Federal Income Tax Outline
· Constitutional Issues
o Must impose direct taxes by the rule of apportionment, and
§ Tax demanded from the very person who is intended to pay it
§ Congress establishes a sum to be raised by direct taxation, the sum must be divided among the states proportionate to their respective populations.
o Indirect taxes by the rule of uniformity
§ Tax paid primarily by a person who can shift the burden of the tax to someone else or who at least is under no legal compulsion to pay the tax.
§ Geographic uniformity
16th Amendment validates Income Tax
¨How do you deal with a tax problem?
1. Read the code
2. look for defined terms (bills, hearings)
3. look at interpretation (reg’s, committee reports, legislative history, revenue rulings, case law)
¨Income Tax Formula: §63(a)
GROSS INCOME – DEDUCTIONS = TAXABLE INCOME x RATES = TAX LIABILITY – CREDITS = TAX DUE
We’ll spend 2/3 of our time on Gross Income, 1/3 of our time on deductions
¨Concept of the taxable year: individuals=calendar year
¨How do you apply the tax rate? We have a graduated structure: not all income is taxed at the same rate. §1 IRC. $36,900 x .15=$5535 + 23,100x .28=6468 ….$12,003 28% “marginal tax bracket” p. 31-38 concept of progressivity: how fast you move up in the rate/bracket? Opposite of the flat tax.
1. Gross Income
A. IRC §61: Gross Income Defined: Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items:
1. Compensation for services, including fees, commissions, fringe benefits, and similar items;
2. Gross income derived from business
3. Gains derived from dealings in property
8. Alimony and separate maintenance payments
10. Income from life insurance and endowment contracts
12. Income from discharge of indebtedness
13. Distributive share of partnership gross income
14. Income in respect of decedent
15. Income from an interest in an estate or trust
CROSS REFERENCES: SPECIFIC INCLUSIONS IN GI: §71
SPECIFIC EXCLUSIONS OF GI §101
Cesarini case: ($ in the piano)
¨We have a voluntary tax system b/c taxpayers self report by filing returns every year. Whether something is includable in income is diff question than whether it was actually reported. Burden of proof rests w/ taxpayer to show its not includable. Generally, IRS/T has only 3 years to make a claim for $. (SOL issue can sometimes be raised)
¨Musselman says the way the court handled this case is how we should do our analysis:
What is “income”?
1. court first looks at list of 15: if its on the list its included
2. court then looks at other inclusionary sections of IRC (§71, etc)
3. court then looks to exclusions in IRC §101
4. Look at Treasury Regs
§1.61-1(a) Regs: Gross income means all income from whatever source derived, unless excluded by law. Gross income includes income realized in any form, whether in money, property, or services. (ie: income from all sources is taxed unless the taxpayer can point to an express exemption, b/c of broad language of §61 IRC))
§1.61-14(a): “Treasure Trove, to the extent of its value in US currency, constitutes gross income for the taxable year in which it is reduced to undisputed possession.”
“Reduced to undisputed possession” (ie: when title vests) is a state law question: here title rested when P actually found the $ in the piano. It’s a property law question, so we look to state law)
Old Colony case: (pymt of taxes by employer)
RULE: Obligations paid on your behalf by 3rd parties are included in gross income. If a 3rd party pays a personal liability of yours, you have to pay taxes on that payment to the 3rd party.
RULE: Substance Over Form: general theme of tax code. Trying to get $ to not pass through their hands, while still accepting value of the deal. Form not important; whole purpose of IRC is to tax substance of the transaction. In this case, the employee gained from the employer for services rendered. It was immaterial that the $ was paid directly to the gov’t (or to anyone else for that matter).
Glenshaw Glass case:
RULE: Regular, punitive & treble damage awards are includable in gross income.
RULE: Definition of Gross Income:
1. “accession to wealth”: ie increased your net worth
2. clearly realized:
“the Realization Principle”: fluctuations in value are not taken into consideration until profit is clearly realized by a “realizable event” like selling the property. Other realizable events include: anything that causes you to no longer own the property. Otherwise you’d have to account for fluctuations in value every year in your taxes.
Reasons why we use the “Realization Principle”:
1. fluctuations in value
3. who’s going to determine the value (not practical to have appraiser come out & appraise everything you own every year)
3. over which the taxpayer has complete dominion and control
Our tax system is referred to as a “transactional system.” Some event must occur to create tax liability.
What makes something realized? “A notorious event occurred.” Where you receive something of value beyond what you had to confer to get it!
Charley case: (frequent flier miles):
Rule: travel credits which were converted to cash can be characterized as additional compensation (either as compensation or a gain derived from property)
· Question to ask: wealthier after the transaction than before?
PROBLEMS (p. 65) GROSS INCOME
1. Would the results to the T in Cesarini be different if instead of discovering $4467 in old currency in the piano, they discovered that the piano, a Steinway, was the 1st Steinway piano ever built and worth $500,000?
(This is a realization principle question. Diff. from land appreciation in that this piano was worth $500 when you bought it. Was the original purchase then a TA that made the accession taxable? Is purchase enough? Is this a notorious event that could constitute realization? Liquidity is a problem–you’d have to sell to be able to pay tax on $500,000. The Practical Problem though is the key: you’re not going to have everything you buy appraised every time you buy. ACQUISITION OF PROPERTY IS NOT THE REALIZABLE EVENT AT ARM’S LENGTH. In addition, this is an accession to wealth because the piano was purchased for a price that was less than the value. (not a taxable event)
2. Winner attends the opening of a new department store. All persons attending are given free raffle tickets for a digital watch worth $200. Disregarding any possible application of IRC §74, must Winner include anything within gross income when she wins the watch in the raffle?
(Is winning the watch in a raffle a realizable event? The problems with it: How do we determine the value of the watch? Liquidity issue: gotta sell to be able to pay tax liability. PRESUMPTION is that when you win something, you have an immediate increase in your wealth! You paid nothing for it really. IRS then says we don’t care about liquidity–pay the tax!)
There are only 2 exceptions under §61:
1. Increase/depreciation in value of property (fluctuations)
2. purchase of property at arms length for cash or debt. (presumption is that you paid mkt value.)
Every other accession to wealth you conceptually have is taxable gross income! You find a Rolex? Income!
What if T in Steinway problem had bought the piano from his employer w/both T & employer knowing it was a Steinway? This is a notorious event–not at arm’s length! No presumption that mkt value was paid–so its included in gross income.
Note IRC §74: an exclusionary section that says that prizes and awards are includable as income, with exceptions of certain achievement awards (charitable, employee, etc). Note that §61’s broad language picks up prizes and awards.
3. Employee has worked for Employer’s incorporated business for several years at a salary of $40,000 per year. Another company is attempting to hire Employee but Employer persuades Employee to agree to stay for at least 2 more years by giving Employee 2% of the company’s stock, which is worth $20,000, and by buying Employee’s spouse a new car worth $15,000. How much income does Employee realize from these TA’s?
(Per Glenshaw Glass case def: 1). T has accession to wealth, 2), which is clearly realized (b/c a notorious event has occurred). We do have a liquidity problem, but too bad, T has to find $ to pay tax on it! Burden is on T to prove the value). Thus T must show $35,000 in gross income. You can also look at this as compensation for services and so T has to pay taxes on the $35,000.)
4. Insurance Adjuster refers clients to an auto repair firm that gives Adjuster a kickback of 10% of billings on all referrals. Does adjuster have gross income? Even if the arrangement violates local law?
(Makes no dif if gain is made by illegal means.)
5. Owner agrees to rent Tenant her lake house for the summer for $4000. How much income does Owner realize if she agrees to charge only $1000 if Tenant makes $3000 worth of improvements to the house? Is there a diff in result to Owner in last question if Tenant effects exactly the same improvements but does all the labor himself and incurs a total cost of only $500? Are there any tax consequences to Tenant in part (b) above?
(§61(a): rental income is includable in your gross income. Here T received $3000 in value in lieu of rent $. We don’t care if T has a liquidity problem b/c of not receiving cash. This is a substance over form problem: substance is same as if she had received $3000 and then hired someone else. T entered into a TA! LOOK AT THE SUBSTANCE OF THE TA! Look at HOW the property was acquired–this is the key! We enforce a transactional system–what is the nature of the TA?
–IRC §109: excludes from gross income any improvements not made in substitution of rent.
The tenant’s tax consequences: Always ask: What would be the theory under which we would tax the tenant at all? What does Glenshaw Glass tell us? Accession to wealth: $2500 realized in rent credits. Look for value of benefit. Income from services rendered is gross income. SUBSTANCE v. FORM!!
6. Flyer receives frequent flyer mileage credits in the following situations. Does Flyer have gross income?
Frequent flyer miles currently under controversy–really they are just a price adjustment–IRS currently doesn’t include frequent flyer miles, but wants to find a way to include ’em in gross income.
(a)Flyer receives the mileage credits as a part of a purchase of ticket for a personal trip. The credits are assignable (Not income, rebate. Revenue rule 76-96)
(b) Flyer receives credits from Employer for business flights Flyer takes for Employer. The credits are assignable. (It is gross income because it is like money coming from the employer. It is like compensation.)
(c)Flyer receives the credits under the circumstances of (b), above, but they are nonassignable. (Not gross income because no complete dominion or control.)
(d) Same as (c) above, except Flyer uses the nonassignable Employer-provided credits to ta
e as an heir. Yes, this is through inheritance
3. Father leaves several family members out of his will and daughter and others attack the will. As a result of the settlement of the controversy, daughter receives $20k. yes, just like Lyeth v. Hoey where an agreement settling a contested will is still a devise because of substance over form.
4. Father leaves daughter $20k in his will stating that the amount is in appreciation of daughter’s long and devoted service to him. (Yes, b/c she had natural status of heir, no contract or arrangement.)
5. Father leaves daughter $20k in will pursuant to a written agreement under which daughter agreed to care for father in his declining years. Not excludable, b/c we have a written agreement.
6. Same agreement as above, except father dies intestate and daughter successfully enforced her $20k claim under the agreement against the estate. Not excludable, for same reasons, substance over form.
7. Same as above, but daughter settles her $20k claim for $10k. No dif, not excludable
8. Father appointed daughter executrix of his estate and father’s will provided daughter was to receive $20k for services as executrix. Not excludable, written agreement.
B. Boyfriend with a “mental problem” with marriage agrees to leave T everything at his death in return for her staying with him without marriage. She does, he doesn’t. She sues his estate on a theory of quantum meruit. Is this settlement excludable under §102? No. She was paid for “services rendered,” her coa was in quantum meruit, rather than as an heir.
C. But what if he had left her everything? Would it be excludable? Argue that she was the “natural object of the bounty of his estate” –he loved her! There was no written agreement–its arguable!
D. What does the term “employer” and “employee” mean in §102c? We don’t know. The def is not in this particular statute.
4. Fringe Benefits
“Fringe benefits” def: non-cash compensation. Ex: life insurance, company cars, etc.
Fringe benefits are gross income under §61. §102c makes 102(a) inapplicable, but §132 is another exception for employees.
NOTE: Don’t make any assumptions as to what terms mean in these §’s!!! Always use definitions in your analysis!!!
There is no definition of property or service in the IRC. State law defines.
Technically, §61 tells us that any form of compensation is gross income, whether employee is paid in $, property or use of property, etc. But then comes §132 with exceptions for fringe benefits.
If an employee benefit is not specifically excluded from gross income, its value must be included within gross income under §61!
¨§132 excludes fringes provided to “employees.” In the 1st 2 classifications of fringe benefits, (no-additional cost services and qualified employee discounts), the definition of an employee is expanded to include not only persons currently employed but also retired and disabled ex-employees and the surviving spouses of employees or retired or disabled ex-employees as well as spouses and dependent children of employees.
¨§132 excludes the 1st 2 classifications of fringes and employee eating facilities provided to highly compensated employees only if those fringes are offered to all employees on a nondiscriminatory basis. The nondiscrimination req means that there is no exclusion for the highly compensated employees unless the fringes are provided on substantially the same terms to a broad group of employees. However, if the employee is in the group but not highly paid, the employee would still get the exclusion, even though the highly paid ones do not get the exclusion.
NOTE: 132(j) says that the discrimination criteria only applies to 132(a)(1) & (2)!!!!!
**What is a “highly compensated employee”? §414(q) tells us it is any employee who:
1. was a 5% or better owner during the year or preceding year or
2. for the preceding year had compensation in excess of $80,000 and was in the top 20% of employee compensation for that year.
¨§132(a)(1): No Additional Cost Services: services provided to an employee by an employer. Excludable from GI if
1. the services are offered for sale to the customers in the same line of business (see below) as that in which the employee is performing services, AND
2. the employer incurs no substantial additional cost in providing the service to the employee, AND
3. in the case of highly compensated employees, the services are provided on a non-discriminatory basis.
Examples: empty seats to airline or hotel employees, free telephone service to employees. This exclusion applies whether the services are provided free of charge, at cost or under a rebate program.
“Same line of business:” Pilot of an airline who works for company that owns planes and cruise ship line too can only get free plane t