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Federal Income Tax
South Texas College of Law Houston
McGovern, Bruce A.

Federal Income Taxation
Fall 2012
Associate Dean and Professor Bruce A. McGovern
South Texas College of Law
Office: Room 232T
(713) 646-2920
bmcgovern@stcl.edu
Resolution of Tax Issues through the Judicial Process
If the IRS Commissioner asserts a deficiency in income tax (taxpayer fails to pay all that is owed), the taxpayer may:
·         Refuse to pay the tax and petition the Tax Court for a redetermination; or
·         Pay the deficiency, file an administrative claim for refund, and upon denial of the claim, sue for refund in federal district court or the US Court of Federal Claims
o    These 3 courts have original jurisdiction in fed tax cases!
The Courts
The Tax Court
·         This court is the most important. It has been referred to as the “poor man’s court” b/c the taxpayer commences an action for redetermination of a deficiency without first paying the asserted deficiency.
o    In contrast, actions for refund in the fed district courts and the Court of Fed Claims are commenced only after an asserted deficiency is paid
·         Becuase it only hears tax cases, the Tax Court is the most sophisticated trial court from the standpoint of tax expertise.
Federal District Courts
·         The USDC has jurisdiction in any tax case against the US seeking a refund of tax, regardless of amount involved. They may be tried before juries. The taxpayer brings the action in the district where they reside or, if a corporation, in the district where it has its principle place of business.
·         Here you have to first pay the amount in dispute
The US Court of Federal Claims
·         Has jurisdiction over all tax suits against the US regardless of amount. A jury trial is NOT available. Where one resides makes no difference.
·         Here you also have to pay the deficiency before bringing suit
Appeals
·         Appeals from the Tax Court are heard as a matter of right by the Fed Court of Appeals of the US. Jurisdiction is given to the circuit where the taxpayer resides.
Resolution of Tax Issues through the Judicial Process
If the IRS Commissioner asserts a deficiency in income tax (taxpayer fails to pay all that is owed), the taxpayer may
o    Refuse to pay the tax and petition the Tax Court for a redetermination
o    Pay the deficiency, file an administrative claim for refund, and upon denial of the claim, sue for refund in federal district court or the US Court of Federal Claims
§  These 3 courts have original jurisdiction in fed tax cases!
 
The Tax Court
·         This court is the most important. It has been referred to as the “poor man’s court” b/c the taxpayer commences an action for redetermination of a deficiency without first paying the asserted deficiency.
o    In contrast, actions for refund in the fed district courts and the Court of Fed Claims are commenced only after an asserted deficiency is paid
·         B/c it only hears tax cases, the Tax Court is the most sophisticated trial court from the standpoint of tax expertise.
 
Federal District Courts
·         The USDC has jurisdiction in any tax case against the US seeking a refund of tax, regardless of amount involved. They may be tried before juries. The taxpayer brings the action in the district where they reside or, if a corp, in the district where it has its principle place of business.
·         Here you have to first pay the amount in dispute
 
The US Court of Federal Claims
·         Has jurisdiction over all tax suits against the US regardless of amount. A jury trial is NOT available. Where one resides makes no difference.
·         Here you also have to pay the deficiency before bringing suit
 
Appeals
·        
 
·         So why not tax the mother? = That would be an invalid assignment of income for tax purposes. Instead, the Taxpayer’s would be taxed on the value of the services performed.
·         We can get to this another way à §61 says “compensation for services”. This works too
·         One question that can arise is what is the value of the services that have been provided?
o   This can be hard, but here we are told the value is $10,000.
·         So totaling the income, the “gross income” is the cash, checks, and services received. This is paragraph 1
·         In paragraph 2, they are owed $30,000 from clients for work they performed during the year. Income?
o   This is a matter of accounting rules. Here, since they are “cash method” taxpayers, and they have not yet received payment, they do not yet have gross income this year!
§  Note the separation b/t the year the work was done and the year the work will be paid for. This is ok, although we’ll see some limitations later (refusing to take the $ this year to lower your taxes). BAD!
·         There is a doctrine for this à constructive receipt. So if you don’t actually receive payment, we say you constructively received it and you have income this year.
o   In paragraph 2, though, we don’t have these facts, so no gross income
o   When we study the accrual method, though, we’ll see they have income
·         Paragraph 3. Payment for business expenses. Do we take this into account in determining taxable income? = Yes!
o   But unlike gross income of §61, we are looking at expenses
·         When we are talking about expenses, if you want it to be deductible, you MUST find authorization
·         Here, §162(a) – all the ordinary and necessary expenses paid or incurred during the taxable year in order to carry on a trade or business. This is the most common one used for business expenses!
o   A litigation question is whether the expense ordinary and necessary. Is it incurred in carrying on a business?
·         Here, there are no red flags. They seem run-of-the-mill business expenses. So this amount in paragraph 3 can be deducted, they just have to POINT TO THIS PROVISION
 
 
 
Appeals from the Tax Court are heard as a matter of right by the Fed Court of Appeals of the US. Jurisdiction is given to the circuit where the taxpayer resides.
 
Accounting Methods
Cash Method of Accounting
·         The applicable Code provisions begin with §441 which tells us to compute income on the basis of the taxpayer’s tax year
o    For our purposes, taxpayers will be on the calendar year (like individuals)
o    Businesses may have fiscal years that begin and end at diff times than the calendar year
o    §441(a) tells us to compute the income under the TP’s method of accounting.
o    This translates into individuals can use the cash method. Businesses frequently use the accrual method (although they sometimes use the cash method)
·         Regs §1.451-1. This Reg states the general rules that gains, profits, and income are to be included in GI for the taxable year in which they are actually or constructively received by the T, unless….(this part won’t be the case for the cash method payer)
·         “Constructively Receive” income
o    Reg §1.451-2 In the year the income is credited to his account, made available to him, etc (see reg)
o    if the control of receipt is subject to limitations or restrictions
Accrual Method Accounting
·         Income §1.451-1(a)(1) and §1.446-1(c)(ii) – An accrual method T must report income when all the events have occurred which fix the right to such income and the amount can be determined w/ reasonably accuracy
Problem: Caroline Taxpayer
Caroline Taxpayer is a business consultant who owns and operates her own unincorporated business and uses the cash method of accounting and reports her income on a calendar year basis. She has provided you with the following information concerning her financial affairs during the calendar year and asks you to compute her tax liability.
Gross Income or Deduction Classification
Item
Authority
Gross Income
Deduction
1a. $275K in Fees
§61(a)(1)
$275,000
 
1b. $10K landscaping
$61(a)(1)
$10,000
 
1c. $30K still owed
Not GI because it has not been received yet.
$0
 
1d. $60K wages to employee
§162(a)(1);
§62(a)(1) – ATL deduction
 
$60,000
1e. $20K for maint/util/supplies
§162 – necessary business expense;
§62(a)(1) – ATL deduction
 
$20,000
1f. $500K for building
§167(a)(1) – prop for trade or business; depreciation
§62(a)(1) – ATL deduction
 
$10,000
2. $5K commuting costs
§1.162-2(e) – Not deductible
$0
 
3. $19K in interest income
$61(a)(4) – interest income
$19,000
 
3. $1K management fee
§212(1) – production of income expense; however, it is subject to the 2% rule limitations under §67(b)(1)
 
$1,000
4. $18K in mortgage interest payments
§163(a) – interest
 
$18,000
4. $6K in principal payments
Not deductible
 
$0
5. $1K dividends
§61(a)(7)
$1,000
 
5. $30K in sale of stock
§61(a)(3) – gains from prop;
§1001 – calculate gains from prop
$15,000
 
6. $9K charitable giving
§170 – charitable giving
 
$9,000
7. $3K in state & local sales taxes
Not deductible; Can possibly deduct in TX under §164(b)(5)(A)
 
$0
7. $5,200 prop taxes
§164(a)1)
 
$5,200
7. $14K in state income tax
§164(a)(2)
 
$14,000
7. $40K estimated fed taxes
Not deductible; it's a tax credit
 
$0
Analysis
Classifying the TP
Caroline is classified as an unmarried individual for tax purposes. The classification will be used for determining her tax liability.
Gross Income: §61
Caroline has gross income in the amount of $320,000. Gross income is defined broadly as any “accession to wealth.”
Adjusted Gross Income: §62
To calculate Caroline AGI, you take her GI and subtract any above the line deductions. An above the line deduction is a deduction that is defined in §62. Here, Caroline has ATL deductions totaling $90,000. They include the $60K in wages paid to employee, the $20K in building maintenance fee, and the $10K in the depreciation of the office building.
 
Thus, Caroline’s AGI is calculated as ($320,000 – $90,000), which gives us an AGI of $230,000.
Taxable Income: §63
To calculate Caroline’s TI, you will need to decide if she will itemize her deductions or take the standard deduction. Generally, if a TP’s BTL deductions are greater than the standard deduction, then the TP should itemize. Caroline has a total of $46,200 in BTL deductions. (Note here that the $1,000 management fee cannot be deducted because of the 2% floor limitation, which is discussed below.)
 
Here, Caroline’s BTL deductions are greater than the standard amount of $5,950, which is found in §63(c)(2) and adjusted for inflation by Rev. Proc. 2011-52. Thus, Caroline should elect to itemize her deductions.
 
To calculate TI, you will also need to subtract any personal exemptions allowed. §151 allows a TP a personal exemption (adjusted for inflation) in the amount of $3,800.
 
Thus, Caroline’s TI is $180,000. Which is arrived at as following.
 
(AGI

BTL Deductions

Personal Exemption)
=
Taxable Income
($230,000

$46,200

$3,800)
=
$180,000
2% Floor Limitation: §67
§67 provides that certain itemized deductions may not be deducted except to the extent that in the aggregate such deductions exceed 2% of the taxpayer’s adjusted gross income. Here, the fee does not exceed $4,600, which is 2% of her AGI.
Tax Burden
Next, we need to determine Caroline’s tax burden. To do this, you find the appropriate tax rate in the tables. Caroline has a taxable income of $180,000. However, part of that income is due to capital gains.
 
Capital gains are calculated at a rate of 15%. The amount of capital gain income that Caroline has is $16,000 ($15K from sale of stock and $1K in dividends). Thus, this amount will be subtracted from the TI and taxed at the lower rate.
Ordinary Income: §64
Caroline now has ordinary income of $164,000 and capital gain income of $16,000.
 
The corresponding tax burden found in the tables is $17,422.50 plus 28% of excess amount over $85,650. Thus we calculate Caroline’s tax burden on her ordinary income as follows:
 
Initial Amount
+
((Ordinary Income – $85,650) * 28%)
=
Tax Burden on Ordinary Income
$17,422.50
+
(($164,000 – $85,650) * 28%
=
$39,360.50
 
Capital Gain Income
Now, we need to calculate the tax burden from the $16,000 in capital gain income. Capital gain income is taxed at 15%. Thus, Caroline has a tax burden of $2,400 on her capital gain income.
 
Finally, we add both of the amounts calculated above and we end up with a total of $41,760.50. This amount represents the total tax burden on Caroline.
Tax Credit
A TP’s tax burden may be reduced by any credits that they are entitled to. Tax credits are different from deductions in that they are a dolor-for-dollar reduction of a TP’s tax burden.
 
Here, Caroline paid $40,000 in estimated federal income tax. §31 allows a tax credit for amounts paid towards a TP’s tax burden. Thus, this amount will be credited towards Caroline’s tax burden.
Conclusion
Caroline will need to send a check to the IRS for $1,760. This will fulfill her tax burden.
 
Chapter 2: Gross Income
What constitutes gross income?
 
The SC, years ago, took a stab at this in Eisner v. Macomber, to determine what income was. In the early IRC years, this was a big question
·         They said it was “gain from capital” (from labor or the combination of labor and capital)
·         But as we’ll see, that it became clear that to the extent this was a definition, it wasn’t a satisfactory one
Cases
Old Colony Trust
·         Facts: The president had a deal with the Board that they would pay him income taxes. In 1918, he was receiving $979,000. The next year, he was down to $500,000. On the $979K, the company paid his taxes, which was 70%!!!! This was a very substantial amount ($681,000 in taxes). So are they compensating him?
·         Issue: Whether the amount paid by the board was additional compensation.
·         Holding: SC said that it was part of his compensation.
 
·         Whose liability was this to pay?
o    The president, because the tax was levied on him.
o    The corporation paid an obligation of the president.
o    So the court said this payment represented consideration for his services rendered, thus part of his compensation (to pay his obligation)
·         What if the corporation was just doing it as a “nice thing”, i.e. not a deal (not even bargained for)?
o    Even if it wasn’t something bargained for, we are still asking the same question: why are they doing this?
§  because they are providing compensation for services rendered
o    The form of the compensation is they are paying his debt.
o    So we have to decide whether this is compensatory or a gift.
·         So how do we look at this transfer in the employer-employee context?
o    Most likely compensation.
·         One objection put forward to this was: once you call this big payment compensation, what is the next step going to be for the president?
·         Determining the tax liability. The payment of almost $700,000, treating it as income, is going to generate more taxes, on and on. The taxpayer argued that you are levying a tax upon a tax.
o    The SC said we don’t have to answer that now, but later the IRS issued guidance that said that is exactly right. If your employer is paying your obligation, that is income. If the employer

nothing to reduce it down into.
·         But if we go back to the Reg, it says “treasure trove” is taxable
o    So you would argue that the gov’t deliberately chose that word.
·         The gov’t would argue that this is not all inclusive.
·         If finding the painting and reducing it to possession was enough to cause immediate taxation, you’d be much worse off – if you made a bargain purchase at a garage sale, are you taxable now?
o    No, you just made a heck of a bargain purchase. We’ll wait until the painting is disposed before taxing
·         But what if you find the same painting? Are you immediately taxable b/c it is treasure trove? You may offer to buy for $10 to avoid this. So the issues are here
McCann
·         H & W took a trip to Las Vegas. She qualified b/c of her sales at her job. The company took the top sales people to a “sales retreat” and paid for all expenses. They weren’t required to attend. It was more of a pleasure trip – the business portion was minor.
·         Issue: They didn’t include any amount for the cost of the trip in their income for that year. IRS audited them.
o    So the court viewed this trip as part of her compensation.
Problems
Part 1(a) – Compensation
·         Under §61(a)(1), this is compensation for services. What is the amount of her compensation?
o    $75,000. However, take-home is $50,000.
o    The $15K withheld is a tax credit under §31
Part 1(b) – Year End Bonus
·         Taxable. §61(a). Also, in Reg 1.61-2(a) specifically lists bonuses as part of income. This has to be the case, b/c if not taxpayers will list their wages as bonuses, not compensation.
o    This is also not a gift, which we’ll talk about later
Part 1(c) – Funiture
·         This is a bargain purchase
·         Peller
Part 1(d) – Law Firm Retreat
·         Law firm ski trip.
·         If you compare McCann to this problem, what is the difference?
o    In the problem she was required to attend. But if Mrs. McCann would have been required to go, would it still be compensation?
§  It would have been a stronger case for her
o    But what else might you like to see that the court was concerned with here in McCann?
§  It is a reward for services. Only the top salespeople go, and it was a recreation trip, there were no substantial business activities going on
·         Here, the TP would say that there really are substantial business activities taking place during this retreat. Also, the fact that she was required to go is helpful
·         Note – in the McCann case, there was frequent reference to the president of the corp. What argument might you make if you were representing the president who was doing all of the same things that McCann and her husband were doing?
o    Even if with respect to Mrs. McCann and her husband, this was in the nature of a reward/bonus (compensation).
o    Even though the president was in the same activities, you can say he is carrying out his job. He has to be here. It’s nice to have a job that involves fun, he is still on duty carrying out his responsibilities for the benefit of the employer.
·         Note – Also, the “convenience of the employer” doctrine would be used in the taxpayer in our problem’s situation.
o    She went at the convenience of her employer. They needed her to go for business purposes. – Code §119
 
Part 1(e) – Brother builds her a greenhouse for thanks for her legal services.
·         Is this a situation where Marcela is taxable on the value of the property that has been built for her at no charge?
·         Is she receiving something valuable from her brother? = Yes.
·         Let’s look at §102(a) – Marcela would assert this. That the work done by her brother was a gift. Her brother would argue that her legal services were her gift to him also.
·         Rev Ruling 79-84
o    Two scenarios. In both, the IRS said there was gross income as a result of the barter arrangements.
§  What is it measured by? = Fair market value of what you are receiving. So if you are providing services and receive services in return, you have GI measured by the FMV of what you received
·         So back to our problem. Why are we NOT applying this reasoning to her and her brother?
o    They are related – close family members. We will assume that these represent gifts.
o    We have a code section that says gifts are not GI (above)
·         From the facts of the Rev Ruling, do we have family relationships?
o    The first scenario talks about a barter club, and the IRS was concerned about this. The IRS said these are taxable, even though no cash changes hand
§  How far will we extend this principle? In our problem, it seems like gifts, not compensation for services
·         Suppose Marcela says to her brother at the outset that she’ll provide the legal services provided you build a greenhouse. This seems closer to barter and further from a gift.
·         So you can see in this Revenue ruling, where we have an arranged barter club, a business arrangement, the IRS will tax it.
·         Note – gifts, for whatever amount, are untaxable.
 
Part 1(f) – Marcela represents herself, saving herself $10,000 in legal fees.
·         Do we have gross income when we perform services for ourselves? Do we have rental income when we use our own property? Are we receiving the rental value of that property? From an economist standpoint, he’d say you do have imputed income.
·         So things you do for yourself, like mowing or building a house for yourself.
·         The IRS makes NO income of imputing your income for your own services
Part 2
·         This is the notion of “realization”
·         Mitch buys stock in a corp and after a year, the property is worth more.
o    So at the end of the first year, is he wealthier? = Yes!
o    Do we tax him on that increased wealth? = No!
·         The reason is b/c the gain in that stock has not yet been realized.
o    We will see that realization comes about upon the sale or other disposition of the property
o    So don’t tax Mitch at the end of Year 1 even though he is wealthier b/c he has not yet realized the gain.
·         Note – we use realization b/c valuation issues for a lot of things would be difficult and a nightmare to administer. So the realization requirement is pretty firmly entrenched