Federal Income Tax Outline
Professor Musselman Fall 2014
¨How do you deal with a tax problem?
1. Read the code
2. look for defined terms
3. look at interpretation (reg’s, committee reports, legislative history, revenue rulings)
¨Income Tax Formula: §63(a)
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
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 vents include: anything that causes you to no longer own the property. Other wise you’d have to account for flucuations in value every year in your taxes.
Reasons why we use the “Realization Principle”:
1. flucuations 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!
PROBLEMS (p. 65) GROSS INCOME
1. Would the results to the T in Cesarini be diff 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. (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 presumtion 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 worker 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.)
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. 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.
INCOME WITHOUT RECEIPT OF CASH OR PROPERTY
Reg §1.61-2(a)(1), 2(d)(2)(i)
Barter or Trade Situation: §1.61-2d(1) states that if services are paid for other than in money, the FMV of the property or services taken in pmt must be included in income. (anyone outside immediate family)
Imputed Income: “doing something for yourself or a member of your immediate family. Note that with relatives what you do for them is often a gift…(next chapter)
Ex: you harvest your carrots for dinner. Is this taxable? No, not enforceable.
Ex: you’re an accountant who prepares his wife’s tax return. Not gross income.
EX: doctor trades out medical services for a will written by his friend the lawyer. Each service was worth $200. Taxable income? Yes, $200 each.
1). When a T gets a loan, its not gross income ever! You’re trading out an obligation to repay for the $–no accession to wealth.
2). Ties in with realization principle–You buy for $1000, you sell for $3000–you have $2000 gross income(the $1000 is just recovery of capital basis–you don’t have accession to wealth here.
BE SURE TO DIFFERENTIATE B/W EXLCUSIONS AND DEDUCTIONS FROM GROSS INCOME!
§71-90 tell us what items are specifically includable in gross income; §101-137 set out specific deductions.
IRC §102(a): Gross income does not include that value of property acquired by gift, bequest, devise or inheritance.
(b): Income from any property described in (a); or where the gift, bequest devise or inheritance is of income from property, the amount of such income.
c. employee gifts/benefits are not excludable under this §: BUT (see §74© and §132(e))
102© is exception is BROAD. Note that the IRS tends to read sections including income very broadly b/c they want as much included in gross income as possible.
§102 is an exclusionary section. Exclusions are very specific. Do the analysis: was the Duberstein car gross income under §61? Yes. Next part is whether its covered under an exlcusion. Always look at all the exclusion codes to see if your facts will fit the others, if it fails to fit the 1st one you look at.
How Do We Determine if it’s a Gift?
1. What is not a gift:
a. A voluntary, executed transfer of one’s property to another, w/o consideration or compensation is not necessarily a gift under IRC!
b. mere absence of legal or moral obligationto make su
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 tickets, not cruises b/c cruises aren’t in same line of business. Reason: to preclude unfair advantage by employees of conglomerates.
¨§132(a)(2): Qualified Employee Discounts: “courtesy” discounts on items purchased by employee for employee’s use.
1. Same line of business and non-discrimination limitations apply. Includes property and services, but not real property, property held for investment or loans. Can be in form of price reduction or rebate.
2. Ceiling on amount of exclusion: services: may not exceed 20% discount. Also, the max discount for property is the employer’s “gross profit percentage”:
aggregate sales price reduced by cost
aggregate sales price
(this is the fraction based on sales of all property in the employees line of business: $800,000 in sales, with a cost of goods sold $600,000, the gross profit percentage is 25%) The employee must report as income anything beyond the 25%…
¨132(a)(3): Working Condition Fringe: exclusion for any property or services provided to an employee that the employee would be able to deduct as a business expense anyhow: ex: company car, airplane use, bodyguard, on the job training.
¨132(a)(4): De Minimis Fringes: Any property or service whose value is so small as to make required accoutning for it unreasonable or administratively impracticable is excluded as a fringe benefit. Cocktail parties, use of copy machines, coffee and doughnuts, retirement gifts like 30 year watches.
¨132(a)(5): Qualified Transportation Fringe: employer may pay for employee’s transportation into/from work via bus, train, vanpool, etc., and or parking. Limited to $65/month for drive costs & $175/mo for parking.
¨132(a)(6) Qualified Moving Expenses
¨132(j)(4): Athletic Facilities: use of athletic facilities on the employer’s premises.
PROBLEMS, p. 101
Do the following have exclusions as fringe benefits?
a. Employee of a hotel chain stays in one of the chain’s hotels in another town, rent free while on vacation. The hotel has several empty rooms. (This does not add substantial additional cost, such as some type of foregone revenue. Must be something that would normally go unused: the excess capacity rule. Not excess capacity: free legal services.)
b. Same as (a) above, except that desk clerk bounces a paying customer to give employee the room. (does add substantial additional cost, so employee is getting an employee discount of 100%; use of hotel room is services, limitation is 20%, thus exclusion is $20)
c. Same as (a) above, but employee pays the bill, then receives a cash rebate from the chain. (cash rebates ok per 132(a)(1).)
d. Same as (a) above, except that employee’s spouse and dependent children travelling without Employee use the room on their vacation. (def of employee includes spouses and children for 2 certain kinds of exclusions, and this is one of them.)
e. Same as (a) above, except that Employee stays in hotel of a rival chain under a written reciprocal agreement under which employees pay 50% of normal rent. (ok, written reciprocal agreements ok under no additional cost services)
f. Same as (a) above, except Employee is an officer in the hotel chain and rent-free use is provided only to officers of the chain and all other employees pay 60% of the normal rent. (Key: is discrimination substantial? §1.132(8)(a)(2): If it is, the highly compensated employee gets no exclusion at all! You can however, discriminate to some degree by setting up reasonable classifications. But the classification itself must not discriminate in favor of hce’s. §1.132-8(d)(2): Example of reason reasonable classifications: janitorial staff and factory workers each being their own classification; or by seniority or # of hours worked each week.)