Freidell – Intro To Federal Income Tax – Spring 2014
I. Getting Started in Federal Income Tax
A. Understanding the Big Picture
1. In General
a. The process for computing tax liability is traced in Form 1040 and summarized below:
i. Gross Income – Certain deductions = Adjusted Gross Income – Standard or Itemized Deductions and Personal Exception = Taxable Income x Tax Rate = Tentative – Tax Credits = Tax Due
2. Gross Income (§61)
a. Gross income encompasses all income from whatever source derived e.g. compensation, dividends, gain from dealings in property and discharge of debt.
i. However, particular sections of the Code exclude certain type of income from gross income.
3. Deductions
a. Deductions are subtractions from income in computing taxable income. Two types of deductions:
i. Deductions From Gross Income in computing Adjusted Gross Income:
ii. Deductions From Adjusted Gross Income in computing Taxable Income
b. An exclusion from gross income means that the item is simply not included in gross income, so it never enters the computation of taxable income, whereas a deduction is subtracted from GI.
4. Multiply Taxable Income by the Tax Rate
a. The tax rate, which depends on filing status, ranges from 10% to 35% for ordinary income and 15% (and sometimes 0%) to 28% for capital gains.
b. The alternative minimum tax is a separate tax imposed on some taxpayers, with tax rates of 26% and 28% of alternative minimum taxable income.
5. Subtract Available Tax Credits
a. A tax credit is a dollar-for-dollar reduction in the amount due and is subtracted from tentative tax.
6. Seven Fundamental Tax Questions
a. Who is the taxpayer?
b. Does the Taxpayer have income?
c. What deductions may the taxpayer claim?
d. In which taxable year should he include items in gross income or claim deductions?
e. What is the character of the taxpayer’s income and loss?
f. To what tax rate is the taxpayer subject?
g. Is the taxpayer entitled to any tax credits?
B. Sources of Tax Law
1. Administrative Interpretation
a. The Dept. Of Treasury issues regulations (temporary, final or proposed) interpreting various code previsions as well as revenue rulings, revenue procedures, notices, announcements, private letter rulings and technical advice memoranda on various issues.
2. Judicial Interpretation
a. A taxpayer may adjudicate tax matters in the U.S. Tax Court without first paying the tax if a petition is filed within 90 days of the date of the Statutory Notice of Deficiency.
b. Claims in other jurisdictions e.g. District Court or Court of Federal claims you must pay first.
c. The Courts interpret ambiguous statutory material in cases properly brought before them.
C. Tax Ethics
D. Reading Tax Statutes
1. Find the General Rule
2. Definitions
3. Exceptions and Special Rules
4. Related Statutory Material
5. Know when the statute is typically implicated
E. Tax Policy
1. Fairness
2. Administrative Practicality
3. Economic Effects
II. Identifying Gross Income
A. IRC § 61 – Income
1. In General
a. Gross income is defined in § 61 as encompassing “all income from whatever source derived.”
B. Definition of Income
1. Haig-Simons Definition –Theoretical Approach
a. Under this approach, income is the sum of:
i. The market value of rights exercised in consumption; plus
ii. The change in value of the store of property rights between the beginning and end of the year.
2. Economic Benefit
a. Income is the value of any economic benefit received by the taxpayer regardless of its form such as:
i. Tangible Items: The receipt of cash or other property generates income even if from a windfall.
ii. Barter: The exchange of services for services (Rev. Ruling 79-24).
iii. Intangible Benefits: Ex: A taxpayer paying the taxes of someone else is included in gross income.
b. The receipt of cash or property is the receipt of an economic benefit, regardless of its source.
c. Treble damages under antitrust law and exemplary damages for fraud is income (Glenshaw).
d. Windfalls: A taxpayer who found $5,000 inside a piano they purchased is income (Cesarini).
e. Satisfaction of a taxpayer’s obligations constitutes an economic benefit and is taxable (Old Colony).
C. Certain Items That Are Not Income
1. Imputed Income
a. The value of any services one performs for him or his family and the value of using your own property are imputed income, which is not considering income for tax purposes.
2. Capital Recovery
a. A taxpayer’s income from the sale or exchange of property is profit on the transaction, not the total amount received, although the timing of such transaction is a matter for legislative determination.
3. Loans
a. Neither the creation nor repayment of loans is a taxable event. However, forgiveness or the discharge of a loan (§108) may generate income to the debtor.
4. General Welfare Exclusion
a. As a matter of practice, governmental welfare payments are not taxable unless directly specified.
III. Specific Inclusions in Gross Income
A. Specific Items §61(a)
1. In General
a. If an item is excluded from gross income, it will never be taxed.
b. It is also very important to identify different kinds of gross income because certain types of income potentially leads to tax benefits e.g. exclusions, deductions, and credits.
2. Compensation Income – § 61(a)(1)
a. Consideration transferred for the performance of services, whether in the form of salary, fees, commissions or fringe benefits and whether in the form of cash, property, barter or other services.
i. Amount Included: Amount of cash received or the fair market value of the property or service.
ii. Timing Issues: The taxable year depends on the method of accounting and by § 83 if restricted property is involved (see Ch. 11).
iii. Character: Compensation is ordinary income, potentially taxable at the highest tax rate.
3. Gross Income from Business – § 61(a)(2)
ts received, depending on their income level.
3. Embezzled Funds
a. Embezzlers must include proceeds of their embezzlements in their gross income unless they can show the transaction is akin to a loan (Gilbert).
4. Damages
a. Damages for injuries are includable in taxpayer’s gross income, unless excluded under §104, which allows an exclusion for personal physical injury recoveries as the damages make up for lost profits.
IV. Specific Exclusions From Gross Income
A. Death Benefits
1. In General
a. Amounts received under a life insurance policy by reason of the insured’s death are excluded.
2. Transfer for Valuable Consideration
a. The exclusion does not apply to payments made under policies that were transferred for valuable consideration; in that case, the exclusion is limited to the purchase price under the contract.
b. Chronic or Terminal Illness
i. The exclusion extends to amounts paid for the care of chronically or terminally ill insured.
B. Gifts
1. Definition
a. A gift is a transfer made without detached and disinterested generosity (Duberstein).
i. A gift that is not motivated by affection and generosity and entails some return is includable.
ii. Transfers to mistresses are not income, they are just gifts (Harris).
b. The recipient may exclude the cash or value of the property from GI regardless of the amount.
2. Exceptions
a. The exclusion does not apply to the income derived from property received by gift or to any transfer made by an employer to an employee as these amounts are considered compensation.
3. Basis – § 1015
a. A recipient of property by gift or inheritance must determine the basis he has in the property.
b. Property received by gift – §1015(a): The recipient of property by gift takes the donor’s basis in the gift, plus a portion of any gift tax paid on the transfer. However, if at the time of the gift, the fair market value of the property was less than its basis, for purposes of determining loss on subsequent sale or disposition, the donee takes the fair market value of the gift on the date of the gift.
c. The basis of the item gifted is the basis in the hands of the donor and not the recipient (Farid).
d. Property received by inheritance – §1014: The recipient of property through inheritance takes as his basis the fair market value of the property on the date of the decedent’s death or the alternate valuation date if that date is elected.
