debt of another is gross income, since the discharge of a debt is gain – the same as having cash in your pocket. (Increasing assets or reducing liabilities the same)
2.                  Tax law looks at substance over form
a.                   Employee provides services to employer; employer provides compensation to employee; payment from employer to IRS is equivalent to payment to the employee and then payment by the employee to the IRS
b.                  Payment of tax usually not deductible.
c.                   Identity of taxpayer is critical because tax paying entities are in different tax brackets or have different schedules.
 
D.                Charley v. Commissioner: Employer gave non-transferable travel credits (frequent-flyer miles) to employee
1.                  The travel credits are taxable income.
2.                  What is the value? Cannot measure market value, since it can not be transferred
3.                  Can take restrictions on transferability into account in order to determine wealth only if it is a permanent restriction. § 83
4.                  Can place a definitive value on the credits (is a gain, since people pay money for them, even though they cannot be turned into cash)
 
Property Transferred in exchange for services
 
I.                   Code Section 83(a): If property is transferred in connection with the performance of services to someone other than for whom the services are performed then:
A.                 Excess of the FMV of the property over the amount paid for the property is gross income.
                                    FMV
–          Amount Paid (purchase price)
________________
          Income
B.                 Timing—Gross income when non forfeitable. § 83(a) (we don’t care whether the property is non-transferable in the traditional sense unless it is a permanent condition).
1.                  Gross income in the first time when either: transferable or non-forfeitable.
2.                  I.e. To not be income must be both nontransferable and forfeitable.
3.                  But, if non-forfeitable, then automatically nontransferable so therefore, we only need to focus on forfeitability.
a.                   I.e. if forfeitable then automatically nontransferable (per statute definition of transferability) and therefore there is no income. I.e. both happen together based on forfeitability.
C.                 Timing—Or § 83(b) election to recognize income when property is transferred even if forfeitable. (see below) but no deduction if subsequently forfeited.
D.                Permanent restriction only considered—if temporary restriction, then not considered in FMV.
E.                 ER takes deduction when TP includes the amount in gross income. § 83(h) for an amount equal to the income recognized by the TP.
F.                  Cash does not fit into § 83 exemption from income for forfeitable property. Even if cash is forfeitable (e.g. signing bonus that is forfeitable if you quit in a year) it is still income when received.
 
II.                Relevant Cases
A.                Lobue: Employee was given reduced-price stock options from his employer as part of a compensation package
1.                  Options are taxable when exercised
a.                  Other options for taxing options is when granted or stock is sold.
2.                  Since ER/EE (employer/employee) situation, bargain purchase rule does not apply (not an arm’s length transaction)
a.                   What you see is what you get in an arm’s length transaction. In other words, there is nothing else included in the bargain.
b.                  No one else can get the same bargain.
c.                   Options are compensation for past and future performance.
 
III.             HYPO: Option to buy Exxon stock anytime within 6 months on these conditions: 
A.                If the EE does not perform services in the next two years his stock is forfeited
B.                 Stock is nontransferable until the third year (Transferable and forfeitable in the third year)
Employee decides to purchase stock option for $1000 (FMV = $20,000)
C.                 Option: An economic opportunity to purchases stock at a particular price and at a certain time
1.                  Option itself must be purchased
2.                  Exercising the option results in the purchase of the stock itself
D.                Is it income?
1.                  § 83(e)(3) requires stock to have readily ascertainable FMV
a.                   To be readily ascertainable, an option must be regularly traded on the market
b.                  No readily ascertainable FMV, then option taxed when exercised
c.                   Normally, an option given without restrictions is taxable when received
2.                  Tax on the excess of FMV-Purchase Price
3.                  Bargain purchase rule does not apply, since this is not an arm’s length transaction (Common Interest)
                                                Taxed when Non-Forfeitable
a.                   Forfeitability: Rights in property are subject to a risk of forfeiture if they are based on the future performance of substantial services by any individual
b.                  Transferability: Rights in property are transferable only if they are not subject to a substantial risk of forfeiture
4.                  Election: § 83(b)– allows taxpayer to include property in gross income in the year of transfer even if forfeitable. This is at the free election of the taxpayer. Obviously, one may make this election is they feel the property will go up in value between the time they receive the property to the time it becomes taxable because it is not forfeitable.
a.                   Choice to be taxed like § 83(a) or at the time of receipt (Difference is the “when”)
b.                  If you elect § 83(b), you are taxed at the year of transfer, when the stock was purchased (even if it is forfeitable) (The only thing § 83(b) does is allow you to tax the property when received, even if it is forfeitable)
1)                  § 83(b) must be elected not more than 30 day