Income Taxation Outline

INCOME TAX
PROFESSOR FRIEL
FALL 2012
LAW6600
SECTION 5247
 
 
 
*Open book exam
*Work problems in the book
*Identify different types of property exchanges.
 
Chapter 1 – Introduction to Federal Income Taxation
 
Problem:
·         Caroline taxpayer is a business consultant who owns and operates her own unincorporated business and uses the cash method of accounting and reports her income on a calendar year basis.  She has provided you with the following information concerning her financial affairs during the calendar year and asks you to compute her tax liability:
1.      With regard to her consulting business:
§  She received $275,000 in fees through a combination of cash and checks from clients;
§  She provided $10,000 in consulting services to one client, a landscaping company, in exchange for $10,000 in landscaping services the client provided, at Caroline's request, for Caroline's mother;
§  Clients still owed her $30,000 for services she provided during the year;
§  She paid an employee $60,000 in wages during the year;
§  She paid $20,000 for building maintenance, utilities, and office supplies during the year; and
§  She purchased an office building for $500,000 which she expects to use in her business for the next 30 years.
2.      Caroline incurred $5,000 in commuting costs in traveling from her home to work during the year.
3.      Caroline received $19,000 in interest income this year from an investment account managed by her bank.  She paid the bank $1,000 for its management services.
4.      Caroline owns her home, on which she made mortgage payments in the amount of $24,000 during the year.  Included in the $24,000 were $18,000 in interest payments and $6,000 in principal payments.
5.      Two years ago, Caroline purchased 100 shares of stock in ABC Corporation for $15,000.  At the end of last year, the stock had a fair market value of $25,000.  This year she received $1,000 in dividends on the stock.  She sold the stock at year-end for $30,000.
6.      Caroline made cash contributions of $9,000 during the year to the church she attends.
7.      Caroline paid state and local general sales taxes of $3,000 on the purchase of various items for personal use or consumption.  She also paid real property taxes of $5,200 on her home.  She also paid $14,000 in estimated state income taxes and $40,000 in estimated federal income taxes with respect to her business.
 
Analysis
 
·         Cash method – reports income when she receives it and takes deductions when she pays expenses
·         Cf. Accrual Method – focuses on when you have earned the income, and when your liability to pay an expense is fixed.
·         Calendar year basis – specific code provisions provides for this.
·         Individual tax payers typically report on a calendar year basis
·         Business often report on a fiscal year basis (starting on a month other than January)
 
Ø  Gross Income – (Step 1)
o   § 61 defines gross income
§  “Except as otherwise provided in this subtitle” (for purposes of our study the entire course is concerned with ‘this subtitle’ which is personal income tax).
§  Gross income is a very expansive category.
ü  $10,000 Landscape Services:
§  See Reg. § 1.61–(a) – gross income includes income realized in any form whether in money, property or services.
§  See Reg. § 1.61–2(d)(1) – if services are paid for in exchange for other services, the FMV of such other services taken in payment must be included in gross income.
§  Value is easily determinable as we can assume this is an arm's length transaction.  May be different if they are family members.
§  Also note that it is irrelevant that Caroline's mother received landscaping services b/c of the assignment of income doctrine.
ü  $30,000 Owed by Clients:
§  taxpayer does not have income until tax payer is paid under cash method.  Therefore, the 30k in services still owed does not count as part of income.
§  ‘doctrine of constructive receipt’ when cash method tax payer will still be taxed in year of constructive receipt (not suggested in this problem).
§  Under accrual method, this would be counted as income
ü  $19,000 Interest From Investment Account:
§  § 61(a)(7)–  interest income specifically listed (here 19k in interest was received)
ü  $30,000 Sale of ABC Stock:
§  § 61(a)(3) – gain received from selling property (stock)  $15,000.  $30,000 was the ‘amount realized’ and the $15,000 cost is the ‘adjusted basis’.  The $15,000 made is the ‘gain’
ü  $1,000 dividends from ABC Stock:
§  Gross income under § 61(a)(7).
 
 
Ø  TOTAL GROSS INCOME:               $ 275,000  
                                                            $   10,000
                                                            $   19,000
                                                            $   15,000
                                                        +  $     1,000                   
$ 320,000
 
Ø  Adjusted Gross Income – (Step 2)
o   Above-the-Line Deductions
o   § 62 – says that AGI means GI minus the deductions listed in this section.
o   The deductions listed in this section are above-the-line deductions.
§  “Adjusted Gross Income” means “Gross Income” minus “above-the-line” deductions.
§  § 62(a)(1) – lists Trade & Business deductions as above the line deductions.
§  No other deductions in the Caroline problem are on the list.
o   (1) $60,000 Employee Salary Expenses
§  can be deducted under authority of §162
o   (2) $20,000 Other Business Expenses
§  other business expenses can also be deducted under §162
o   (3) $500,000 New Building:  depreciable capital asset under §§ 263 & 168
§  Building can also be deducted but it is different than wages and supplies.  As it will benefit Caroline over 30 years.  So we cannot deduct all $500,000 this year
·         It is a CAPITAL EXPENDITURE that we deduct according to the rate of depreciation.
·         Just assume for this year that it is $10,000.
o   All three of these are business expenses and thus above-the-line deductions.
o   So, only $90,000 is deductible from Gross Income to produce an AGI of $230,000.
o   AGI ® $320,000 minus $90,000 = $230,000
o   Above the line deductions are sometimes described as business deductions (in a rough sense).
 
 
Ø  Deductions, Below-the-Line – (Step 3)
 
o   Definition: below-the-line
§  Phrases come from the 1040 return form
§  The distinction has to do with the availability of the standard deduction.  You compare itemized below the line deductions with the standard deduction and you take the better of the two.
§  You apply whichever one you pick to AGI to arrive at Taxable Income.
 
 
ü  (1) $5,000 Commuting Expenses
§  Code § 262(a) – no deduction shall be allowed for personal, living, or family expenses.
§  Code § 162 – allows deductions for expenses incurred in carrying on a trade or business including travel expenses while away from home.
§  So, what are commuting expenses considered to be?
§  See Reg. § 1.162-2(e) – “Commuters' fares are not considered as business expenses and are not deductible”
§  See Reg. § 1.262-1(b)(5) – “the taxpayer's costs of commuting to his place of business or employment are personal expenses and do not qualify as deductible expenses.”
ü  (2) $1,000 Bank Investment Fee
§  Not deductible as a business expense under § 162.
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