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Federal Income Tax
SUNY Buffalo Law School
Leviner, Sagit

Federal Income Taxation I
Professor Sagit Leviner
Fall 2012
 
 
I.                   Introduction – Policy behind taxation
A.    Tax Burden Distribution
1)            Progressive / Regressive / Neutral
a)      Progressive System – Higher income class pays a greater percentage of their income to tax.
b)      Regressive System – Inverse of above.
c)      The U.S. has progressive marginal tax rates (IRC Sec. 1 – 10% to 35%)
d)     Income Inequality – pretax and post-tax.
2)            “Head tax” – simplest way to tax (very regressive)
a)      Taxes an equal monetary amount on everyone, subject to other rules like “over the age of…”
b)      Extremely inefficient, would not distort economic activity. Same tax owed regardless of hours worked, etc.
3)            “Ability to pay” – Those with greater wealth are expected to bear a greater tax burden. (progressive or neutral, depending on specifics)
a)      The wealthier you are, the less each dollar lost diminishes your well-being.
4)            Taxing Income, Consumption, & Investment (Savings)
a)      Tax income because it is the most “fair” way to tax based on ability to pay principles.
b)      Tax consumption & Investment to generate additional revenue, encourage/discourage taxpayer behavior, and not favor spending over saving, or the adverse.
c)      “Imputed Income” – Value of goods & services provided to oneself.
B.     Economic Consequences
1)            Income Effect – Change in taxpayer behavior induced by the tax system increasing or decreasing the amount of money available to the taxpayer.
a)      All taxes have an income effect leading taxpayers to work more to make up for lost income.
2)            Substitution Effect – Change in taxpayer behavior arising from relative attractiveness of different commodities or activities caused by taxation.
a)      Home Mortgage Interest Deduction
b)      Tax on cigarettes
3)            Income taxes generally have both income and substitution effects.
a)      Often difficult to determine which effect dominates
b)      Effect on income taxes on labor supply is weakest among men in their prime working years.  Labor supply of married women can be very responsive to income taxes – effects vary by income class.
4)            Other examples include provisions designed to encourage particular kinds of economic activity.
a)      Charitable contribution deductions
b)      Going green deductions
C.     Goals of Income Taxation
1)            Funding
2)            Regulation of private sector
3)            Reduce Inequality
 
II.                Computing Tax Liability
A.    Five Step Process
1)            Gross Income – (§61, §§71-140) What goes into the tax base.
a)      §61(a) – All income from whatever source derived, including but not limited to the following: §61(a)(1)-(15)
                                                                                            i.            §§71-100 – Items specifically included
                                                                                          ii.            §§101-140 – Items specifically excluded
2)            Adjusted Gross Income (“AGI”) – (§62) Gross income less certain deductions (Above the Line Deductions – allowed to all taxpayers)
a)      Income, less;
                                                                                            i.            Certain costs of earning income
                                                                                          ii.            A mix of other items (ex. Alimony)
b)      Expenditures:
                                                                                            i.            Generally deductible (ex. Wages employer pays to employee)
                                                                                          ii.            Generally not deductible (ex. Personal expenses)
                                                                                        iii.            Deductible over a period of time (ex. Purchase of a building for production/manufacturing)
·   Cost of building/machine divided by the number of years it is expected to be utilized by business.
3)            Taxable Income – (§63) Gross income minus the deductions allowed by this chapter.
a)      Taxpayer’s AGI, less the sum of:
                                                                                            i.            Personal Exemptions (§151)
                                                                                          ii.            Standard or Itemized Deductions (must pick one)
b)      Standard Deduction option vs. Itemized Deductions
                                                                                            i.            Deductions – Costs incurred in producing income, and economic and social policies congress seeks to implement. 
·   Every deductible expense must be listed with a specific code section authorizing the deduction.
·   Courts: Gross Income has broad definition, however deductions are viewed as “legislative grace,” therefore provisions are narrowly construed.
                                                                                          ii.            Itemized Deduction (Below the Line) – apply only if taxpayer forgoes standard deduction and chooses to itemize.
·   (§67) – 2% Floor of miscellaneous itemized deductions:
Ø  Deduction must exceed 2% of the taxpayer’s AGI.
Ø  §67(b) – List not subject to 2% floor. (Includes: Home Mortgage Interest, State Income Tax, Real Property Tax, Charitable Contribution, Medical Expenses) *Other rules apply
                                                                                        iii.            Standard Deduction – Policy: Creates a tax threshold that frees millions of poverty-level individuals from the burden of taxation.
·   §151(b)
Ø  Single or Married filing separately – $5,950
Ø  Married filing jointly or qualified widower – $11,900
Ø  Head of household – $8,700
·   §151(c)
Ø  $3,800 deductible per dependent.
4)            Compute tax due – (§1(a)-(d))
a)      Apply the taxpayer’s taxable income to the appropriate rate structure.
                                                                                            i.            Marginal Rate is the rate applied to the last $.
                                                                                          ii.            **Remember to hit every bracket on your way up!
                                                                                        iii.            Effective / Average Rate: Tax liability divided by taxable income for the year.
·   Always lower than marginal rate.
·   Doesn’t consider exemptions/deductions/credits
b)      Rates vary depending on filing status (single / joint) & character of income/gain (ordinary income / capital gain(§1(h)) ).
c)      Capital Gains (§1(h))
                                                                                            i.            Almost everything a taxpayer owns & uses for personal or investment purposes is a capital asset.
·   Examples: Home, household furnishings, stocks, bonds, etc.
                                                                                          ii.            Capital gain/loss occurs when a taxpayer sells a capital asset and there is a difference between the amount received and the basis of the asset.
                                                                                        iii.            Classified as long term or short term
·   Short term capital gains are taxed as ordinary income (regular tax rates)
·   Long term capital gains are taxed at lower rates.
5)            Reduce tax due by applicable credits – (§§21-53)
a)      §31 – Most common credit
                                                                                            i.            Withheld taxes paid through the year by employers, on behalf of the employee (taxpayer).
b)      §24 – child tax credit (up to $1,000 for a qualifying child – refundable)
c)      §32 – Earned Income Tax Credit (

of American Woolen Company from 1918 – 1920.
b)      In 1918 & 1919 he received $978,725 & $548,132.27 as salary & commissions from the company, which he included in his federal income tax return for each year respectively.
c)      Company adopted a resolution in 1916: company will pay all income taxes upon the salaries of all officers of the company.
d)     The company paid for Mr. Wood $681,169.88 for 1918 taxes, and $351,179.27 for 1919 taxes.
3)            Ruling:
a)      Payment of taxes by employer was in consideration of the services rendered by the employee and was a gain derived by the employee from his labor.
b)      Form of payment makes no difference.
c)      Cannot be argued as a gift.  Payment for services, even though entirely voluntary, was compensation within the statue.
4)            This is similar to year-end-bonus­’. §1.62-2(a)
I.       Barter Income §1.61-1(a)
1)            Income may be realized in any form: including money, property, or services.
a)      Considers fair market value of services or property.
b)      Evaluation and fairness issues with fair market value determinations are generally outweighed by issues of not including as income.
c)      Fair Market Value determined (§120.2031-1(b))
                                                                                            i.            The price at which the property/service would change hands
                                                                                          ii.            Between a willing buyer and a willing seller
                                                                                        iii.            Neither being under any compulsion to buy or sell
                                                                                        iv.            Both having reasonable knowledge of relevant facts.
d)     “If services are rendered at a stipulated price, such price will be presumed to be the fair market value of the compensation received in the absence of evidence to the contrary.” – §1.61-2(d)(1)
e)      Fair Market Value requires Three Conditions: (all must apply to argue for a FMV transaction)
                                                                                            i.            A willing buyer/seller
                                                                                          ii.            Not under compulsion
                                                                                        iii.            Both having reasonable knowledge of relevant facts.
f)       Assessing the value of good/service: Look at. . .
                                                                                            i.            Cost of similar good/service seller charged regular customers
                                                                                          ii.            Cost of similar good/service other sellers charged customers
                                                                                        iii.            Cost of similar good/service to other family members
                                                                                        iv.            Cost of labor & equipment used/required