FEDERAL TAXATION
KNAUER, SPRING 2014
I. MECHANICS AND POLICY
Calculating Tax Liability
· Gross Income is “all income from whatever source derived” – [§ 61]. It is pretty much all realized gains (including money “in kind” i.e. goods/services), minus statutory exemptions
o Includes gains on the sale of property.
§ Taxable Gain = sale price – purchase price
§ Basis is the portion of the sale that the taxpayer can recovery without incurring tax liability. In essence, it is the purchase price of the asset. Adjusted basis is the basis minus depreciation, or plus capital expenditures. If the adjusted basis exceeds the sale price, there is a loss.
· Adjusted Gross Income (AGI) = gross income – above the line expenses
· Taxable Income = AGI – (greater of standard deductions or itemized [below the line] deductions) – personal deductions.
· Total Tax Liability = Taxable income x (average tax rate) – (credits)
· Marginal Tax Rate = the rate that applies to additional dollars of taxable income
· Average Tax Rate = (total tax liability) ÷ (taxable income)
So, follow these steps:
1. Calculate gross income [§ 61]
2. Subtract above the line deductions [§ 62]. The resulting figure is AGI [§ 62].
3. Subtract personal exemptions [§ 151] and below the line deductions (the greater of the standard deduction [§ 63] or itemized deductions [§ various]). The resulting figure is taxable income [§ 63].
4. Apply the tax rate schedules [§ 1] to taxable determine tentative tax liability.
5. Subtract any tax credits from tentative tax liability.
a. Remember that deductions reduce income while credits reduce tax liability.
Overarching Policy Considerations
· Three Pillars:
· Equity: Those with greater ability to pay, pay more. The IRS should not impose a different burden on different people in similar economic circumstances.
· Efficiency: Taxes should interfere as little as possible with a taxpayer’s economic behavior. Analyzed from the viewpoint of a hypothetical, taxless economy.
· Simplicity: The result of being both equitable and efficient. This is better because, in theory, it allows all citizens to use the IRC to their advantage equally.
Pros of a progressive tax code
· People with more are better able to pay more; deliberate reduction in income inequality
· Proportions the overall tax burden by offsetting regressive taxes (i.e. federal payroll, excise, and sales)
· Value of government expenditures increases with income and wealth (i.e. rich people need the government to take care of international affairs, etc)
· A progressive system allows governments to collect more money from higher income earners. This results in more money collected, rather than if everyone paid the same percentage. As a result, the government can provide more programs and services that benefit society.
Cons of a progressive code
· “How is it fair that I have to pay a higher percentage of my income than the guy across town who makes less money? I certainly don't get to cast more votes even though I provide more money to the federal tax base.” To proponents of this argument, a flat tax or tax where everyone pays the same percentage would be more fair.
· Motivates the wealthy to look for loopholes.
Alternative Systems
· Head tax- probably the most economically efficient. Unfair because it ignores individual ability to pay, since everyone is paying the same amount
· Benefit tax – tax based upon the extent to which an individual benefits from a government service. This is difficult to instate because its hard to measure demand for and individual use of a government service, such as national defense
· Expenditure tax – tax based on total consumption of an individual. It may be a proportional or a progressive tax; its advantage is that it eliminates the supposed adverse effect of the personal income tax on investment and saving incentives. Difficult to administer, it has been applied with only limited success in some countries.
· Payroll tax – levy imposed on wages and salaries. In contrast to income taxes, payroll taxes do not include income from capital sources such as dividends and interest.
· Flat tax – consistent marginal rate, so everyone is taxed at the same rate.
II. WHAT IS INCOME?
· Found Money and Other Windfalls
o Cesarini v U.S. [piano windfall case]
§ F&I: P bought a used piano and found $5000 inside of it years later. He paid taxes on the sum, but sued for a refund, claiming that the windfall was not included in gross income under § 61. Is found money part of gross income?
§ H: Yes. Court held that the windfall is gross income.
§ D: §61(a) lists specific types of income, but that list is not exhaustive. Instead, §101 specifically lists exceptions to gross income, and windfalls are not one of them. If you are looking for an exemption, you must point to the specific listed exemption; otherwise, the broad language of § 61 will make your income taxable.
o Haverly v U.S. [textbooks case]
§ F&I: A school principle received free, unsolicited sample textbooks, which he donated to the school’s library. He didn’t include them as gross income, but claimed a charitable deduction for the donation. He paid the difference in his taxes and sued for a refund. Does the value of these books constitute gross income?
§ H: No. Taking a deduction from the donation proves that the books were income. Otherwise, he would be double dipping (deduction and exclusion).
§ D:
· Under Glenshaw Glass (SCOTUS), if the following requirements are met, there is income:
o Accession to wealth
o Clearly realized, and
o Taxpayer has complete dominion.
· Here, all three requirements were met for the unsolicited sample books to be included in gross income.
o The books clearly had some value; the deduction was for their market value.
o Receiving and having possession of the books demonstrated that he “clearly realized” them
o Because the Principal had the option to take a deduction for the donation, so he clearly had dominion and control
· No double dipping/double tax benefits allowed. Say the principal makes $10k a year. He receives the books and sells them for $1k. His taxable income is $11k. If he donates that $1k to charity, he can take a $1k tax deduction and have a taxable income of $10k again, no problems. But, by taking a deduction for the books and not including them in gross income is unfair, as he uses the books to reduce his gross income to $9k.
o For the textbooks, the IRS only cares if there is some benefit derived therefrom.
o Business Travel
§ U.S. v Gotcher [business travel case]
· F&I: Employer paid for employee and his wife to go to Germany for the primary purpose of helping the business. Neither Employee nor his wife included cost of trip in income. Is this excludable?
· H: Yes, for the employee, no for his wife
· D:
o The economic benefit will be taxable to the recipient only when the payment of expenses serves no legitimate corporate purpose.
o In determining income, look to see whether the taxpayer had an economic gain, and, if so, if that gain was primarily for the purpose of taxpayer’s employer instead of the taxpayer himself.
o Even if small parts of the trip were dedicated to sightseeing, it is primarily for the employer’s benefit, not for the taxpayer.
o The wife had to pay taxes on her share of the trip because it was unrelated to business. When a member of the employee’s family receives a taxable fringe benefit, it is included of the gross income of the employee, not the family member. § 274(m)(3) provides that travel expenses are deductible for a spouse or dependent only if: (1) the spouse is an employee of the taxpayer; (2) there is a bona fide business purpose; and (3) the expenses would have otherwise been deductible.
o Meals and Lodging
§ To be excluded from income, meals must be “furnished for the convenience of the employer” and cannot represent compensation for services rendered by the employee. § 119.
§ An employee and his spouse/dependents may exclude the value of meals IF the meals are furnished on the business premises of the employer.
· Comm’r v. Kowalksi: Refusing to permit NJ state troopers to exclude cash reimbursements received for meals at restaurants while on duty. Restaurants were not the private business premises and § 119 did not allow “in kind” transfers like this.
· Christey v US: Permitting state troopers to deduct (but not exclude) the costs of meals they were required to eat at public restaurants adjacent to the highway while on duty under §162(a).
· American Airlines v US: $50 meal vouchers were not excluded as a de minimis finge because employees could use the vouchers at any time.
§ In the case of lodging, excludible only IF the employee is required to accept such lodging on the business premises of his employer as a condition of his employment.
· A home provided to you by your company can be excluded if that home is the site of business activities (i.e. governor’s mansion)
· Hargrove v Commissioner: Americans required to accept housing as a condition of employment abroad could not exclude the housing because the homes were not on the business premises of the employer.
