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Federal Income Tax
South Texas College of Law Houston
Musselman, James L.

Gross Income
I. Is it gross income (GI)? – §61
A. Gross Income – a clearly realize accession to wealth
a. excluding return of capital
b. not accompanied by contemporaneous obligation to repay
c. not excluded by specific statutory provision
1. Accession to wealth – anything ↑ wealth
a. When items acquired in arms length transaction no accession to wealth b/c presumed even trade, $ value = product’s value
b. Clearly realized – T receives benefit of ↑ wealth
c. Complete dominion by T
2. Burden of Proof on T to prove something is not GI
3. 3 year SoL for IRS to assess additional taxes
B. Imputed Income
1. Monetary value of goods/services someone produces and consumer w/in immediate family unit (Ex: vegetable garden in back yard)
2. Exchange of services – if one person provides service in exchange for return service, the value of return service is income (substance: one person provides service and gets paid $, then hires other to perform service)
II. Discharge of Indebtedness – § 1017
A. Generally
1. GI includes amount of debt discharged – always ordinary income
2. Rational – Borrowing money initially was not accession to wealth b/c of obligation to repay debt equaling amount of debt itself. Once debt discharged, amount of debt unpaid was clearly realized accession to wealth at the time debt incurred
3. Indebtedness – Any indebtedness for which T is liable, or subject to which T holds property
a. T not liable is debt is illegal (illegal gambling – Zarin)
b. Contested Liability Doctrine
i. If T in good faith disputes amount of debt, subsequent settlement of debt amount treated as mount of debt for tax purposes
B. How much is includable? – § 61
1. Full amount of discharged debt not excluded by § 108 is includable as GI.
2. Relief of recourse debt by transfer of property (usually cash payment) satisfies only as much of the debt as the value transferred
a. If property other than cash xferred, would be disposition of property requiring § 1001 analysis, where AR will be relief from debt.
b. Must analyze tax consequences of disposition of property apart from consequences of discharge of indebtedness
3. Discharge of debt occurs when lender agrees to accept value less than amount of debt in full satisfaction of the debt: amount discharged = Total debt – value paid
a. If property other than cash xferred, would be disposition of property requiring § 1001 analysis, where AR = debt d/c + FMV
b. Must analyze tax consequences of disposition of property apart from consequences of discharge of indebtedness
4. SoL – Discharge of debt by SoL running is still includable in GI
5. By Gift – Occasionally, discharge of debt could qualify as gift and would be excluded by § 102
6. Example: In 1980, F transfers to C an asset with FMV = $6k. C d/c $7.5k in recourse indebtedness.
a. AR on disposition of asset = FMV = $6k.
b. F has GI = d/c of debt = $1.5k
C. Exclusions from GI of Discharge of Indebtedness – § 108
1. Exclusions
a. Title 11 bankruptcy
b. D/c occurs when T is insolvent
i. Amount excluded cannot exceed the amount by which T is insolvent (T must pay up to the point T is insolvent)
c. Indebtedness d/c is qualified farm indebtedness
d. if T other than C corp, indebtedness d/c is qualified real property business indebtedness
2. If exclusion fits, use amount of exclusion to reduce tax attributes of T in the following order
a. Net Operating Loss – dollar for dollar
b. General Business Credit – 33 1/3 cents on the dollar
c. Minimum Tax Credit – 33 1/3 cents on the dollar
d. Capital Loss Carryovers – dollar for dollar
e. Basis Reduction – dollar for dollar
3. Election to apply reduction against depreciable property
a. T can elect to apply reduction to § 1017 reduction
4. Purchase of Property from Financing Seller
a. discharge of debt owed by solvent purchaser to seller is treated as price reduction if such
i. debt resulted from purchase of such property
ii. otherwise would be GI from d/c of debt
b. Does not apply if to title 11 case or purchaser is insolvent
Exclusions from Gross Income
III. §102 – Gifts and Inheritances
A. Statute
1. § 102(a) – GI does not include value of property acquired by gift, bequest, devise, or inheritance
2. § 102 (b) – (a) doesn’t exclude the following from GI
a. (1) income from property referred to in (a)
b. (2) where the gift, bequest, devise, or inheritance is of income from property, the amount of such income
3. § 102(c) – (a) doesn’t exclude ER to EE xfers or xfers for EE’s benefit
a. § 1.102-1(f)(2) – xfers to relative-EE’s still excluded if xfer can be attributed to familial relationship, not employment
b. for benefit of EE à likely covers $ given to deceased EE’s family
B. Gifts
1. Factors to Determine if Gift
a. Intent of transferor/donor (most important)
i. Donor’s characterization not determinative
ii. Court makes objective evaluation
b. Did transferor expect something of value in return?
c. How did donor treat “gift” on own tax return?
2. Role of Trial and Appellate Courts in tax cases
a. Jury Trials: Appellate review only reverses if reasonable man could not reach jury’s conclusion
b. Bench Trial: Appellate review reverses only if “clearly erroneous”
c. Trial courts make all findings of fact – usually won’t be reversed
3. §102c – EE Gifts
a. 102a doesn’t exclude from GI amount xferred from ER to EE, or from ER for benefit of EE
b. Case law doesn’t address situation where EE quits, then receives money
c. Family EE’s – if purpose can be attributed to familial relationship, not circumstances of employment, 102c doesn’t apply
d. Tips/Tokes are GI under § 62
4. § 74c – EE achievement awards
a. FMV of EE achievement award excluded from GI
b. § 274j defines EE achievement award
C. Bequests Devises & Inheritances
1. Property acquired by bequest, devise is excluded from GI, subject to 102b.
2. K to settle contested will serves in place of K to devise property to heirs and is not separate K, therefore property acquired as such excludable under § 102
3. Compensation for services not excludable, even if compensation xferred by bequest, devise, inheritance
a. examine intent of donor (quid pro quo or intent for gift – “detached and disinterested generosity”)
b. usually requires some intent to be compensation
c. If will challenged as quantum meruit (or any other K remedy), then payment pursuant to K, not gift.
IV. EE Fringe Benefits – § 132
A. Statute
1. §132a – GI doesn’t include: (1) no additional cost service, (2) qualified EE discount, (3) working condition fringe, (4) de minimis fringe, (5) qualified transportation fringe, (6) qualified moving expense reimbursement, (7) qualified retirement planning services
B. § 132 not exclusive section for fringe benefits, others could also apply (§ 401k, 403b, etc)
C. Rational for allowing exclusions:
1. Non-compensatory: Retail EE’s need to wear clothes/use products to better sell them
2. Working condition fringe – prevents EE from having to include in GI only to deduct later under 162 or 167
D. Specific Fringe Benefits
1. No Additional Cost Service
a. 3 Elements
i. Li

ry – Exclusions still allowed (common for sports team to insure star player for career ending injury)
5. Policy sold for valuable consideration (§101(a)(2)
a. Exclusion of transferee can’t exceed amount of investment – consideration paid + (premiums + other amounts subsequently paid by transferee)
b. Doesn’t apply if:
i. Transferee’s AB is determined by reference to transferor’s AB (gift, part gift/part sale, or spousal transfer)
ii. transfer to insured, partner of insured, partnership in which insured is partner, corporation in which insured is shareholder/officer
c. § 1041 still controls xfer to spouse
6. Terminally ill person sells policy to “viatical settlement provider” – terminally ill person not taxed, but VSP is taxed – §101(g)(B)(ii)
a. allows terminally ill to use money tax free, but VSP taxed in course of business
b. Terminally ill – individual certified by physician as having illness/condition which can reasonably be expected to result in death w/in 24 mos or less
c. Viatical Settlement Provider – any person regularly engaged in trade/business of purchasing, or taking assignments of, life insurance K’s
B. Annuity Payments
1. Generally
a. People pay lump sum up front to get periodic payments of set amount for set number of years
b. Payments from annuity is includable in GI – §72 (101(d) about life insurance payments may trump this)
c. Exclusion ratio:
i. Exclusion = investment/expected return
(i) Expected return = (annual payment) x (life expectancy)
ii. Limitation: total exclusion can’t exceed initial investment in K
iii. If payments cease b/c of death of annuitant, amount of unrecovered investment allowed as lump deduction
VI. Damages and Related Receipts
A. Ask question “In lieu of what were the damages received?” to determine if the are includable in GI
1. If answer would have been includable w/o lawsuit, then it is includable now
B. Physical Injuries/Sickness – § 104(a)(2)
1. GI doesn’t include damages rec’d on account of physical injuries or sickness – §104(a)(2)
a. on account of physical injuries means that physical injury is cause of suit and loss being compensated, not necessarily directly caused by injury
2. damages for nonphysical personal injury (ex: defamation, 1st Amend., Age/sex descrimination), not exludable
3. Emotional distress – depends on underlying action
a. distress incurred on account of physical injury – excludable
b. distress itself is not a physical injury
4. Punitive Damages – always GI, even if physical injury relates to recovery
a. Exception: wrongful death action in which state law enacted before 9/13/1995 provides rules of decision and only allows for punitive damages
5. Settlements
a. Express allocation – generally be followed for tax purposes if (1) agreement entered in adversarial context, (2) at arm’s length and (3) in good faith