Federal Income Tax
Professor Paul Caron
I. SOME CHARACTERISTICS OF INCOME
Reasons to Tax Income
a. Fair to tax according to ability to pay.
b. Income is a good measure of the ability to pay.
Goals of a Good Income Tax
i. Horizontal: Tax people in the same financial system the same.
ii. Vertical: As income goes up, so does the ability to pay. Progressivity.
b. Practicality (Administrative Feasibility)
c. Sound Economic Effects
d. Dominant Themes of Course
a. The What Question
i. What is Income?
1. TP always says it’s not income.
2. IRS always says it’s income.
ii. What is Deductible?
1. TP always says it’s deductible.
2. IRS always says it’s not deductible.
b. The When Question
i. When is it Income?
1. TP always says it’s income later.
2. IRS always says it’s income now.
ii. When is it Deductible
1. TP always says it’s deductible now.
2. IRS always says it’s deductible later.
Formula for Computing Tax Liability
Gross Income – Adjustments/Exclusions = AGI
AGI- (Personal Deductions + Personal Exemptions) = Taxable Income
Taxable Income x Tax Rate = Tax
Definitions of Income
a. § 61: Gross income is “all income from whatever source derived, including but not limited to” a list of 15 items.
b. Eisner v. Macomber: Gain derived from capital, from labor, or from both combined.
c. Glenshaw Glass: Gain from whatever source derived; Congress did not apply limitations to what could be taxed.
d. Haig-Simmons: Sum of the fair market value of rights exercised in consumption and the change in the value of stored property rights over a specified time period.
Non-cash benefits ARE income. Income is not avoided because the tax payer is paid in a form other than cash.
§ 61 declares that gross income is all income from whatever source derived.
Reg. ‘ 1.61-1(a): Gross income includes income realized in any form, whether in money, property, or services.
Reg. ‘ 1.61-2(d)(1): [I]f services are paid for in property, the FMV of the property taken in payment must be included in income as compensation.
1. Example (p.51): Alice makes $5,000/month (60,000/year). She pays $1,000/month in rent. If sec. 61 did reach noncash benefits, then the employer could reduce Alice’s salary to $4000/month and pay Alice’s rent for her. This saves $3,360 ($12,000 x 28%) in taxes if Alice’s tax bracket is 28%.
Old Colony Trust Co. v. Commissioner: Court held that an employer’s payment of federal income taxes on behalf of its employee constituted income to the employee. The Court found it immaterial that the taxes were paid directly over to the federal government – “the discharge by a third person of an obligation to him is equivalent to receipt by the person taxed.”
Meals & Lodging
a. § 119(a): The value of meals and lodging furnished to an employee, employee’s spouse, or an employee’s dependents is excluded from gross income if such meals and lodging are provided for the convenience of the employer, but only if:
i. the meals are furnished on the premises of the employer, or
ii. the employee is required to accept lodging on the business premises of his employer as a condition of employment.
b. Bengalia v. Commissioner
Facts: Bengalia was the manager of a hotel and received a free room on the premises and free room service as part of his employment contract. The IRS sought to tax this as income.
Holding: The Court found that as manager of the hotel, petitioner was required to be present at all times, and therefore, his living at the residence was a necessary part of the job. Petitioner said that he would not work at the hotel and the hotel said they would not hire him unless he lived on the premises. Therefore, the Court found that petitioner was not required to include the value of the housing and the meals as part of his income because the advantage to him was incidental to carrying out his responsibilities.
Aftermath: Congress passed § 119, affirming the holding in Bengalia and exempting meals and lodging furnished for the convenience of the employer (i.e. forced on employee).
5 Alternative Ways to Tax Bengalia: (1) Retail FMV (IRS position), (2) Subjective Value to the Employee (impractical), (3) Cost of the alternatives to the employee (Dissent), (4) Cost to the Employer (Unknown), and (5) Forced Choice (Court’s holding).
§ 132: Fringe Benefits
a. § 132 (a): Gross income does not include any of the following: (i) no-additional cost services (ii) qualified employee discounts (iii) working condition fringe benefits (iv) de minimis benefits (v) qualified transportation fringe benefits (vi) qualified moving expense reimbursements (vii) qualified retirement planning services (viii) on-premises gym.
b. § 132(b): No-Additional Cost Services, such as free seating for airline employees on flights that would not otherwise have sold out. Gross income does not include services provided to the employee if such services are (1) offered for sale to customers in the ordinary line of business of the employer in which the employee is performing the services and (2) the employer incurs no substantial additional cost (including foregone revenue) in providing the service (determined without regard to an amount paid by the employee for such service).
i. No-additional cost services have 2 additional restrictions.
i. In order to claim the exclusion, one must work in a line of business of the employer in which the item at issue is ordinarily offered for sale to customers. Sec. 132(b)(1).
1. Example: If the same corporation owns an airline business and a department store, pilots cannot get a tax-free discount at the department store. Similarly, the department store employees cannot get a tax-free discount on flights.
ii. If the corporation/business only offers the discounts to “highly compensated” employees only, then these employees do not get the discounts tax-free. Sec. 132(j)(1).
ii. No additional cost services may be provided tax free to an employee’s spouse, surviving spouse, or dependent children but not to others such as same-sex domestic partners. Sec. 132(h).
1. Airline employees flying standby for free = No income taxes to be paid because airline seats is in the ordinary line of business and the employer incurs no substantial additional cost because those seats are going to be empty seats anyways.
2. What if the airline permits a pilot to reserve a seat for free? = Income taxes to pay because this would be lost revenue because the seat could have been sold to a purchaser.
3. What if airline only lets pilots fly standby for free? = Income taxes to pay because this violates the second additional restriction. Since the pilots are “highly compensated” employees and are the only ones who receive the discount, the discount is taxable income.
4. What if Delta and United allow employees to fly on each other’s planes on a stand-by basis? = No income taxes to be paid because this is in the ordinary line of business of both companies without incurring a substantial cost since the seats would be empty anyways. The employees work in the airline business so this is an item that is ordinarily offered to customers in the line of business they work in, and the discount is not for “highly compensated” employees only.
o de minimis benefits. Reg. 1.132-6(f)
f. §132(f): Qualified Transportation Fringe. Employee can exclude $120/month (in 2011) for mass transit. There is a tax bill increase to $230/month. Employee can exclude $230/month (in 2011) for parking. If employee accepts cash for these things, then that cash amount is taxable income.
1. Senior partner gets $75 free parking (as do all employees) = Not taxable as long as it’s not $75 cash.
2. Associate chooses $75 free parking rather than cash = Not taxable income.
3. Same facts, except parking is only given to partners and associates (not support staff) = Not taxable income because the “highly compensated” employees restriction does not apply to qualified moving expenses.
i. This kind of tax policy gives incentives to drive because it is the only scenario where the employee receives more value (where the parking is not taxed).
g. § 132(g): Qualified Moving Expenses excluded from income.
h. § 132 (h): Certain Individuals Treated as Employees for No-Additional Cost Services. The following are treated as employees for no-additional cost services and are not required to include the benefit of these services in income: retired employees, spouses of employees, dependents children of employees, and parents of employees (but only for air travel).
i. § 132 (i): Reciprocal Agreements. For purposes of no-additional cost services, if employer A agrees to provide services to am employee of employer B and vice versa, then the employee of company B may exclude the value of from income if: (1) the service is provided pursuant to a written agreement between the employers and (2) neither employer incurs any substantial additional costs in providing the service (3) the employers are both in the same line of business.
Example: Delta employees flying standby on United is O.K.
Example 2: Agreement between Delta and Hilton not O.K. because not same line of business.
j. § 132 (j)(1): No-additional cost benefits and qualified employee discounts only apply to highly compensated employees if the fringe benefit is available on substantially the same terms to each member of a group of employees. Employers cannot set up groups that discriminate in favor of highly compensated employees.
i. 132(j)(1) only applies to 132 (a) and (b).
Example: Can’t just give pilots benefits and not grounds crew.
Doesn’t trump the de minimis fringe benefit.
k. §132 (j)(4): Gross income does not include the value of an athletic gym so long as the gym is (1) on the premises of the employer, (2) is operated by the employer, and (3) its main use is for the employees, their spouses, and their dependent children.
1. Attorney uses on-site gym = non-taxable income
2. Associate works for small firm which pays $25 per month at the YMCA = Taxable income because the gym facility is not operated by the employer.
3. Country club caddie uses course one day per week = taxable income because the country club’s main uses is not for the employees, their spouses, and their dependent children.