FEDERAL INCOME TAXATION – McGovern FALL 2011
Chapter 1: Introduction to Federal Income Taxation
a. A Brief History of Federal Income Tax
i. Federal Income Tax system serves a number of functions:
1. Raising Revenues
2. Social Policy
3. Economic Policy
ii. Govt. can raise incoming revenue two ways:
1. increase tax rate
2. increase tax base
b. Tax Practice
i. Tax practice involves not just the application of tax principles to past events or transactions but, more importantly, advising clients regarding tax implications of actions they are about to undertake.
c. Sources of Tax Law
i. Legislative: Congress à produces Internal Revenue Code (title 26 of USC) and Legislative History [IRC trumps Treas. Reg.] ii. Executive: Treasury Department à IRS=bureau; Treasury Regulations [interpret the IRC]; Revenue Rulings [provide guidance to public taxpayer]; Revenue Procedures; Private Letter Ruling [issued to a specific taxpayer] iii. Judicial:
1. U.S. Tax Court: taxpayer does not have to pay tax in question before bringing suit; this crt has the highest level of tax expertise
2. U.S. District Court: taxpayer must pay tax in question first and then bring suit for refund; jury trials used here; precedent relied on
3. U.S. Claims Court: taxpayer must pay tax in question first and then bring suit for refund; precedent relied on
4. Appeals: all appeals go to the U.S. Courts of Appeals and then to the U.S. Supreme Court
d. Tax Liability = (Tax Rate [§ 1(a)]) x (Tax Base [à Taxable Income under § 63 à Gross Income – Deductions])
e. Methods of Accounting
i. Cash Method à included as ‘received’
ii. Accrual Method à included as ‘earned’
f. Gross Income = all income whether in money, property, or services
g. Adjusted Gross Income: gross income less certain deductions
i. Above The Line Deductions: deductions which a taxpayer may consider in determining his or her adjusted gross income
ii. Below The Line Deductions: deductions which the taxpayer may take into account only after the adjusted gross income has been determined.
iii. Standard Deduction: assumption that all taxpayers had incurred a certain amount of deductible personal expenses
h. Deduction v. Credit
i. Deduction: reduces taxable income, thus providing a reduction in tax that is dependent on the tax bracket of the individual
1. less valuable than tax credit
2. amount of deduction x the individual’s tax rate = effect of deduction
ii. Credit: reduces one’s tax on a dollar for dollar basis
II. Chapter 1 Problem
a. Gross Income: §61
i. 235,000 Cash and Checks
ii. 5,000 house painting (§1.61-2(d)(1)) [PP – if u didn’t force Mr. and Mrs. T, then you would permit the assignment of income to someone in a lower taxable bracket]; gift was given to mother so it’s excluded in gross income
iii. 1,000 Dividends (§61(a)(7))
iv. 9,000 Interest (§61(a)(4))
v. 15,000 Gain from Stock [30,000-15,000] (long term capital gain b/c held stock as capital > 1 yr) (§61(a)(3))
vi. 30,000 owed by clients not included b/c they are “cash method” tax payers (§451a and §1.446-1(c)(1)(i))
vii. Cash Method – included when actually or constructively received v. Accrual Method – included in the yr when the services were performed
b. Deductions: §161
i. Above the line: §62(a)(1) = business deductions
1. 45,000 Wages (§162(a))
2. 5,000 Office Supplies (§162(a))
3. 5,000 Depreciation (§167(a)) – spreading the cost of the bldg each yr
4. 2,500 commute to and from work not included = nondeductible personal expense (§1.162-2(e) and §1.262-1(b)(5))
ii. Below the line:
1. 500 Investment Fees (§212) – not deductible b/c of the 2% floor
2. 10,000 Mortgage Interest (§163)
3. 5,000 Charitable contribution (§170)
4. 2,000 Property Tax (§ 164(a)(2))
5. 3,000 State Income Tax (§ 164(a)(3))
6. = $20,500 (w/ 2%floor on miscellaneous deductions)
c. Adjusted Gross Income: (§62 defines AGI) = gross – above line deduct.
i. §62(a)(1) does not allow for business expense deductions if you work for someone else
ii. AGI = 265000 – 55000 = 210,000
d. Taxable Income §63 = AGI – deductions
i. Itemized (below the line) v. Std Deductions
1. Std Deductions = basic std deduction + add’l std deduction
a. Basic std – look at back of book to get amt (pg 1835)
2. Itemized Deductions – other than deductions allowable in arriving at adjusted gross income and deduction for personal exemptions provided by §151
a. 2% floor on miscellaneous itemized deductions §67 –> can’t exceed 2% * AGI = 4,200 so management fee of $500 is not deductible (if exceeds then only allowed to deduct the portion that is over -> [amt – 2% * AGI])
b. §68 Overall limitation on itemized deductions
i. Overall limit = Itemized deductions – [(AGI – Applicable Amount) x 3%] or if lesser, reduction = 80% of itemized deductions
ii. Applicable amt – back of book for amt (pg 1835) = 142,700
iii. 3% * (210,000 – 142,700) = 2,019 or 80% * 20,000 = 16,000; therefore, overall limit = 2,019
c. 20,500 – 500 – 2,019 = 17,981 (below line deductions)
ii. Personal Exemptions §151
1. can exempt taxpayer and spouse and each child
2. look at back of book for amt (pg 1836) = $3,100/exemption; therefore, 3,100*4 = 12,400
a. If AGI > threshold amt, then exemption amt reduced by applicable %
b. Applicable % = 2% pt for each $2,500 by which the AGI exceeds threshold amt
c. Say threshold amt = 214,050 and AGI = 234,050, so an excess of 20,000; divide by 2,500 = 8; 8 * 2% = 16% so exemption is reduced by 16% = 3,100 – 16%*3,100 = 2,604
iii. 210,000 (AGI) – 17,981 (below line) – 12,400 (personal exemptions) = 179,619 (taxable income)
iv. If you hear the words “adjusted for inflation”, look at the back of the book for actual amt.
e. Tax Rate
i. long term capital gains/net capital gain (NCG) are entitled to a better rate (generally 15%) so you can take that amt out of taxable income -> §1(h)
1. includes dividends and sale of stock = 1,000 + 15,000 = 16,000
2. divide up taxable income: 16,000 (NCG) & 163,619 (ordinary income)
3. 15% * 16,000 = 2,400
ii. Look at back of book for amt (pg 1834): 22,787.50 plus 28% of excess over 117,250 -> 2,400 + 35,770.82 = 38,170.82 (tax liability)
iii. now apply any tax credits!!
1. amts. w/held in paychecks -> if individual employer, then must make monthly tax payments of estimated amt owed
2. child tax credit §24
iv. Marginal rate of tax – highest rate of tax which taxpayers are subject to -> 28%
v. Effective rate of tax – avg rate of tax which taxpayers are subject to -> take taxable income and divide it by tax liability: 179,619/38,170.82 = 21.25%
Chapter 2: Gross Income, Concepts and Limitations
I. Definition of ‘Income’ §61:
a. Eisner v. Macomber: “The gain derived from capital, from labor, or from both combined, provided it be understood to include profit gained through a sale or conversion of capital assets….” – old definition
b. Glenshaw Glass Co.: Whether punitive damages must be reported as gross income? YES.
i. Relies on definition in the code and determines it has a ‘sweeping scope’ à all income from whatever source derived. Congress meant to exert all is taxing power.
ii. Court reasons that with punitive damages you have ‘instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion’.
iii. ‘Accession to wealth’ is the key!!
c. So now we know that the definition of income is all-encompassing and very broad.
d. Roco: Whether a qui tam payment is includable in income? YES. Whether petitioner is liable for the accuracy-related penalty? YES.
ne and benefiting the employee, then GI.
1. McCann: Π was sent to a seminar for work (volunteered to be there) that was all expenses paid and included his spouse. Most of the activities were recreational with a few meetings in the mornings. Should the Πs have included the cost of travel and other expenses in their GI?
a. GI = all income from whatever source derived
b. SC stated that Congress intended to tax all gains except those specifically exempted
c. income includes any economic or financial benefit conferred as compensation, however accomplished §1.61-1(a)
d. when services are paid for in a form other than $, it is necessary to determine the fair market value of the thing received §1.61-2(d)(1)
e. the payment for the trip was an economic benefit to Πs and was recieved as a reward for good work in increasing net sales; therefore, it was compensation for services -> GI; also a spouse was allowed to attend so it was a benefit of the employee and employee volunteered to attend.
iii. Also, look at the separate expenses [transportation à probably not GI à serving the employer; but if ski lift à probably GI à purely recreational] iv. Whether she is serving the ‘convenience of the employer’ à GI exceptions. § 119. Meals or lodging furnished for the convenience of the employer.
e. $3,000 airline tickets from frequent flyer miles [most trips paid by employer] i. FF miles go into one account w/ both personal and business miles [how do you sort it when she uses the miles to buy the ticket] & [what is the value of the ticket] & [problems w/ a uniform reporting system for tax purposes] ii. Bottom line à Announcement 2002-18 à not GI; exception if FF miles are converted to cash.
iii. Could argue that there’s something of value that employee is gaining by receiving the FF miles so it is GI
1. GI can be determined when she actually uses the miles -> FMV of the flight
2. or when she earns the miles
3. if all personal travel and FF miles earned from it, no GI since it is a reward from the airline
4. suppose some travel is personal and some is business and GI is determined when uses the miles -> this is a problem
f. $2,500 greenhouse unexpectedly built by her brother for free legal work done.
i. Possibility #1: gift transfer from brother to sister then no GI
ii. Possibility #2: compensation for services [GI of $2,500]. Barter transaction.
1. Reg. § 1.61-2(d)(1) à use ‘Fair Market Value’ if property received in exchange for services ($2500)
2. Revenue Ruling 79-24. p. 41-42 in casebook. à when u have barter transactions, then have GI
iii. If she was given $1000 cash then GI = 1000 but what if she gives it back in exchange for $2500 greenhouse?
iv. If $1,000 legal services for $2,500 greenhouse. Bargain purchase? If so, then GI is $1,000. $1,000 tax basis in greenhouse.
III. Problem 2. Mitch and his XYZ Corporation stock.
a. Year 1: Purchased for $1,000 and valued at $1,500 at the end of the year. à no realization event ($1000 = basis)
b. Year 2: Worth $2,000. Mitch declines Alberto’s offer to buy stock. à no realization event
c. Year 3: Worth $2,500. Mitch borrows $2,000 from bank w/ stock as security. à he still has obligation to pay back $2,000; no GI; no realization event
d. Year 4: Repays loan. B/c of fire, gets new certificates. Worth $3,000. à same stock, only ‘evidence’ of stock was destroyed; no realization event
e. Year 5: Worth $3,500. Mitch gives it to creditor to satisfy $3,500 debt. à realization event of $2,500 gain; § 61(a)(3)