INCOME TAX OUTLINE
I. INTRODUCTION TO INCOME TAX
A. History of the Income Tax: Income tax a 20th century invention that required 16th Amdt. to pass.
i. Civil War (1864): 5% on $5 – 6k; 7.5% on $5 – 10k; 10% on $10k +. Repealed after War.
ii. 1894: Income tax under Grover Cleveland struck down in Pollock v. Farmers’ Loan & Trust because an “unapportioned direct tax”.
1. Tax on rich: 2% on $4k + and entire income of corporations ($4k = $100k in 2005)
iii. 16th Amendment (1913): Similar to 1894 and also targeted rich though rates modest.
1. $3k exemption + $1k for married & living with spouse.
2. %1 tax, surtax ranging from 1% on $20 – 50k up to 6% for $500k +.
B. Fluctuations in Rates: Highest bracket of 77% in WWI; 24% after; 91% in 1960s; 28% in 1986; and currently around 40% (see Tax Relief Act of 2001 which sunsets in 2011: Chirel p. 3).
i. Has been a mass tax (across a broad range of incomes) since WW2 though still -> rich
ii. Impact: In 2005, top 3% earned 1/3rd of all income and paid > ½ of all income taxes
iii. Income Disparity: But over past 40 years:
1. Top 10%: increased share of wealth from 1/3 to ½ of all income.
2. Top 1%: increased share from 12% to just under 23%.
C. Tax opinion confidence levels: If reasonable basis, taxpayer not guilty of crime for not reporting.
i. Reasonable basis: 15-30%; Substantial authority: 30-50%;
ii. More likely than not to prevail: >50%; Should prevail: > 70%
D. Compliance and Administration: Relies on self-assessment and audits
i. Failure to file: no statute of limitations on civil penalties, 6 years on criminal
ii. Audits: Some done randomly, most based on ev. of probability of error. IRS has 3 years to assert a “deficiency” (6 years for omission of 25% of gross income).
iii. Disputes: compromise w/ IRS or ordered to pay deficiency + interest + penalties. 3 ways to dispute in court:
1. Tax Court: if tax has not been paid; tried by judges with tax backgrounds; appealable to federal circuit courts. Lost -> pay underpayment + interest.
2. Federal District Ct.: can pay tax and sue for refund. Non-specialist judge and jury.
3. Court of Federal Claims: Favorable ruling here is applied to all taxpayers (bad for IRS)
iv. Penalties: 20% of underpayment if “negligent (reckless + intentional) or “substantial” (10%)
1. 5% per month not to exceed 25% for failure to file a return and .5% for failure to pay
2. In practice, usually will only be required to pay underpayment + interest
3. Fraud: 75% civil penalty but usually only for “highly culpable conduct”
a. No SoL on civil fraud penalties, but 6 years for criminal
4. Incentive for Aggressive Reporting: Audit probability 2% and interest on underpayment often less than market rates.
5. Mistakes: Make an adjustment or file amended return; no clear penalty for failure to.
E. Sources of Tax Law:
i. Internal Revenue Code of 1986
ii. Legislative Materials: Debates and hearings not usually important but Committee Reports prepared by technicians on the staff of the Joint Committee on Taxation are.
iii. Treasury Regulations: §7805 delegates Congressional authority to Secretary of Treasury to proscribe “all needful rules and regulations for the enforcement” of IRC. Quasi-legislative.
1. Other specific §§ such as §3 tax tables, §472 last-in-first-out inventory, §11501-1505 on consolidated returns for affiliated businesses.
2. Issued in form of Treasury Decisions. Can ordinarily be amend if prospective only
iv. Revenue Rulings & Revenue Procedures: Published by gov in weekly Internal Revenue Bulletin and permanently every 6 months in Cumulative Bulletins. Persuasive to courts.
v. Private Letter Rulings: advice to specific taxpayers that do not have precedential force outside of that specific taxpayer. May be developed into formal Revenue Rulings.
vi. Acquiesce/Non-Acquiesce: after court loss, IRS issues in IRB whether it will accept or continue to challenge the court decision.
II. GOALS AND JUSTICE OF INCOME TAXATION: What do we tax and why?
A. Economic Effects of Taxes: Income (reduced $ to spend) and substitution (incentivizing some commodities/activities) effects. Leads to tax’s ability to be used as a policy tool.
i. Tax Expenditure Budget: Equating certain tax benefits with direct subsidies to show policy.
B. What to tax? General concept of taxing people who are “able to pay” complicated.
i. Liquid vs. illiquid assets affects “ability to pay.” So should we not tax people with paintings?
ii. Taxing people who are “better off” leads to taxing rich because they have declining marginal utility of income (each additional dollar is worth less to them).
iii. Difference in amount of work (people who make the same but work less) may lead to taxation of “endowment/wage rate” or opportunity to earn whether or not exercised.
1. Would address problem of taxing only people who exercise their earning power because they are “better off” when in fact they just work more.
iv. Broad range of extreme possibilities, but we accept some variation of “ability to pay.”
v. Wealth/Income/Consumption Taxation: Tax on total wealth would create disincentive to hold wealth before consumption; income tax includes consumption tax within it.
C. We tax Income: Complex definition, but begin with “receipts minus expenses of producing them”
i. Tax incidence: shifting of tax burden to others. Ex. Difference in interest rate between tax-free bonds and taxable bonds is “putative tax”
ii. Inflation: price rise due to inflation creates a false “gain” that is not adjusted for under our tax system and results in overtaxing of investment income. Would also slowly push taxpayers into higher tax brackets if not adjusted for using CPI in §1(f) and §151(f)
iii. Marginal Tax Rates: different brackets, deductions affects your taxable income and increase the value of the reduction to you. Ex. $1k gift saves you $150 in taxes lowers cost of gift.
iv. Imputed Income: Long-standing practice excludes imputed income from §61 taxation.
1. This incentivizes home-owners and stay-at-home spouses by not taxing those services.
a. Similar effect reached by allowing borrowing to buy a house and deduction of interest on mortgages from income. Shows policy incentive of home-ownership.
b. So the money you borrow isn’t considered income so you can deduct interest.
2. Revenue Ruling 79-24: Personal services for others is not excludable as imputed income.
a. We distinguish between imputed income and non-cash benefits
3. General Rule §6045: Barters/exchanges must be reported as income
a. Exception Regs 1.6045-1(a)(4): Excepts arrangements that provide solely for exchanges of similar services on a noncommercial basis.
v. Marriage Penalty: Most favorable rate schedules are for (1) married joint filers, (2) heads of households, (3) unmarried individuals, and (4) married separate filers. So incentive to file jointly; however, if spouses have similar income, may end up with higher tax burden than if they were unmarried.
vi. Psychic Income: some leisure activities taxable and others not (watching sunset vs. sailing in yachts) so that even if happiness is the same we tax differently.
1. We may wish to tax leisure-work tradeoff differently by taxing those more likely to work (youth) more and those less likely to work less.
2. But too hard to measure and divide based on differences in preferences.
D. Theories of Taxation:
i. Paternalism: discourage certain behavior (cigarettes).
1. Sometimes turns into just a way to get more money.
2. Income tax not paternalistic in this way (i.e., discourage work) but every tax discourages something.
ii. Internalize externalities: creates a way, like in tort law, for actors who cause negative externalit
ired to stay at hotel, so his and wife’s food/lodging was tax-free. Reflects recognition that taxpayer’s rewards may be worth less to him than market value, so solve measurement problem by valuing benefit at zero.
b. §119: Bengalia essentially codified in §119. Excludes from income value of meals and lodgings furnished to employee by employer, provided that they are on business premises and for the employer’s “convenience.”
i. Convenience of the employer: usually established when shown that the employee is “on call” outside business hours.
ii. Must actually be furnished by employer, cannot be cash.
1. Commissioner v. Kowalski: highway patrolman given cash to eat at restaurants on highway had taxable income bc meals were not “furnished” directly by employer but given in cash.
2. Constructive receipt rule does not apply here (cash is normally treated the same as in-kind benefits under IRC)
3. But see Sibla v. Commissoner: fireman given $3 a day to participate in mess excludable bc it was obligatory and he could not spend it wherever he wanted.
iii. (1) in the case of meals, the meals are furnished on the business premises of the employer, or
iv. (2) in the case of lodging, the employee is required to accept such lodging on the business premises of his employer as a condition of his employment.
v. (3) Meals excludable if on premises where half of all meals excludable.
vi. §119(b)(1): what the employment K says is not determinative as to whether meals or lodgings are intended as compensation or for the convenience of the employer
c. Key: how much freedom you have to do what you want with what the employer gives you vs. “convenience of the employer.” Whether it is a “fringe benefit” to retain you or something required as part of your job. Factor for determining exclusion depends on constraints on TP’s choices.
E. EMPLOYEE FRINGE-BENEFITS
i. Old Colony Trust: employer’s payment of income tax on behalf of employee constitutes income to employee. “The discharge by a third person of an obligation to him is equivalent to receipt by the person taxed.”
ii. Historically, fringe benefits were not taxed bc of administrative problems/belief that they were de minimus, eventually leading to such widespread abuse that it damaged taxpayer morale.
iii. §132 Fringe Benefits: Exhaustive list of fringe benefits excludable from income. A “cease fire” legalizing industry practices in exchange for stopping expansion of fringe benefits.
1. Employee: Employee’s close family members and surviving spouses qualify for the exclusion if a no-additional cost service or qualified employee discount.
2. No-Additional Cost Service §132 (b)
Justified on efficiency grounds (no cost to employer and may even
