Federal Income Tax Outline—McGovern
Ch. 1: Introduction to Federal Income Taxation
Tax Liability = Tax Rate x Tax Base
(how much you owe) (bracket) (what you pay tax on; taxable income)
§1(a)-(d) §63(a): Taxable Income = GI – Deductions allowed (except std deduction)
§61: GI = all income from whatever source derived
Realization principle = not taxed on gains from assets until that gain is realized (a realization event) (most common type = sale)
§63: 2 alternative definitions of taxable income—(a) & (b)
-regardless of which you use, need to determine AGI
§62: AGI = GI minus the following deductions…(ATLD)
§62 is not a deduction granting provision (have to go find specific code section that authorizes the deduction)
§451: Accounting Methods
1. Cash Method: included in GI the year the income was actively/constructively received
2. Accrual Method: included in GI the year income was earned
Above the Line Deduction (ATLD): deductions taken into account in determining AGI
Below the Line Deduction (BTLD): deductions that can only be taken into account if they exceed the standard deduction
Imputed income is not taxed
Questions addressed by income tax system:
1. What is included in GI?
2. What items of expense are allowed as deductions?
3. When is an amount included in GI?
4. Who is the TP?
5. What is the character of the items of income or the deductions?
§67: 2% floor on miscellaneous itemized deductions (those not subject to a mortgage, state income tax, real property tax, & charitable contributions, etc.)
§68: overall limit on itemized deductions
–inflation-adjusted applicable amount: p. 1834 – 1837
(68 has been repealed, but it will not be gone until 2010)
§67 is meant to be applied before §68; §68 applied after all other limits have been applied
§151: Personal Exemptions
For items specifically includedin GI = part 2 (§71 et seq)
For items specifically excluded from GI = part 3 (§101 et seq)
Part of a TPs taxable income may be subject to more favorable treatment
-Long-term capital gains are entitled to a preferential rate of tax (gen., that’s 15% rate of tax): §1(h)
Net capital gain vs. Ordinary income
After applying the preferential tax rate, TPs may have moved down a tax bracket with respect to their ordinary income
Tax credits = decrease tax liability dollar for dollar (refundable & nonrefundable credits)
Generally, you take non-refundable credits first (usually good for TPs)
Most common type of tax credit = when ERs withhold various taxes from your paycheck
Child tax credit = §24; 24b phases out credit for high income TPs (with AGI of more than $110k)
Marginal Rate of Tax vs. Effective Rate of Tax
Marginal Rate of Tax = refers to the highest rate of tax to which the TPs are subject; the rate that would apply to the next dollar of income that would apply to the TPs if they had earned it (often useful to know to decide additional tax liability—like if you wanted to go out and get another job)
Effective Rate of Tax = average rate of tax to which you are subject; to determine, take total tax liability and compare to taxable income
Tax Liability/Taxable Income = Effective Rate of Tax
A. SOURCES OF TAX LAW
Legislative- Congress (primary sourceà IRC) Title 26 of U.S.C. This class is Subtitle A only. Legislative history: bills, hearings, committees, debates
Executive- IRS & treasury- IRS= bureau w/in treasury dept that produces:
1) treasury regulations- interpret IRC (invalid if inconsistent w/ IRC)
2) Revenue rulings- dictate tax consq of transactions- guidance on specific fact patterns; issued to public at large
3) revenue procedure
4) private letter ruling- guidance request on consq; issued only to specific taxpayer, no one else can rely on
3 courts that interpret code and regulations and create judicial doctrine (in addition to code):
1) U.S. Tax Ct.
a) most common court
b) TP not have to pay tax to bring in ct- only court where can get into w/o paying up front
c) no jury (only judge- so more knowledge about tax)
2) U.S. District Ct
a) get jury trial
b) refund tribunals
c) must pay tax and ask for it back from IRS then bring suit
3) U.S. Claims Ct
a) no jury
b) must pay tax before bring suit
B. OVERVIEW OF COURSE
1. TAX LIABILITY= Tax rate (1(a) based on taxable income) x Tax base (à TI= GI – deduc)
2. BIG PICTURE:
GI- certain deductions= AGI
AGI- Personal Exemptions- either Standard or Itemized deduction= Taxable Income
Taxable Income X Tax Rate- Tax Credits= Tax Due or Refund
3. GROSS INCOME- §61
GI includes all income from whatever source derived including (list 15 items)- 61(a). Income from compensation, dividends, gains from dealings in pp, and discharge of debt are common types, but other code sections exclude certain type of income
1.61-1(a) GI includes income realized in any form (money, pp, services)
1.61-2(d)(1) if services are paid in exchange for other services, the FMV of such other services taken in payment must be included in income as compensation. (pp, services, etc).
Only include appreciation of stock when it is realized- “realization event” (sell, exchange)
sale of stock are included in GI as gains made – 61(a)(3)
Every time you have an expense you think is deductible, you must find a specific Code section authorizing the deduction. Two types of deductions available in computing taxable income:
1) Deduction from GI in computing AGI (AL)
2) Deductions from AGI in computing TI- TP subtract PE and then take larger of either SD or ID (BL)
§162(a) allows deduction of ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.
depreciate any equipment as a deduction over time and not all at once 1.263(a)-2(a) -167-8. Methods of depreciation: 1) allocate over life of property 2) first year more
Personal expenses- not deductible 262 (commuting cost/ personal mtg. payments) 1.162-2(e) and 1.262-1(b)(5)
Exception- “qualified resident interest” on personal debt (mtg) is deductible under 163(a)
You can deduct expenses paid or incurred “for the production of collection of income” 212(1) (not 162). 61a(4) interest and (7) divided- can’t reduce interest and dividends
This includes a management fee for investment activity, however 62 limits only certain types of 212 expenses to above the line and mngmt fee is not one of them.
General sales taxes are not deductible under 164 or 262, but if bus exp- it would be deductible
Real pp/ State and local taxes are deductible under 164(a)(1) and are taken below the line.
Estimated state income tax payment made that year is deductible under 164(a)(3) (below line), but cash method taxpayers can’t deduct the actual state income tax liability until pay the balance owing-so deduct next year
Charitable Contributions- deductible under 170(a)(1), but170(b)(1)(A) limits deduction to 50% of “contribution base.” 170b(1)(F) defines contrib. base as AGI. So long as AGI of twice amnt donate then entitled to the full deduction for the charitable contribution.
Deduction v. Credit: deduction reduces liability, amount save depends on tax rate; Credit reduces tax rate dollar for dollar by crediting to tax liability (Ex. 5K to church, 1,500 less to govt; 3,500 what get)
5. ADJUSTED GROSS INCOME
62: AGI= GI – certain deductions (62 not a deduc granting provision-only gives def)
2 categories of deductions:
1) above the line (62)- those used in determining AGI- allowed to all TPs regardless if itemize
trade or business- rent, wages, office supplies, deprec on equipment, not mngmt fee
2) below the line- only use after AGI been determined- taken only if the taxpayer itemizes
6. TAXABLE INCOME
Formula depends on if itemize deductions (claim below line deductions rather than std deduc)
If NOT itemize, only get std deduct in place of any below the line deductions (other than pers exp)
If below line deduction exceeds std deduct (3.07)(63c2) à should itemize 63(d)(def for itemiz deduc)
ITEMIZE- TI= GI- allowable deductions 63(a)
Section 67(a): 2% floor on Misc ID- this section says certain itemized deductions can’t be deducted unless the aggregate deduction exceeds 2% of the AGI. Higher income people (higher AGI) are not taking deduction as much because mean need more expenses.
Rationale= To get more taxes: increase tax rate, increase tax base, decrease misc deductions
Identify misc 67(b) + compare to 2% of AGI
Not subject to 67: home mtg interest, state income tax, real pp tax & charitable contrib. 67(b)
Subject to 67: bank mngmt fee
Section 68: Overall Limits- otherwise allowed item deduct are reduced by 3% of the amount by which the AGI exceeds an inflation-adjusted “applicable amount (68(b)(1))” (or if lesser, the reduction is 80% of otherwise allowable itemized deductions) 68(a). See table 3.08
Personal Exemptions: 151-
Annuities – 61(a)(9), 72- TP receiving annuity pymt is receiving partial return on invested capital and so balance of pymnt is income. Must figure the amnt of pymnt excluded from GI X exclusion ratio (investment in K/ total expected return under K). The amnt of payment in excess of excluded amnt in included in GI.
f) Alimony- 61(a)(8)- Person getting alimony must include this in GI. 71(a)
g) Discharge of Indebtedness income- 61(a)(12)- if creditor not collect debt, debtor will have indebtedness income equal to amnt of debt forgone and must include in debtor’s GI. EXCEPTION- if creditor receives what bargain for, even if diff amnt than loan= no discharge; 108 also list exclusions in this category
any discharge of debt for amnt less than its face value= GI- Kirby Lumber
h) Satisfaction of Obligation= GI à satisfaction of TP’s obligation by another person is an economic benefit and is GI. [Old Colony Trust- er paying income taxes of ee] 1) GI can include discharge of TP’s obligation to a 3rd party
2) If payment was in consideration of services, then it is GI.
Note: 3P discharge of obligation could be gift, but if discharge arise out of ER-EE relationship + considered to be discharge connected w/ performance of services, then not likely gift.
i) Prizes/ awards- 74, Exception- did nothing to win and not have to give future service as
j) Embezzled Funds
Exclude from GI: Specific statute provides not included in GI- construed narrowly
a) Death Benefits- 101: if receive $ under life ins policy b/c of death, or chronic or terminal illness. Limit- transferred for consideration exclusion limited to purchaser’s purchase price under K.
b) Gifts: 102: exclude cash or value received from GI. Def- detached disinterested generosity. Basis (1015(a))à a) pp received by gift (gain)= donor’s basis + gift tax paid, but if FMV less than basis (loss) = FMV of gift on date of gift. b) pp received by inheritance= FMV of pp on date of decedent’s death. Exceptions- income from pp and ee gifts= included in GI.
c) Compensation for PI or Sickness- 104: compensatory das from suit/ settlement of personal physical injury. Exceptions (include): punitive damages, previously deducted medical expenses or pre or post-judgment interest, if er contribute and not in ee GI.
d) Discharge of Indebtedness- 108: exclusion conditioned on TP giving up certain tax benefits. Bankruptcy (title 11), Insolvency, qualified farm indebtedness, qualified real pp business debt.
e) Contributions by er to accident and health plans-
f) Qualified Scholarships- 117: degree candidates that get $ at ed inst for tuition, books, fees and supplies. Limit- not include room and board or amnts paid for services.
g) Gain on sale of principal residence- 121- exclude gain up to 250K (500K joint), but msut owned and use as principal residence for at least 2 of past 5 years.
h) Life Insurance Proceeds paid by reason of death of insured- 101(a)
i) Employment related Exclusions-
a) meals/lodging- 119- if convenience of er, meals- on business premises of er, and if lodging- ee required to accept as condition of employment
b) fringe- 132- no additional cost service, QED, WCF, deminimis, Qual transp fringe
c) insurance premiums and payments- 79. 105, 106- cost of premiums and payment excluded up to amnt of ee’s medical expenses. Exclude cost of life ins up to 50K. Exception- premiums for excess coverage included in ee’s GI.
j) Educational Incentives- interest on US savings bonds- 135f; 529 plans (state); 530- education savings accounts. Limits- used for qualified ed exp
k) Child Support- 71