Federal Income Tax
What are some of the goals that a tax system should achieve?
1) raise government revenue
2) we want to discourage certain behaviors (drinking, smoking) by taxing these things more
3) we use taxes for fiscal reasons – to stimulate the economy, we can use the tax system to stimulate the economy
4) Encourage promote social policies – what congress wants to see is that all the benefits of the tax benefits should go to the charities.
5) We need a system of fairness, if so and so pays more, why should I have to pay this, ECT…
a. It’s a voluntary system so in order for people to volunteer they have to think it is the same
b. Horizontally Equity – people that are similarly situated should pay the same amount
c. Vertical Equity – people who are differently situated should not pay the same amount.
6) We try for an efficient system, we don’t want to encourage or discourage a transaction because of the tax, and we want to keep tax as much out of things as possible. Kind of like transaction costs, the goal is to keep these as low as possible.
7) Simplicity –we don’t want the tax code to complicate the every life for the taxpayer by requiring that transactions be structured to take tax consequences into account. Also we want the tax system to be easy for everyone to understand and easy to administer.
Haig-Simons Definition – personal income is the sum of consumption and accumulation. Income is the “increase of accretion in one’s power to satisfy his wants in a given period in so far as that power consists of (a) money (b) anything that can be valued. Income is something that one can consume without any increase or decrease in their capital. While the administribility of this type of tax scheme is next to impossible, it is widely accepted as the theoretical benchmark against which we can compare the current tax treatment of specific items.
Defining the Tax Base
Gross Income is Defines in § 61.
– Costs of producing income are allowed as deductions by § 162 and are subtracted from gross income
– § 262 disallows or defers deductions for certain expenses, such as expenses that provide a benefit beyond the taxable year.
Gross income includes not just money from salaries and dividends but also income from Property Transactions
Capital v. Ordinary Expenditure – Not all profit seeking expenditures is deductible when made. Because income generally refers to changes in net worth, expenditures which merely convert one asset into another do not result ina loss meriting deduction from the tax base. E.G. a person buys 10K worth of stock, they merely converted one asset into another and should not be taxed because no change in net worth has occurred
Realization and Recognition – while under H-S the increase in the value of property would be a taxable occurrence, under the federal income tax rules it is only taxable when the event is realized, the property is sold.
Depreciation – economic depreciation is the estimate of the annual decline in value of depreciable property and is an appropriate deduction under an income tax. Depreciation deductions permitted under the tax law greatly exceed economic depreciation. § 167, 168, and 197 are the principle provisions governing depreciation.
Capital Gains & Loses – Preferential tax rates are given to capital goods. The most significant preferential tax rate is reduces the tax by 15%. The purpose of this is to encourage people to expand their businesses and invest in capital intensive ventures.
Tax Base – this can be anything, consumption, income, wealth, ECT… Our tax base however is based on income. It is not however an entirely based on income and there are a lot of consumption things built into it. The best way to think about it is like a spectrum with income and consumption on either side, right now our tax falls somewhere in the middle but is moving towards consumption.
When we first thought about income what they thought of was “how much money you could spend in a particular period and still be as well off and in the manner that you were accustomed to in the beginning of the year”. Basically how much can you spend and still live life the same.
Income = ∆ Wealth + Consumption
Income = Gross Income – Allowable Deductions
The difference between an income and a consumption tax is how they tax savings; a consumption tax does not tax savings
Reasons why we want a consumption tax
1) we want to encourage savings – which is good thing for us a country
2) There are some aspects that are more favorable for business, help capital investment, businesses expenditures, ECT…
3) Sales tax is so much easier, its easier for everyone and less prone to abuse
Why Consumption tax is not great
(1) its regressive, a sales tax puts more of a burden on someone with less income then on someone with a large income
(2) yes it is similar, but we live in a country with a legislature and a consumption tax as perfect as it may seem in theory is going to have a lot of special rules because in order for congress to pass the law they are going to want to tack on all the crap they have tacked onto this one. The legislature will fuck up the simplicity of the consumption tax
If you have to revalue everything you have every year then you have to get it appraised (expensive, difficult, fraud possible)
What are allowable deductions?
(1) they have to be real decreases in wealth
(2) real decreases in wealth that are businesses or investment expenditures
There are 3 structures
(1) Proportionate – what ever you earn everyone pays the same proportion across all income levels. A very fair way to tax but the rich win
(2) Progressive – this is what we have, the more you earn the higher you get taxed, and the greater your ability to pay the more you should.
(3) Regressive, the more money you make the less you pay, you are taxed on the first 100k and than nothing after that.
We just don’t pay income we pay all types of taxes some proportionate, some progressive, some regressive, therefore we need a progressive income tax to balance out the other types of taxes.
The Taxable Unit
Shifting Income Among Taxable Units
Generally the taxpayer is the individual or entity who earn or owns the property that produces the income. The simplest way therefore to shift income is for one taxpayer to give income producing property to another taxpayer. Because however there is a low level where income is not taxable, certain smart people attempt to shit some of their taxable assets to people with low tax rates so they can cheat the government. This happens in families where a child
in name may get an asset which helps offset the gathers taxes.
Lucas v. Earl – The taxpayer claimed that he should not be taxed for the whole of the salary and attorney fees earned by him because he and his wife had contracted that any property either of them owned or thereafter acquired, including salaries, would be owned as joint tenants, with right of survivorship. Revenue Act of 1921, 42 Stat. 227, required salaries to be taxed by those who earned them and provided that the tax could not be escaped by anticipatory arrangements and contracts however skillfully devised to prevent the salary when paid from vesting even for a second in the man who earned it. This case turns on the important and reasonable construction of the taxing act.
Rule – income is taxed to the person who performs the services and cannot be shifted to a lower-bracket taxpayer.
Analysis – There is no doubt that the statue could tax salaries to those who earned them and provide that the tax could not be escaped by anticipatory arrangements and contracts however skillfully decided to prevent the salary when paid from vesting in the man who earned it.
Poe v. Seaborn – this case took the opposite approach from Lucas and held that in a community property jurisdiction each spouse is taxable on one-half of the community income regardless of which spouses earned it.
Armantrout v. Comm. – § 83 (employee-parent) – the tax payers employer set up a trust for the educational needs of his employees children. The tax payer said he did not have to pay taxes on this because HE was not receiving the benefit.
Holding – because the education benefit paid for the taxpayers children were the product of the taxpayers employment relationship and were thus in the nature of compensation.
U.S. v. Bayse – these doctors entered into a partnership and took part of their payments from the hospital into a retirement trust. The court held that the payments into the retirement trust were includable in gross income by the partnership and were this taxable to each doctor-partner as their share of partnership income earned.
Teschner v. Comm. – RAFFLE PRIZE CASE – taxpayer entered a contest and designated his daughter to receive the prize. Person over the age of 17 were ineligible for the prizes and had to designate someone else. When the taxpayer one he said he had no gross income because the prize was not payable to him under the rules.
Holding – the court held that the taxpayer’s mere power to direct the distribution of the prize to his daughter was not sufficient to tax its value as income to him because the taxpayer did not possess a right to receive the prize under the contest rules.
Commissioner v. Giannini – instead of receiving some profits from his bank, taxpayer said don’t give me the money give to the University of California. The IRS said all they are doing is making a donation and are avoiding tax liability by having the corporation make the donation for them. The tax court said ok, you don’t have to pay taxes on this. However a similar court in Hedrick v. Comm. held differently and said the person had to pay.
Analysis – These cases hinge on who controls the money or assets. If you control it, if the fruit grew on your tree, then you should be taxed for it.
When someone has no ability to receive the money (pie eating) he should not get taxed on it because he never had the money in the first place, there are no opportunities for earl to cheat the system, and he never took the money from him and gave it to someone else.
Income from Property
You can waive your right to collect money, and you can waive your rights prior to earning the income and you can make suggestions over where the money should go. Once however the money is earned (its on the tree) you cannot waive your right to receive It after you earn it.
Blair v. Comm. – Petitioner assigned the income from a testamentary trust to his children. The trustee accepted the assignment and distributed the income directly to the assignees. Respondent Commissioner of Internal Revenue ruled that the income was taxable to petitioner. The United States Supreme Court reversed the judgment of the appellate court, which held that petitioner w
etic ear if this joker had paid his taxes at all. He did not pay taxes for 10 years. This guy says he should get a marriage deduction because he and his partner live together,
Holding – a law is considered to burden the right to marry only where the obstacle to marriage imposed by the law operate to preclude marriage entirely for a certain class of persons. Petitioner therefore places himself in a class that includes nonmarried couples, family members, and roommates. With all of these people in this group, there is no way the court can say this is a suspect class.
What important about marriage is some of the policy’s and how they work or don’t work together, how they flow into other things we do.
§1(g) – Kiddie-Tax
Ordinarily a child is not apart of the marriage but is their own tax payer – with children you get a potential opportunity to shift income to the child that you can’t do with a wife. You have to transfer the tree, you can’t just shift the fruit (Blair) the Kiddie-Tax is meant to prevent this. If the courts thought the person was sneakily assigning income to dodge taxes, the court says the kid is going to have to pay the tax at the parent’s highest marginal rate. This is because we add the child’s income on top of the parent’s income so it is at the highest marginal rate.
Ex: if the child has $400 of unearned income and no earned income, the child’s standard deduction is $400 (its allowed up to $500) so the child pays no taxes.
Ex: If the child has $900 of unearned income and no earned income, the child deducts $500 and then pays tax at the child’s rate on the remaining $400 because it is below $500. If the remaining taxable amount though was $2,000 then the child would need to pay taxes at his parent’s marginal rate.
The starting point for determining “taxable income” is “gross income” which is – all income from whatever source derived. § 61. We always start with § 61 and then work our way out from there.
Commissioner v. Glenshaw Glass Co – Income Definition – Gross income, which is taxable, is defined through a host of terms but for this case it is income derived for any source whatever
Issue – whether money received as exemplary damages for fraud or as the punitive 2/3 portion of a treble damage anti-trust recovery much be reported as income by the tax payer.
Holding – the mere fact that the payments were extracted from the wrongdoers as punishment for unlawful conduct cannot detract from their character as taxable income to the recipients
The Three Definitions of Income
(1) Income has to be something that is regular or continuous – Not so much
(2) Fruit and the Tree – Income is something that is derived from your labor or capital
(3) An accessions to wealth, that is clearly realized, over which you exercise control – WINNER
Analysis – this case makes it clear that the source of an increase in net worth is irrelevant for income definition purposes. Lottery winnings or other windfalls are clearly includable in gross income under Glenshaw. The is no question that the receipt of economic benefit from a third party is income.
Cesarini v. U.S. – Found Money – A guy found $5K in a piano seven years after he bought it. The court held that the finder of a treasure trove is in receipt of taxable income, for income tax purposes, to the extent of its value in U.S. currency….in the year it was discovered. The guy had to pay taxes on the money. Treasury Reg. § 1.61-14(a)
Haverly v. U.S. – unsolicited books – Appellee taxpayer, a school principal, received unsolicited textbooks from publishers. He donated them to a library and took a tax deduction. Appellant United States claimed the books were income and assessed additional tax. Appellee paid the tax, filed a claim for refund and then instituted this action. The district court found that the textbooks were not income and ordered appellant to give appellee a refund. On appeal, the court held that the language of 26 U.S.C.S. § 61(a) encompassed all accessions to wealth, clearly realized, over which the taxpayers had complete dominion. The court ruled that when the intent to exercise complete dominion over unsolicited samples was demonstrated by donating those samples to a charitable institution and taking a tax deduction therefore, the value of the samples received constituted gross income. The court reversed and remanded.