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Federal Income Tax
University of California, Hastings School of Law
Field, Heather M.

Heather Field – Federal Income Tax – Spring 2012

GROSS INCOME [§61] à broadly defined

a. (1) Undeniable accession to wealth, (2) clearly realized, and (3) over which TP has complete dominion

b. Gross income = receipt of ANY financial benefit

i. Not the mere return of capital.

1. Ex: TP receives repayment of a loan.

ii. NOT excluded by specific provision of the code

c. Gross Income Realized in any form [§1.61-1] à money OR property OR services

d. Laundry List Examples [§61(a)]

i. Compensation for services (including fees, commission, fringe benefits, and similar items)

ii. Gross income derived from business || Gains derived from dealings in property || Interest || Rents || Royalties || Dividends || Alimony and separate maintenance payments || Annuities || Income from life insurance and endowment contracts || Pensions || Income from discharge of indebtedness || Distributive share of partnership gross income || Income in respect of decedent || Income from interest in estate or trust

iii. Items of Gross Income [§1.61-14]

II. Miscellaneous Items of Gross Income à[§ 1.61-14]

a. Punitive Damages (Glenshaw Glass) || Illegal Gains

b. Obligations (taxes, loans, etc.) paid/discharged by someone else on your behalf à income

i. Ex: Old Colony Trust

1. Company paid employee’s taxes directly to the gov’t à NOT a gift à compensation for services rendered by the employee

c. Treasure Trove

i. Ex: Cesarini – TP’s purchased used piano and discovered money 7 years later

1. TP must now include the money as income

2. When money was reduced to undisputed possession à include as income

III. Compensation for Services [§ 61(a)(1)]

a. Forms of Compensation [§ 1.61-2(a)]

i. Wages, salaries, commissions on sales, profit percentages, commissions on insurance premiums, tips, bonus (including Christmas bonuses), termination or severance pay, rewards, jury fees, retired pay of employees, pensions, retirement allowances

ii. Imputed Income – NOT INCLUDED IN INCOME – flow of satisfaction from the goods owned by the taxpayer or from goods / services arising from the taxpayer’s own efforts. Taxpayer is wealthier by the services he has provided to himself, and is a deviation from the theoretical concept of accessions of wealth as income.

1. Ex: Child care / housekeeping are the largest areas of untaxed imputed income

a. PP: Wealthy families more likely to have a stay at home parents, is this a subsidy for the wealthy?

2. PP: reason not to tax à administrability of the task is absurd.

3. Ex: Independent Life Ins. – rental value of a building used by the owner does not constitute income

a. Counter Ex: Dean Case – Taxpayer lives in residence that is owned by a corporation where he / wife are only shareholders. Tax is owed on FMV of the rental amount.

4. Ex: Imputed Income Accountant preparing his own taxes is NOT income for services rendered to himself

b. Compensation NOT in cash [§ 1.61-2(d)(1)]

i. If TP is paid in property OR services in exchange for his services rendered

1. Amount of income = FMV of property or services

ii. If services rendered by TP at stipulated price

1. FMV = stipulated price (presumed)

Assignment of Income

a. Income for services à “You earn it; you pay the tax” (Lucas)

i. Income from services is taxed to the person who performs the services

1. Earns the salary

ii. This matters because of our progressive rate structure.

iii. TPs attempt to shift income from people in high tax brackets to those in lower brackets.

iv. Assignment of income principles are not in the code à source = case law

b. Income from Property / Investment

i. If you control the income producing property then you pay the tax resulting from the property.

ii. Your tree; your fruit. à If you ONLY own the fruit OR are only entitled to the fruit; an effective gift can be made

iii. Identify who controls the income producing property:

1. If you control the property and give away the income then it is still your income. (Horst)

2. If you transfer away your interest in the property, then the transfer of the property is effective. (Stranahan)

3. Bona fide gift of the property = tax is no longer allocable to you.

iv. Horst – Conveyance of the bond interest is the same as gifting income

1. Donor retained (control of) the bond principal, but gifted the interest coupons to his son.

2. Donor owes tax on the income.

v. Stranahan

1. Son paid father sufficient amount of money for interest in the dividends, & decedent divested his entire interest in the dividends to the son.

2. No tax is owed by the decedent on the dividends because he did not earn them as income prior to assignment to the son.

3. Service may try and classify as a loan instead of a sale of the dividends.

a. Look for accelerating income to “monetize a deduction”; more certain that the later payment will be made then the more likely it is a loan and not a sale. Ex: Bond interest payments might be more likely to occur than stock dividends

b. If considered a loan from son to dad à dad pays tax on the income; dividends serve security of payment of the loan. Father was trying to accelerate income to monetize a deduction, not avoid paying tax on the dividends

vi. Susie Salvatore – LOOK AT THE TRANSACTION AS A WHOLE

1. “A sale by one person cannot be transformed for tax purposes into a sale by another by using the latter as a conduit through which to pass title.”

a. Each step in the process of the sale must be looked at, from the commencement of negotiations to the consummation of the sale.

b. Cannot solely look at who transferred the title.

Year of Inclusion – TIMING!

Income

Deduction

Cash

PP: simplicity for common TP

Receipt

Actual or Constructive

Payment Made

Accrual

Earned

-All Events Test

-Amount Fixed

Liability Arises (Obligation)

-All Events Test

-Amount Fixed

-Economic Performance

IV. Motivations to adjust when tax is paid or income claimed

a. Substantive tax law may change year to year || (ii) Statute of limitations

b. Tax rates change year to year, and if the rates are lower this year, then you would rather pay it now.

c. Time value of money.

i. Reduce tax sooner by claiming deductions. || (2) Split income over taxable years would è lower marginal rate potentially

V. Account Method used must CLEARLY REFLECT INCOME

VI. Example

a. Attorney renders services in Dec of year 1 || Business person pays for services in Jan of year 2

b. As cash method taxpayers

i. A = Income in year 2

ii. B = Deduction in year 2

c. Accrual method taxpayers

i. A = income in year 1 because that is when the advice was rendered

1. Late payment does not matter

ii. B = deduction in year 2

Cash Method à Reg. §1.446-1(c)(i) Gross Income à included in the taxable year in which actually or constructively received || Deduction à when payment is made

d. Checks DEDUCTIBLE when mailed // Check is INCOME when received

i. Ex: “Immaterial that delivery of a check is made too late in the TY for the check to be cashed in that year.” [as long as check honored]

ii. BUT If substantial restriction on the check/income, then TP does NOT “receive” the money. (Payer tells him not to cash it until next year)

e. Boylston Market Association à Prepaid Insurance, when to deduct premiums, term of 3 years may be easily allocated:

i. Clearly an ASSET having a longer life than a single taxable year à creation of a “long-lived asset” à useful life extending substantially beyond close of year CANNOT be fully deducted in year payment is made 1.461-1(a)(1)

1. Expenditure must be capitalized and deductions may be taken only ratably over the asset’s useful life”

ii. EXCEPTION à mortgage points 461(a) for “points” (prepaid interest) that are paid on a principle residence. Deduction is allowed for “points.”

iii. Reverse: person RECEIVING prepaid insurance PAYMENT à includes TOTAL payment in year of receipt.

f. Constructive receipt – credit to account, set apart for him, or otherwise made available so he can draw on it any time without substantial restriction. TR §1.451-2(a).

Accrual Method

a. Income à Entitlements // Earning Income

i. All events have occurred that fix the right to receive the item (all events test)

1. Amount of the item can be determined with reasonable accuracy.

2. Economic performance with respect to the income occurs.

ii. Prepaid income is an exception

g. Deduction à Obligations // Incurring Costs

i. All events have occurred that establish the fact of the liability that gives rise to the deduction

ii. Amount of the liability can be established with reasonable accuracy and economic performance has occurred.

b. Prepaid income for both goods and services must be included within income in the year of prepayment à §446(b)

iii. “Deferral would not clearly reflect income”

iv. New Capital Hotel à Prepaid income (rent) is includable in gross income in the year of receipt of the item representing it, rather than in a subsequent year when it is considered earned.

v. Exception:

1. Incredibly limited sets of facts allow this deferral method. Magazine subscriptions are one and the Devil Rays case allowed it as well

2. Artnell Co à Where an accrual basis TP receives pre-payments for future services and the method employed clearly reflects income, the TP may defer the unearned income to the year in which the service is scheduled to occur . [Baseball tickets] à treated VERY narrowly.

3. Revenue ruling 2004-30

a. Allows prepaid income to be split as income received and allocable for the current year (claimed in year one) and then the rest to be claimed in year two

c. Financial trouble NOT reason to prevent recognition, BUT LEGAL dispute over liability is b/c all events have not occurred that give rise to the obligation. §461(f)

VII.Prepayments RECEIVED must be included in the year of receipt whether the TP is cash or accrual method

VIII. Prepayment of interest – cash vs. accrual example:

a. BOTH DEDUCT a portion over the next 5-years

b. Reasoning is different though

i. Cash method à capital expenditure that is ratably deducted

ii. Accrual method à all the events have not occurred that fix the liability to the debtor. We do not know whether the lender will be entitled to the interest or not b/c the debtor may pay back the principal.

1. No economic performance occurs on the prepayment to warrant a liability arising.

2. Amount is NOT reasonably determinable

3. Threshold question is not about payment (like the cash method) – instead whether a liability has been incurred.

Exclusions from Gross Income

a. Gross income does not include the value of property acquired by gift or inheritance.

b. Income from inherited/gifted property à TAXED

c. Gifts [§ 102(a)] à EXCLUDED

iii. Consider à transferor’s intent (most critical) for determining valid gift.

1. “From transferor’s detached and disinterested generosity, out of affection, respect, admiration, charity or like pulses.” (Duberstein)

2. Whether transfer of money/property constitutes a gift is question for trier of fact.

iv. EXCEPTION à if Business relationship à NO exclusions

1. Gift as disguised compensation [Duberstein]

i. TP cannot exclude gift from income b/c of business relationship.

ii. Transferor’s intent is most critical à gift here was not made with detached generosity…

v. Exception à Employee Gifts [§ 102(c)] à NO exclusion

vi. Exception to the Exception à Transfers and Gifts between Related Parties [§ 1.102-1(f)(2) Proposed] à Exclusion from income

1. If purpose of gift is substantially attributed to a familial relationship of parties OR

2. NOT related to the circumstances of their employment.

d. Inheritance [§ 102(a)] à EXCLUSION

vii. Ex: Lyeth – inheritance from an estate. Interpretation of the tax code is a Federal decision NOT a state decision.

1. Settlement agreement after the validity of a contested will was determined is still inheritance.

viii. Business Relationship à No Exclusion

1. Writing a compensation arrangement into a will is NOT sufficient.

2. Person must receive the property because of his status as a devisee or heir.

e. Employee Fringe Benefits à EXCLUDED – see below

f. Scholarships

ix. Qualified Scholarship [§117] à EXCLUSION

Forgiveness Programs [§108f] à discharge is EXCLUDED

i. Student loan discharge does not have to be included IF

1. Student Loan

a. Loan to assist individual in attending educational organization

2. Loan Forgiveness Provision

a. Loan provision that provided the debt would be discharged if individual worked for certain period of time in certain professions for any broad class of employers

3. Certain Lender

a. Loan made by the fed/state gov’t, public benefit corp., or education organization.

ii. LRAP – Revenue Ruling – law school loan meets definition of a “student loan” under §108(f)(2) and the discharge of the debt is excludable from income.

X. Damages & Workman’s Comp

a. Damages (in general) [Raytheon] (p. 191)

i. Characterization of a damages settlement depends on why the payments are made.

ii. Consider à in lieu of what were the damages awarded?

1. Ex: damages to recover lost profits à income

2. Ex: damages payments for “services” à included as income

3. Ex: damages to injury to goodwill à return of capital (investment) à NOT income

iii. Punitive damages are income under the definition in Glenshaw Glass

b. Damages for Personal Injuries (Compensatory Damages) [§104(a)(2)] à EXCLUSION

i. Amounts recovered for personal physical injuries OR physical sickness

1. From law suit OR settlement

a. Torts

2. In lump sum OR periodic payments

3. Emotional Distress à NOT a personal physical injury

4. No emotional distress damages without a PHYSICAL injury

a. There must be “medical care expenses” to recover §104 – last 2 sentences

b. ED damages are excluded ONLY to the extent of medical care costs

c. P will argue all of his ED arises from the physical injury.

ii. EXCEPTION à Punitive Damages [§104(c)] à generally NO EXCLUSION

1. Exception Does NOT apply to punitive damages

a. In wrongful death action; AND

b. Where state law provides that only punitive damages may be awarded in such action

2. Punitive v. Compensatory Damages

a. Damages Characterization à Consider à P’s prayers for relief in complaint

i. Use the damages requested in the complaint to create a ratio between compensatory / punitive to determine allocation of final award

1. (RR 85-98)

ii. Settlement allocation will generally be followed for tax purposes unless something is amiss. (p. 196)

b. Works well for P/D to avoid punitive damages in settlements

i. Tax reasons

ii. Guilt of party

iii. Policy

1. Why limit to physical injuries?

a. Physical injuries à quantifiable and easier to prove / more trustworthy

2. Administrability issues arise with emotional distress

c. Worker’s Compensation Payments for Personal Injuries [§104(a)(1)] à EXCLUSION

i. Amounts received acts as compensation for injuries or sickness related to employment

1. INCLUDES à job-related deaths

XI. Interest on State and Local Bonds [§103] à EXCLUSION

a. State and local bond interest is excluded from income

XII.Employee Fringe Benefits [§132] à EXCLUSION

a. Spouses and dependents are treated as employees for the purposes of §132(a)(1) & (2) exclusions

i. This is a “broad” definition of employee

b. No Additional-Cost Services [§ 132(a)(1) à § 132(b)] à broad definition of “employee”

i. Services provided by employer to employee for use by employee à ELEMENTS 3x

1. Services are offered for sale to customers in ordinary course of line of business of employer

2. Employee performs services in same line of business

3. Employer incurs no substantial additional cost in providing service to employee

a. Excess Capacity Services [§1.132-2(a)(2)]

i. Ex: Hotels, airplanes, trains, bus, subway, telephone services

ii. Non-Excess Capacity Services

1. Brokerage firm services for facilitating the purchase of stock

2. Still may be eligible for qualified employee discount of up to 20% of the value of the service provided (§1.132-3)

b. Cash Rebate – Employee gets reimbursed after using the service à still excluded [§1.132-2(a)(3)]

i. Benefit can be in the form of a cash rebate for a service (ex: hotel room)

1. Partial or total cash rebate is allowable à both excluded

ii. No substantial difference to receiving the benefit at no outlay

c. No-Substantial Additional Cost [§1.132-2(a)(5)]

i. Cost à includes forgone revenue because service provided to employee rather than customer

1. Cannot displace a customer by providing for an employee

2. Maid service is incidental cost to providing space-a room

d. Must be non-discriminatory à if highly compensated officer [§132(j)(1)]

e. Same line of business (even if a corporate owns a hotel and a shipping biz)

i. PP: do not want to provide more advantages to the employees of conglomerates.

ii. Counter Ex: Comptroller of conglomerate whose services benefit both shipping and hotel lines of business à services on either à excludable

iii. 1.132-4(a)(1)(iv)