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Federal Income Tax
South Texas College of Law Houston
Yamamoto, Kevin M.

Federal Income Taxation Outline – Kevin Yamamoto Fall 2012

Introduction to Federal Taxation

Functions of a Tax System:

1) Raise revenue

2) Means by which govt. can pursue fiscal policy

– Stimulate economy by reducing tax rates in depressions

– Increase tax rates in inflationary periods

3) Accomplish a distribution of wealth and set up burden sharing among taxpayers

– Graduated/progressive system disproportionately burdens highest wage earners with greatest taxes

4) Accomplish social policy by providing incentives for people to do certain things

– Done by exempting certain receipts, deductions, and tax credits

– Negative implications:

o Tremendous amount of complexity

o Sometimes doesn’t operate fairly – the higher your tax bracket the more valuable tax deductions are

16th A.: The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.

– Today, Internal Revenue Code of 1986

Overall fed. tax level and individual tax have remained relatively constant, but:

– Revenues for Social Security and Medicare have risen dramatically

– Revenues from corp. tax decreased dramatically

Income (items of inflow)

Definitions of Income:

§ Haig-Simons = increases in wealth + consumption

– Problem: isn’t workable admin., as everyone would have to appraise their property each year

– All income is either saved or spent, and thus def. usually produces a higher income figure than govt. def.

§ Govt. def. GI (§61) = “all income from whatever source derived”

– Glenshaw Glass: “an undeniable accession to wealth, clearly realized, over which individual had complete control”

– Problem: tautological

Income:

§ Salary and other compensation for services rendered (regardless of form)

– Old Colony Trust: co. paying EEs fed. taxes

o Fed. tax = tax-inclusive (amt. paid not deductible)

o Sales tax = tax-exclusive (amt. paid is deductible)

– If paid other than in cash = fringe benefits taxed at their FMV

§ Punitive damages from lawsuit (Glenshaw Glass)

§ Prizes and awards under §74

– However, excluded if they aren’t retained and meet several other criteria

§ Gains derives from dealings in property (§61(a)(3))

§ Treasure troves under Reg. §1.61-14: found $/FMV of found property in US currency

– Cesarini: cash found in piano bought for $15 includable as income, as would a ring

Not Income (Exclusions):

§ Certain fringe benefits:

– Deviation of HS def., as govt. values consumption at 0

o Thus, better to get fringe benefits below than an increase in salary of that amt.

1) Tax expenditure fringe benefits:

– Contributions to health insurance, workers’ comp., disability, and medical expenses (§104-106)

– Retirement plan contributions – taxes deferred until benefits received, except Roth IRAs

– Dependent care – limited to $5,000/year under §129 (closely parallel dependent care credit)

– Education – limited to $5,250/year under §127

– Cafeteria plans – allow EEs to pick their fringe benefits

2) Work related fringe benefits:

– Justified for admin. simplicity = policy reason

– §132 stat. exclusion for people in ER/EE rel. (1984):

b) No-additional cost services – free airline tickets

c) Qualified EE discount – must be a good/service of the same type ordinarily sold to public in the

line of bus. EE works in

– For goods, excluded to extent it doesn’t exceed ER’s gross profit

– For services, excluded to extent it doesn’t exceed 20% of selling price

d) Working condition fringe – deductible to the extent that if EE had paid for it himself, he would

have been able to deduct

– Normal office furnishings (painting on EEs wall)

e) De minimis fringe – accounting unreasonable and admin. impracticable to tax

f) Qualified transportation fringe

– Gotcher rule: looks to dominant purpose of payer in providing benefit (for all, not just for his EE)

Trips intended to benefit the payer’s bus. are NOT includable in income

– Mr. Gotcher (EE of Economy, not VW): didn’t really have a choice in going if he wanted to exercise sound bus. judgment (forced consumption) and VW set itinerary

Trips intended to benefit the payee personally are includable in income as consumption

– Mrs. Gotcher

§ Meals and lodging under §119 (to EE and his immediate family):

– Justified as forced consumption = policy reason

– Following criteria must be met:

1) Must be furnished

– Kowalski: cash meal allowances to state troopers is NOT furnishing food, implying that the meal must be furnished “in kind” (bought by ER and handed to EE)

2) On the bus. premises – functional, not spatial test

– Adams v. US: US corp. house owned in Tokyo a bus. premise because co. bus. was done there

– Dole v. Commissioner: houses 1 mile from mile not on bus. premise because no bus. done there

3) For the convenience of the ER – requires a substantial non-compensatory purpose

– Prong satisfied by:

o Being required to be on call after bus. hours

o Policy that precludes EEs from eating away from bus. premise

4) Must be accepted as a condition of employment (for lodging only)

– Benaglia: wife and manger of 2 HI resorts allowed to exclude cost of hotel suite and dining room expenses

§ Imputed income (deviation from HS def.) – benefits derived from labor on one’s own behalf or ownership of property

– Violates horizontal equity – similarly situated taxpayers pay diff. tax

§ Gifts (donor is alive) and bequests/inheritances (donor is dead) under §102

– Justified because donor has already included amt. in income, and it shouldn’t be counted again in donee’s income = policy reason

– While HS would tax the donee and not the donor, the IRS taxes the donor and not the donee

o Admin. easier to trace $ and donor is more likely to be in a higher tax bracket

– Duberstein: whether there is a gift is a fact-based inquiry into the dominant motivation of the donor

o Gift = proceeds from a “detached and disinterested generosity,” out of affection, respect, admiration, charity, etc.

– Ex.: giving EEs a Christmas turkey/ham

o Not gift = proceeds from the constraining force of a moral/legal duty, incentive of anticipated benefit, or where payment is in return for services

– Ex. not gifts: Christmas bonus, waitress’ tips, dress provided for an actress to wear to the Oscars, Cadillac given to Duberstein

– Limitations on exclusion:

o §102(c): transfers from ER to EE is always income, except if EE is ER’s child and gift doesn’t relate to bus.

– However, §274(b) permits a $25 de minimis exception to this basic rule

o Donor and donee viewed together, so donor deducting the expense negates “detached and disinterested generosity” needed to qualify as a gift

§ Scholarships and fellowships (including $ for teaching/rendering other services) under §117

– Exclusion for $ covering tuition, fees, books, and supplies, but not room and board

– Must be for “courses of instruction” at “an educational org.” (no research grant to work at NIH)

§ Welfare and other govt. benefits

§ Recovery of basis:

– §1001: gains and losses are accounted for in GI, but recovery of capital is not

o Gains = AR – AB

o Loss = AB – AR

– AR = sum of any $ received + FMV of property

– AB = the means employed to ensure that taxpayer is taxed only once on his accruements by tracking appreciation and depreciation until a realization event occurs

o §1012 general rule: basis = cost

– Rule holds true even if taxpayer got a good deal unless the bargain purchase is the result of a rel. between the parties

o If ER and EE as essentially a substitute for salary, EE is treated as acquiring the asset at FMV with the amt. of price reduction being included in GI

– Philadelphia Park: basis = FMV of property received, or if that can’t be valued then the FMV of what was given up as consideration for it (presumed to be roughly equal)

mts. over the years

– Leftover basis is carried over, so that at the end if any is left unrecovered taxpayer can claim a loss

3) If neither max. price not fixed # of years, then basis is allocated over 15 years

– Installment method is the presumption, so you have to elect/opt out to get either closed or open treatment

o Caution: can elect out thinking you have an open transaction (esp. with contingent sales) just to have IRS determine that you are wrong and put you way back in closed category again

o Least preferred closed transaction (TKP considered realized at once in Year 1)

– Might be preferred if change in Exec. control (get lower Repub. rate before Dems. move in)

§ Life insurance (pure insurance and savings elements – interest earned excluded from tax):

– Premiums paid for life insurance by insured (not deductible)

– Payments due to insured’s death under §101 ≠ income

§ Borrowed funds:

– From illegal sources = income:

o James v. US: taxpayer has received income when he “acquires earnings, lawfully or unlawfully, without the consensual recognition, express or implied, of an obligation to repay and without restriction as to their disposition”

o Collins: EE first stole $80k and then spent it unwisely by gambling (punching his own betting tickets), so $38k loss at end of day (placed $42k in winnings back in till) is a taxable gain

– Loans ≠ income since there is a mutual understanding of a legal duty to repay, and borrower has a bona fide intent to do so (no deduction for repayments)

– Discharge of indebtedness (cancellation of debt – COD) = usually income (ordinary, not capital)

o Old way of thinking about COD = balance sheet approach

– Kirby Lumber: co. repurchased bonds (debt) for less than it was taken out for, with diff. being income

o Assets = capital/net worth + liabilities

– §61(a)(12) codified Kirby Lumber by listing COD as income

o New way of thinking about COD = tax benefit/consistency

– Income results at the point taxpayer knows he no longer has to pay the loan back

– Zarin: taxpayer lost $3.4M at casino, paid back $500k, and casino forgives remainder

o Tax Ct. finds $2.9M COD income, relying also on new and old balance sheet approach

– §165(d): gambling losses are deductible only to offset gambling gains (basket approach)

o 3rd Cir. Ct. of App. reversed, saying debt was unenforceable

o BEWARE: sometimes COD is the mechanism for which gift/compensation between ER and EE is delivered, but this is not COD income

– COD exists when there is no other source of income to classify $ as

o §108 exceptions for COD income excluded from GI (because of harshness of rule):

1) Insolvency of the debtor (§108(a))

– Exclusion limited to extent of insolvency (excess of liabilities over FMV of assets)

– Debts are discharged, but most of debtor’s assets are also taken to pay off as much debt as possible in order of priority and credit is tarnished for many years

2) Purchase price adjustment/reduction of basis (§108(e)(5))

– Very similar to contested liability doctrine – settlement amt. of disputed debt is taken for the actual amt. of the debt

– Does NOT apply if taxpayer is insolvent, subject to bankruptcy proccedings, or if seller or purchaser transferred debt to a 3rd party