BASIC FEDERAL INCOME TAX TODRES SPRING 2014
[1] The starting place is the proper identification of the basic facts about the taxpayer in question. Because tax problems usually involve more than one taxpaying person or entity, the first task is to identify which tax payer’s tax consequences are relevant to the problem. The second task is to identify that taxpayer’s tax characteristics that are important in the analysis of his income and deductions: the taxpayer’s tax status, taxable year, and method of accounting.
[2] Gross Income includes all income from whatever source derived. § 61. See Figure 2 (Analyzing Income) and Figure 12 (Gain/Loss on Property Dispositions)
[3] The first set of deductions available to a tax payer are the above-the-line deductions, i.e., those that are subtracted from Gross Income to produce Adjusted Gross Income. See Figure 3 (Personal Deductions), 4-9 (Deductions and Losses), 11 (Capital Recovery) and 12 (Gain/Loss on Property Dispositions)
[4] A taxpayer must choose between claiming the standard deduction and the itemized deduction, and a rational taxpayer will chose the larger of the 2. See Figures 3-5 (Deductions) and 6-9 (Losses). Subtracting these deductions from AGI will produce Taxable Income
[5] Once Taxable Income has been computed, the taxpayer must apply the appropriate rates of tax, considering the rates on ordinary income and capital gain and the alternative minimum tax (AMT)
[6] A credit is a dollar-for-dollar reduction in the amount of tax owed and, in some cases, may reduce the tax liability below zero, resulting in a refund
[7] The point of this exercise is to calculate the amount of tax owing or the refund due to the taxpayer. But in most law school classes, this calculation is of relatively minor importance. Instead, most professors focus on the legal questions inherent in each of the previous steps
[1] In any given problem, there is usually more than one taxpayer involved in a transaction, and it is important to identify the relevant taxpayer. The relevant taxpayer is the one who experienced the accession to wealth, regardless of what he did with that wealth. Usually, each taxpayer’s tax consequences are analyzed separately. However, situations do exist in which the tax consequences of the relevant tax payer may be entwined with outers in the problem, such as when a gift occurs (e.g., the donee takes the donor’s basis in the gifted property).
[2] An accession to wealth is an event that causes the taxpayer to be better off even if he doesn’t end up with cash in hand. For example, if someone else pays a debt of the taxpayer, the taxpayer is better off and has therefore experienced an accession to wealth.
[3] § 61 refers to “income from all sources,” requiring a definition of income. There are 5 kinds of benefits that are not considered income in the sense used in § 61: (1) imputed income; (2) loan proceeds; (3) the capital that one has invested in the property (basis); (4) noneconomic benefits; and (5) certain general welfare payments. In addition, the income must be “realized.”
[4] In order to be excluded from gross income, a specific statutes must apply and its requirements must be strictly met. Construe exclusions narrowly.
[5] Consider these potentially applicable exclusions statutes §§ 71 (child support) 102 (gifts) and 1041 (transfers of property between spouses/former spouses)
[6] Consider these potentially applicable exclusion statutes: §§ 103 (interest on state/local bonds), 125 (Interest on savings bonds used for education), 408 (Roth IRAs), 529/530 (distributions from certain college savings accounts, and especially 71 (defines including portion of distribution from annuity, regular IRA distribution)
[7] Consider these potentially applicable statutes: §§ 101 (life insurance received on account of death of insured), 104 (personal injury settlements, but not punitive damages), and 108 (discharge of debt when taxpayer is insolvent or in bankruptcy, and certain other situations)
[8] Consider these potentially applicable exclusion statutes: §§ 74 (prizes and awards), 102 (gifts), 111 (tax benefit recoveries), 117 (scholarships), 121 (sale of personal residence), and 1202 (sale of qualified stock).
[9] Consider these potentially applicable exclusion statutes: §§ 79 (group term life insurance), 106 (health and disability insurance), 119 (food and lodging), 120 (group legal services), 127 (education assistance), 129 (child care assistance), 132 (other fringe benefits), and 137 (adoption assistance). Consider also that a taxpayer must deduct the unreimbursed expenses of employment, but these are subject to the 2% floor of § 67.
[10] It is common for the benefit of exclusions to be phased out, usually based on the taxpayer’s AGI level. See, e.g., § 135(b)(2). Other exclusions apply only to a certain amount of a benefit received. See, e.g., §129 (maximum $5,000 dependent care assistance). As a result of these phase outs and limits, some portion of the amount of taxpayer’s actual expenditure may be excluded from gross income, and some portion may be included in gross income.
[11] If an item is excluded from gross income, it never enters the computation of Taxable Income and thus is never taxed. Compare a deduction, which has the same net effect but appears as a subtraction in the computation of tax
[12] If an item of income is included in Gross Income, it is potentially subject to tax, even though it may be offset by a deduction. The amount included in Gross Income is the amount of money or FMV of the property received.
[13] Figure 2 addresses only whether an amount is included in gross income. It doesn’t address when (in what taxable year) that should occur, which depends on the taxpayer’s taxable year, method of accounting, and special rules for some kinds of income.
EXAMPLE TO FIGURE 2
A congressman, upon retiring from public service, becomes a consultant to a Washington lobbying firm. An old friend offers him the free use of a car-and-driver service for the next 2 years. The former Congressman accepts. What are the tax consequences of this transaction to the former Congressman?
[1] The former Congressman is the relevant taxpayer
[2] The receipt of a car-and-driver service increases the former Congressman’s we
if the TP itemizes, i.e., claims the itemized rather than the standard deduction. Consider §§ 163; 164; 165; 212; and 213.
EXAMPLE TO FIGURE 3
Emily, a cash method TP, has an AGI of $35,000. This year, she made the following expenditures that she would like to deduct:
Medical Expenses for herself $15,000
Contribution to § 529 plan for nephew $500
Cash contribution to the Red Cross $600
Vet expenses to her cat (on credit card) $1,000
Purchase of “coffee cart” for starting new business $10,000
[1] Emily has a number of outlays or expenditures, as listed. For the vet expense, it doesn’t matter that she paid with a credit card; as a cash method TP, this is still her “expenditure.”
[2] All of the expenses related to Emily’s personal life, except for the purchase of the coffee cart, which is potentially a business expenditure. Analyze that expenditure using Figure 4.
[3] Emily’s question to you is precisely this: Does she qualify for a deduction for any of the expenditures other than the coffee cart?
[4]-[7] These boxes are designed to get you thinking about possible deductions Emily might claim
[4] Family members: Although Emily may think of her cat as a family member, she cannot claim a deduction for its medical expenses. The § 529 plan for the nephew is possible
[5] Planning for the Future: Emily’s contribution to the § 529 plan is not deductible for federal tax purposes, although it may be for state
[6] Unpleasant Events: Emily’s medical expenses, assuming they are qualified medical expenses, will be partially deductible
[7] Pleasant Events: Emily’s charitable contribution, assuming it is to a qualifying charity, will potentially be deductible.
[8] There are limits potentially applicable to the charitable deduction and the medical expenses. Emily may potentially make a charitable contribution of up to 50% of her contribution base. Emily’s medical expenses are deductible to the extent that they exceed 7.5% of her AGI
[9] Emily’s AGI is $35,000, so 7.5% of that amount is $2,625. This is the nondeductible portion
[10]-[11] The rest of the medical expense ($12, 375) is deductible. The charitable contribution and medical expenses are allowed as itemized deductions, if Emily “itemizes,” i.e., claims the itemized deduction rather than claiming the standard deduction. If she does not itemize, they are nondeductible.
