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Tax
Penn State School of Law
Barker, William B.

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 transferable 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 serv

ge equals two transactions:
1)                  SALE: Vegy sold vegetables for $100
2)                  PURCHASE: Vegy purchased tuna for $100
b.                  It is assumed that what you sell equals that what you purchase (Exchange)


When is it Income?—TIMING UNDER Cash method

I.                   Key Elements of Timing in Cash Method
A.                Fundamental Principle: CONTROL: When is something sufficiently in hand to say that it is the appropriate time to tax?
1.                  Control can be dropped off at office, home, etc.
B.                 Cash Method of Accounting: Two Essential Components
1.                  Income: Receipt of Cash or its Equivalent
a.                   Reported in the year in which the TP RECEIVES, regardless of when it was mailed or cashed.
1)                  Unless TP is specifically asked not to deposit the check for lack of funds. Charles F. Kahler.
b.                  GAINING Control (In-Flow)
2.                  Deductions: Payment of cash or equivalent
a.                   The moment TP relinquishes control
1)                  Date mailed regardless of when received or cashed.
C.                 Miscellaneous
1.                  If received and then robbed, treat as two transactions.
2.                  If client tells you there are not enough funds to cash check, possible argument that in this one case, there is no income until the funds exist. However, no case law on this.

II.                HYPOS:
A.                Attorney works for a client
1.                  Timeline:
a.                   October: Signs the agreement
b.                  November: Does the work
c.                   December: Sends the bill
2.                  December 31st: Receives $5000 cash payment
a.                   Attorney: Has income, taxed on December 31st (because received at this time)
b.                  Client: Deducts on December 31st (because paid at this time)
3.                  December 31st: Receives $5000 check
a.                   Attorney: Has income, taxed on December 31st (even if there are insufficient funds; treated as equivalent of cash)
1)                  If the check did not constitute a payment upon receipt, he could hold the check until next year and get a deferral
b.                  Client: Deducts on December 31st (assuming there are sufficient funds)
4.                  December 31st: Receives diamond for payment
a.                   Attorney: Has income, taxed on December 31st (not cash or equivalent, since it cannot be liquidated readily, but still constitutes income because it constitutes payment under § 83)
b.                  Client: Deducts on December 31st (when paid)
5.                  December—Client Mails check;         January attorney Receives check
a.                   Attorney: Income in January, when payment is received
b.                  Client: Deducted in December, when he relinquishes control
B.                 Customer buys a chain saw from Sears (assume cash basis accounting for HYPO)
1.                  Customer pays with a Sears credit card
a.                   Customer: Deduction when actually pays the credit card bill
b.                  Sears: Not income to Sears because not guaranteed payment. Income when customer pays the Sears card.
2.                  Customer pays with a VISA (3-party credit system) credit card
a.                   Customer deducts when he signs the slip
1)                  Slip is VISA’s promise to pay – IRS ruled that signing the slip constitutes payment
2)                  This is the thing that constitutes payment between the customer and Sears