Federal Taxation
Professor Ordower
Fall 2010
The most important question to ask for every problem is: What will the TP need to include in gross income?
Formula to Compute Tax:
Gross Receipts (Revenues) §61
+ (COGS) or (Certain Exclusions)
Gross Income (Section 61)
+ (Adjustments to Gross Income)
+ (Personal Exemptions)
Adjusted Gross Income
+ (Itemized Deduction or Standard Deduction)
Taxable Income
x Tax Rate
Tax Payable
+ (credits) (claim or right doctrine)
Tax Due
Things to note:
*If filing separate returns and your spouse is itemizing, then you are required to take the standard deduction
**An exclusion causes an item of income not to be included in gross income; this is different from a deduction, which the receipt is included in gross income, and then later deducted
Amount realized 1001(b)
Gain realized 1001(a)
Gain realized is also recognized 1001(c)
Two rules of statutory interpretation
1. When you express one thing you exclude others
o i.e. if there is a list of non- capital assets if something is not on the list then assume it’s a capital asset.
2. Things of the same type
o i.e. things of the same type should be included in the list
Ways to divide up property
o Physical division of property
o Carving out certain rights (easement) and keeping other rights
o Leases (use of property for the term of year
o Dividing up property temporarily there
o Dividing up property via stock
3 definitions to distinguish:
– 1) Realize:
o 1001—gain taxpayer realizes from sale (excess of adjusted basis over the sale price)
o Also used in context that income which taxpayer realizes in activities (not just in sale of properties): from salary, etc.
– 2) Amortize:
o In context of a debt, amortize the debt in paying down principal of it in rational matter under amortization schedule where principal/interest (payments amortize the principal over time: reduce what is owed)
o Intangible property that has limited useful life and used for production of income in course of business: recover cost over straight line over time (also depreciation)
– 3) Capitalize:
o Distinguishes an expenditure from others that are currently deductible
§ Capitalize means you add it to the cost/basis of the property
Key Terms and Concepts:
ú Adjusted Gross Income (AGI) – The amount of income, which is taxable, consisting of gross income from all taxable sources minus all allowable adjustments.
ú Basis - Purchase price, including commissions and other expenses, used to determine capital gains and capital losses for tax purposes. This can be determined by several methods:
o For a purchased investment, the tax basis is the amount paid.
o If inherited, the tax basis is the value of the stock on the date of the original owner's death.
o If received as a gift, the tax basis is the amount that was originally paid for the investment, unless the market value of the investment on the date the gift was given was lower.
ú Capital Gain – An increase in the value of a capital asset (investment or real estate) that gives it a higher worth than the price at which it was purchased. A capital gain may be classified as short-term (one year or less) or long-term (more than one year) and must be claimed on an income tax return.
ú Deduction – Any allowable item or expenditure that can be subtracted from gross income in order to reduce the amount of income, which is subject to taxation.
ú Exemption – A deduction, based on a status or circumstance, allowed by law to reduce the total amount of taxable income.
ú Tax Credit – A dollar-for-dollar reduction, which lowers the actual amount of tax owed.
ú Taxable Income – The amount of net income (gross income minus all adjustments, deductions, and exemptions) that is used to calculate income tax owed.
ú Tax shelters – A legal method of minimizing or decreasing an investor's taxable income and, therefore, his or her tax liability. Tax shelters can range from investments or investment accounts that provide favorable tax treatment, to activities or transactions that lower taxable income. The most common type of tax shelter is an employer-sponsored 401(k) plan.
Chapter 1: Introduction
“Time Value of Money”
The future value of $ is greater than the present value of $
Concept of Time Value
A. Current $ > Future $
B. Current payment < Future payment
C. Reasoning: Because of interest and future tax liability.
a. Value of deferring payment is based on the interest and how soon the tax will have to be paid and how the taxpayer employs the funds.
i. Example: Tax shelters - the idea was to construct your taxes in order to pay the taxes later without paying interest on the deferral
D. If had the choice of paying tax today or the same tax five years from now, then you should choose to pay five years from now (assuming you will pay the same amount);
E. Present Value = Future Value
(1+ interest rate) ^number of periods deferred
F. What is the tax benefit of home ownership?
a. Take to tax payers A and B… each one has 100,000 in cash. Either one can buy a residence for that price. A buys a house for 100,000 and lives in it. B invests the 100,000 in an interest bearing investment in which the interest rate B can get is 5% a year. B can rent a comparable house for 5,000$ a year. Who is better off for tax purposes and why?
i. B would have been taxed on the 5,000 income on interest and not have that much after taxes. Assuming the house does not lose value A is in the better situation.
b. Why don’t we tax on the value of the use of his personal house?
i. Our system fails to tax what is called imputed income. Use of one’s own property or service for oneself or occupants in the same household. Some countries do this.
ii. This is the REAL tax benefit!!! Mortgage interest is a peripheral tax benefit or if house becomes more valuable
c. Why isn’t this problem as serious as with clothes, cars, and computers?
i. These things get used up and are no longer of value you can’t resell it for the same price you bought it for. These items get used up and waste, but houses usually don’t waste they retain their value
G. Some Definitions/ Terms:
a. Tax base which the income tax is computed is taxable income which is defined as gross income minus allowable deductions. Certain statutes allow credits for deduction rather than expenditures.
b. Annual Accounting is when income taxes are returned on an annual bases verse accrual basis with income and expenses recorded when earned or incurred.
H. Certain statutes attempt to prevent the manipulating the timing of losses
a. i.e. §1091- wash sales
Chapter 2: Characteristics of Income
A. Non Cash Benefits
a. Real Income
i. Real goods and services consumed or accumulated rights to such goods and services whether they are purchased with money income or received in kind.
ii. Problems arise in taxing non-money income
b. Employment Related Exclusions
i. §119 Meals and Lodging: an employee may exclude from gross income the value of meals and lodging provided by an employer if the meals or lodging are provided for the convenience of the employer, are provided on the business premises of the employer, and in the case of lodging, the employee is required to accept the lodging as a condition of employment
1. Required for Exclusion:
a. Convenience of the employer: means that the employer has a substantial non-compensatory business reason for supplying the meals and lodging, considering all the facts and circumstances of the situation
i. i.e. when employee is “on call”, Court in Kowalski says this factor places an emphasis on the necessity of the benefits to functioning of the employer’s business
b. Business premises: the business premises of an employer are the grounds of the employer’s place of business
c. Condition of employment: the condition of employment requirement is generally satisfied by showing that the employee is on call for the business of the employer
2. Cases/ Examples:
a. Commissioner v. Kowalski
i. State police trooper was designated an allowance for meals based on a cash system. Meal $ were paid biweekly and $ were not required to be spent on meals or show receipts. Ct finds that the Meal $ are undeniably accessions to wealth, clearly realized, over which the troopers have complete dominion and thus should be i
ers. (if company operates airline and department store – airline workers would be taxed on discount department goods). Here, if AA has reciprocal agreements with UA and this employee is treated as employee of UA.
3. determine who the employee is without regard to 1b (so couldn’t be a parent of widow or widower) parent of living spouse is not accounted for
iii. Turner v. Commissioner
1. Turner won tickets for cruise line when he was randomly selected and called by a radio station to answer a question and win. He won and reported the ticket at $520 and the commissioner said it was worth $2,220. The issue is how much should be included in his income for the tickets.
a. The court agreed on the price of $1,400 as the price to be added to the income; the court split the difference here; this is because they didn’t know how to come up with a fair conclusion so they simply split the difference of the two parties claims
b. It’s clear that retail is NOT the correct measure; and we can’t look at wholesale because he was not allowed to sell the tickets
c. The court was essentially unable to determine the value of the tickets; as opposed to the last case (Bengalia) where they didn’t charge the hotel manager for the benefits received
iv. Haverly v. United States
1. Principal Haverly received unsolicited samples of textbooks worth $400. Donated the books and included a charitable deduction on tax report, but not income for the books. Ct held that when a tax deduction is taken for the donation of unsolicited samples the value of the samples received must be included in the taxpayer’s gross income. He exercised complete dominion over the books by the unequivocal act of taking a charitable deduction for the property because through that he manifests the intent to accept the property as his own.
2. The Court in this case says we won’t worry since it’s so hard to determine price of the unsolicited books until the tax payer tries to take the deduction. This is an administrative rule of convenience b/c the court doesn’t want to get into the business of determining this stuff.
v. Ken Griffey Jr. Baseball catcher:
1. He makes the point about the painting or diamond in the middle of the street and how we would assume it should be included in income. However, when someone catches a valuable homerun ball, we all think it should not be included in income, yet we really don’t know why. This is odd to him…how does this end up impacting the tax laws? Is this a prime example of how the public can influence the tax consequences of such acquisitions?
B. Imputed Income
a. Imputed income results from the investment of capital or performance of services for one’s own personal or family use which is not considered income for purposes of federal income tax.
i. i.e. income that one technically [gains] from doing services on their own instead of paying someone else (e.g. taxes, construction on home, or the rental value of the home if you use the house instead of renting, etc.)
b. Property other than cash
Buying a house with inheritance v. investing the inheritance: the person buying a house is not paying taxes on the earnings that he is technically getting by not paying rent each month (the money already paid the rent for him); however, the person investing their money will have to pay taxes on the interest earned each year; thus, the person investing is not receiving the same advantages as the person buying a house even though they are in the same financial position
