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Federal Income Tax
University of Illinois School of Law
Colombo, John D.

I. Defining Income
FUNDAMENTAL TAX EQUATION: Tax Base X Rate = Revenue
§61- GROSS INCOME DEFINED:
General definition. – Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items:
(1) Compensation for services, including fees, commissions, fringe benefits, and similar items;
(2) Gross income derived from business;
(3) Gains derived from dealings in property;
(4) Interest;
(5) Rents;
(6) Royalties;
(7) Dividends;
(8) Alimony;
(9) Annuities;
(10) Income from life insurance and endowment contracts;
(11) Pensions;
(12) Income from discharge of indebtedness;
(13) Distributive share of partnership gross income;
(14) Income in respect of a decedent; and
(15) Income from an interest in an estate or trust
 
Glenshaw Glass Test for Income:
Accession to wealth
New wealth that the taxing system has not seen
                                                              i.      Payment for services is an accession to wealth
                                                            ii.      Illegally obtained income is taxable
                                                          iii.      A loan is NOT income, because there is an obligation to pay
                                                          iv.      Discharge of indebtedness is an accession to wealth
Clearly realized
Realization: refers to the fact that sometimes it is not appropriate to exercise taxing authority even though there has been an accession to wealth
                                                               i.      An administrative decision to wait for an appropriate event to use taxing powers
                                                             ii.      Keyed to Two things:
1.      Is there an event upon which we should tax?
2.      Is this event appropriate?
Over which the taxpayer has control
Person has the ability to direct where a payment goes, does NOT require physical control
 
HYPO: Suppose student has $50 worth in parking tickets, Colombo offers to pay tickets in exchange for work. à An accession to wealth, control at time of agreement
 
Old Colony Trust Co. v. Commissioner p. 54
HELD: The payment of CEOs taxes by the company was an accession to wealth, clearly realized, over which he had control – paying taxes was consideration for services rendered
 
Barter Transactions:
–         Both people in the exchange gain taxable income
o       Accession to wealth
o       Realization at the time of barter
o       Each person receives the economic benefit of the services
 
Imputed Income:
–         Income generated by services done for yourself –imputed income is not taxed
 
BASIS: System for determining what money has already been taxed – running total of how much you have already paid tax on
 
BASIS = AFTER TAX INVESTMENT
 
Philadelphia Park p. 118: 
Held: If a taxpayer engages in a taxable barter in property, then the initial basis will always be equal to the acquired property’s fair market value
General Holding: In an arms-length exchange we always assume that property exchanged for other property is of equal value
 
–         §61(a)(3) – gains derived from dealings in property = gross income
–         §1001 – (fundamental equation of property transactions)
o       GAIN = AMOUNT REALIZED – ADJUSTED BASIS
 
o       §1001(b) Amount Realized = amount of money you get + fair market value of property
 
ANALYSIS FOR ADJUSTED BASIS:
–         §1011 – Adjusted basis for determining gain or loss
o       §1012 – Basis of Property: Basis of property is after tax investment – “how much money has the taxpayer invested in this property that she has already paid taxes on and is therefore entitled to get back without further tax?”
§         PLUS or MINUS any adjustments under;
o       §1016 – Adjustments to basis
§         General Adjustment Rule: If you put money into your basis it increases, if you withdraw money it decreases
§         Two Most Common Adjustments:
·        Basis goes up when you add investment to a property
·        Basis goes down with respect to depreciation
 
§         HYPO: Hillary buys an office building for $1million cash, she then spends $200,000 to refurbish the building, what is her initial basis, what is her adjusted basis?
·        Initial Basis: Hillary’s initial basis is $1million – her after tax investment
·        Adjusted Basis: Hillary’s adjusted basis is $1.2 million
 
§         HYPO: Hillary buys an office building for $1million, spends $200,000 to refurbish it, then a hurricane hits the building. The insurance company gives Hillary $300,000 to fix the roof which blew off in the hurricane, what happens to the basis?
·        Adjusted basis pre-hurricane: $1.2 million – the basis cannot equal more than this unless she affirmative puts more in
·        If Hillary uses the $300,000 to fix the roof her basis:
o       FIRST, drops to $900,000 (the $300,000 was gone with the roof)
o       THEN, after she fixes the roof, her basis is once again $1.2 million
·        If Hillary pockets the $300,000:
o       Her basis remains $900,000
 
–         DEPRECIATION: Deductions over the course of many years which compensate for the declining value of a piece of property – the deduction is subtracted from the initial cost basis each year
 
DEDUCTION: A way to give money tax free – yay!
 
OTHER BASIS:
 
Property Acquired by Gift:
 
§1015. Basis of property acquired by gifts and transfers in trust
 
1015(a) Gifts after December 31, 1920
–         Basis shall be the same as it would be in the hands of the donor, or the last preceding owner by whom it was not acquired by gift
–         If basis (adjusted for the period before the gift as provided in §1016) is greater than the fair market value of the property at the time of the gift, then when determining a loss the basis shall be the FMV
–         If the basis is unknown attempt to use facts to determine the donor’s basis, if you can’t go with the FMV at the time the donor acquired the property
 
1015(d)(1)(A) Increased basis for gift tax paid. – In general. –
–         For property acquired after September 22, 1958, the basis shall be determined under subsection (a), increased (but not above the FMV of the property at the time of the gift) by the amount of gift tax paid with respect to such gift
1015(d)(4) Treatment as adjustment to basis
–         For purposes of §1016(b), an increase in basis under paragraph 1 is treated as an adjustment under § 1016(a)
 
Transfers of Property between Spouses:
 
§1041. Transfers of property between spouses or incident to divorce.
(a)   General Rule. – No gain or loss shall be recognized on a transfer of property from an individual to
(1) a spouse, or
(2)    a former spouse, but only if the transfer is incident to divorce
(b)   Transfer treated as gift; transferee has transferor’s basis. – In the case of any transfer of property described in subsection (a) –
(1) for purposes of this subtitle, the property shall be treated as acquired by the transferee by gift; and
(2) the basis of the transferee in the property shall be the adjusted basis of the transferor
(c)    Incident to divorce. – For purposes of subsection (a)(2), a transfer of property is incident to the divorce if such transfer –
(1) occurs within 1 year after the date on which the marriage ceases, or
(2) is related to the cessation of the marriage
 
General Rules for Transfer of Property between Spouses/Incident to Divorce:
–         §1041 is an absolute rule
–         Spouses are treated as a single economic unit, so transfers between spouses are not taxed
–         Basis is transferred from transferor to transferee intact in all cases regardless of built-in gains or losses – this is different from gifts where basis is adjusted
–         System ignores the transfer of property between spouses and keeps the basis the same, so when the property is transferred outside of the marital unit the tax consequences are the same regardless of which spouse owns the property
–         Even barter transactions between spouses are not taxable
 
Property Acquired from a Decedent:
 
§1014. Basis of property acquired from a decedent (a.k.a. “stepped-up basis rule”)
(a)   In general. – Except as otherwise provided in this section, the basis of property in the hands of a person acquiring the property from a decedent or to whom the property passed from a decedent shall, if not sold, exchanged or otherwise disposed of before the decedent’s death by such person, be –
(1)     the fair market value of the property at the date of the decedent’s death, or…
 
(b)   Property acquired from the decedent. – For purposes of subsection (a), the following property shall be considered to have been acquired from or to have passed from the decedent:
(1)     Property acquired by bequest, devise, or inheritance, or by the decedent’s estate from the decedent
 
General Rules for Property Acquired from a Decedent:
–         If the decedent waits to transfer property until death, the property’s basis will shift up or down to the FMV at time of death
–         The “stepped-up basis” rule makes good administrative sense – do you know the basis of all of your grandma’s possessions?
–         Intended to protect the family farm
 
THE AMOUNT REALIZED:
 
§1001(b) Amount Realized. – the amount realized from the sale or other disposition of property shall be the sum of any money received plus the fair market value of the property (other than money) received. In determining the amount realized –
(1)   there shall not be taken into account any amount received as reimbursement for real property taxes which are treated under §164(d) as imposed on the purchaser, and
(2)   there shall be taken into account amounts representing real property taxed which are treated under §164(d) as imposed on the taxpayer if such taxes are to be paid by the purchaser
 
–         §1001(b) CANNOT BE READ LITERALLY – READ IT TO MEAN AMOUNT OF ECONOMIC VALUE
 
International Freighting Corporation, Inc. v. Commissioner p. 134
HELD: When we read §1001(b) we cannot read it literally, we have to substitute “economic value received” because the system cannot work any other way – whatever economic gain you get in exchange for property has to be counted
 
Crane v. Commissioner p. 137
–         Recourse debt: borrower is personally liable for the debt, bank can get a judgment and take whatever they want
–         Non-recourse debt: the borrower is not personally liable, the lender’s only recourse is to take the property subject to the indebtedness, if the lender cannot sell the property for the balance of the debt, the lender cannot go after the borrower in another way
–         Two Potential System for Treating Non-Recourse Debt:
o       Include loan money in basis of buyer, and then in amount realized when property is sold – allow depreciation deductions
o       Do not include loan money in basis of buyer, do not include money in amount realized – do not allow depreciation deductions
–         HELD: Court determines that non-recourse debt should be included in basis and amount realized, and depreciation deductions will be taken – creates a tax shelter which existed until 1986
 
 
 
Commissioner v. Tufts, p. 145
–         Answers technical question left open after Crane: what happens when the FMV of the property upon sale is less than the non-recourse debt outstanding?
o       Entire amount of debt must be included in amount realized; has nothing to do with economic value only with the tax system making sense
o       If the FMV of property is SO much less than debt that no one would buy it except to speculate then the system will give the buyer a basis of $0 (thus making it an option)
 
General Rule: Non-recourse debts and recourse debts are treated identically – both are included in the basis and the amount realized
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
II. Exclusions from Income
 
GIFTS:
 
§102. Gifts and inheritances
(a)   General rule. – Gross income does not include the value of property acquired by gift, bequest, devise, or inheritance
(b)   Income. – Subsection(a) shall not exclude from gross income-
(1) the income from any property referred to in subsection (a); or
(2) where the gift, bequest, devise or inheritance is of income from property, the amount of such income.
 
            General Rule: Gross income does not include the value of property acquired by gift
            Why not include gifts in gross income?
o       A little bit of the “one economic unit” thing going on here
o       Gifts are not always money, and it is administratively difficult to determine their value for tax purposes
o       Notion that the IRS is intruding on a personal relationship when taxing gifts; most people would find taxing gifts offensive
o       Notion that when someone gets something involuntarily, it is inappropriate to tax
 
Commissioner v. Duberstein, p.71
HELD: Whether something is a gift is based on a factual inquiry done on a case-by-case basis
TEST: To the extent that there is a test for what is a gift it is whether the gift is “detached and disinterested” – if there is a quid-pro-quo it is NOT a gift, if there is NOT a quid-pro-quo and is detached and disinterested it IS a gift
 
What is a “bequest, devise or inheritance’?
–         Not soley a federal question
o       Federal law determines whether status comes within code
o       State law determined the question of status, whether or not you are an heir
 
REMEMBER: Substance over form – what is really going on matters, the economic substance of the thing, not its form is of most concern – when determining if something is really a gift follow the money and ask:
–         Where did the money come from?
–         Where is it going?
–         Why?
o       If the person is being nice (even self-interestedly) then it is probably a gift
o       If the money is in exchange for something, it is NOT a gift
 
FRINGE BENEFITS:
 
§132. Certain fringe benefits
(a)   Exclusion from gross income. – Gross income shall not include any fringe benefit which qualifies as a –
(1) no additional cost service, – NON-DISCRIMINATION RULE APPLIES
(2) qualified employee discount, – NON-DISCRIMINATION RULE APPLIES
(3) working condition fringe,
(4) de minimus fringe,
(5) qualified transportation fringe,
(6) qualified moving expense reimbursement.
 
(b)   No additional cost service defined. – For purposes of this section, the term “no additional-cost service” means any service provided by an employer to an employee for use by such employee if –
(1) such service is offered for sale to customers in the ordinary course of the line of business of the employer in which the employee is performing services, and
(2) the employer incurs no substantial additional cost (including forgone revenue) in providing such service to the employee (determined without regard to any amount paid by the employee for such service)
 
(c)    Qualified employee discount defined. – For purposes of this section-
(1) Qualified employee discount. – The term “qualified employee discount” means any employee discount with respect to qualified property or services to the extent such discount does not exceed-
      (A) in the case of property, the gross profit percentage of the price at which the property is being offered by the employer to customers, or
      (B) in the case of services 20 percent of the price at which the services are being offered by the employer to customers  
 
(j) Special Rules
      (1) Exclusions under subsection (a)(1) and (2) apply to officers, etc., only if no discrimination. –Paragraphs (1) and (2) of subsection (a) shall apply with respect to any fringe benefit described therein provided with respect to any highly compensated employee only if such fringe benefit is available on substantially the same terms to each member of a group of employees which is defined under a reasonable classification set up by the employer which does not discriminate in favor of highly compensated employees.
 
Rule § 132(b) Outline:
–         must be a service
–         provided by employer to employee
–         must be offered for sale in the ordinary course of business
–         in the line of business of the employer in which the employee works
–         must incur no substantial additional cost to the employer, including foregone revenue
–         NON-DISCRIMINATION RULE APPLIES!
 
Rule §132(c) Outline:
–         must be a discount
–         qualified property or services:
o       that is offered to customers by the employer in the ordinary course of business
o       the employee works in that line of business
–         amount that will be excluded is limited to 20% of the normal price in the case of services
–         amount that will be excluded is limited to the “gross profit percentage” of the property in the case of property discounts
o       gross profit percentage = Aggregate Sales – Aggregate Cost/ Aggregate Sales
o       based on the income report for previous year
–         NON-DISCRIMINATION RULE APPLIES
 
Rule §132(j)(1) Outline:
–         Is it a no-additional cost service, OR a qualified employee discount?
–         Is the person highly compensated?
–         If so, is the fringe non-discriminatory?
 
General Rules from the Regs. to Remember:
–         If it violates the non-discriminatory rule, none of it is excluded from gross income
–         Conglomerates are not given special advantage – if the fringe applies to a conglomerate the employee must actually work in the line from which the fringe derives – BUT an employee performing substantial services for many lines within a conglomerate, then they can take discounts etc., for all of those lines – discrimination rule
–         Insurances policies are a type of service, and are excludeable
–         A rebate is treated the same as being discounted up-front
–         Occasional cocktail parties are excludeable – probably 1 hour long weekly happy hours would be also
–         Use of on-premises athletic facilities excluded
 
MEALS AND LODGING:
 
§119. Meals or lodging furnished for the convenience of the employer
(a)   Meals and lodging furn

ck (and will fix car); reprocesses paperwork – now only own $15,000, is that discharge of indebtedness?
–         No – simply renegotiated the purchase price of the car, NOT discharge of indebtedness
o       Equivalent of dealer giving X $5,000 and then X giving that money to creditor to reduce debt to $15,000
§         If economic value is coming from person who sold X the property, then renegotiation
§         If economic value is coming from the creditor, then discharge of indebtedness
HYPO: You have $100,000 and decide to build office complex – so borrow $1.9 million via non-recourse loan in order to build $2 million office complex. You later find out that the office building was built over nuclear waste dump – reducing the value of the building to zero. You tells bank about it, give them the deed to the property and leave. Is this discharge of indebtedness income?
o       Were not obligated to pay off the debt in the first place
o       Have basis of $2 million
§         Upon disposition of this property (by giving it to the bank in exchange for leaving the loan) under §1001
·        measured by amt realized minus adjusted basis
·        here didn’t get anything – but disposed of property and the debt went with it (same concept as in Tufts)
o       what if there had been $300,000 in depreciation taken, lowering basis to $1.7 million
§         Amount Realized = $1.9
§         Adjusted Basis = $1.7
§         $200,000 gain – not discharge of indebtedness, it’s a property disposition gain
·        cannot be discharge of indebtedness because as the borrower under a nonrecourse loan he was never personally liable to pay the amt of the loan
HYPO: Assume same facts except that the debt is a plain old recourse debt – X is personally liable for the debt, does the analysis change? 
–         YES
–         Bank chooses to not sue X to recover the amount of the loan
–         The difference here is that the bank has the option of going after X
o       Here the bank chose to FORGIVE the amount of the deficiency
§         This is a discharge of indebtedness
§         Have every right to sue X personally but chose not to
–         Two things happen here
o       Sold property back to the bank and the amt X realized on that sale was zero – that’s what the property was worth
§         Results in a $1.7 million loss
o       Bank could have sued X for deficiency ($1.9 million) – chose not to do that (unrealistic)
§         This is an example of discharge of indebtedness
·        $1.9 million income
·        $1.7 million offsetting debt
·        X put $300,000 depreciation in his pocket tax free, and had put $100,000 into the project initially
o       The $200,000 left to X in the end is the PERFECT CORRECT answer because he will have to pay tax on the $200,000 which represents the remaining money he pocketed tax free via depreciation
 
If you were insolvent before and after discharge of indebtedness – then there is no income
–         Obviously no accession to wealth – would be torture to tax on the limited benefit the taxpayer got via being hoisted up from the dregs of debt
 
If you were solvent and a creditor forgave some portion of a debt – that amount is considered income
–         need to make sure that the transaction was a discharge of indebtedness transaction
o       cannot be renegotiation (car)
o       cannot be nonrecourse loan
 
DAMAGES/INSURANCE:
 
Essential question is “what is it that the damages replace?”
–         Lost income, profits
o       then the damages will be income, just as if they had been received as income
o       Recoveries which represent reimbursement for lost profits are income
–         Injury to property – more complicated
o       When damages are awarded, they are viewed as a return of basis
§         Basis in property decreases as a proper adjustment under §1016(a)(1)
§         If damages exceed basis then the excess becomes gain from the sale or exchange of that property
§         If the damage payment is reinvested in the property (i.e. repairs) then the basis will go back up
–         With certain exceptions, returns on capital are not taxable
o       Damages for injury to goodwill is a return on capital and is not taxable
 
Raytheon Productions Corp. v. Commissioner p. 183
HELD: There was nothing to indicate that the suit was for recovery of lost profits – the object of the suit was to recover damages for the destruction of the business and loss of goodwill. 
–         THEREFORE, the damages recovered represented a return of capital
–         HOWEVER, that doesn’t automatically exclude it from gross income
o       The injured party (Raytheon) may not be deriving a profit as a result of the damage suit itself, but the conversion of the property into cash as a result of the suit is a realization of a gain
–         Compensation awarded for loss of Rayhteon’s goodwill in excess of its cost is gross income
 
If you have a business you can then sell the business and related goodwill
–         Goodwill: the ongoing value of the business, in excess of what the assets themselves are worth
 
HYPO: If a company is forced out of business, via anti-competitive behavior, do damage payments represent lost profits, or should damage payments be considered forced sale of company?
–         This is the same as Raytheon, when a business is destroyed via anti-competitive behavior it is viewed as a FORCED SALE
o       Thus, damages are receipts from sale of goodwill of company
 
Damages and Other Recoveries for Personal Injury:
 
HYPO: Lawyer works for Sidley and is injured on the job and can’t work as a result. Lawyer sues the person who injured him for $5million. The damages are partially pain and suffering, and partially reimbursement for medical expenses, part is also for lost wages.
 
§104(a)(2) – addresses personal injuries – excludes from income ANY DAMAGES from gross income, IF
–         you get damages on account of a physical injury
o       emotional distress damages are not included unless there are actual physical symptoms springing from the emotional distress
–         punitive damages are not excluded
–         excludes damages for making the body whole and for replacing lost wages
–         it is ok if damage money is received over time   – rule says “any damage”
–         wrongful death damages are excluded
 
Medical Insurance:
 
General Rules (Gilbert’s):
–         Employee Pays Premiums:
o       Benefits received under a medical or disability insurance policy purchased by the taxpayer are excluded from income, whether or not the taxpayer deducted the premiums paid to purchase the insurance §104(a)(3)
§         EXCEPTION – no double exclusion: If medical expenses were deducted, the insurance reimbursements for these expenses must be included in income
–         Employer Carried Plans:
o       If the employer pays for the insurance for its employees, the employees are not taxed on the premiums or on benefits received. 
o       If the employer directly pays for medical expenses of employees (or family of employees), the employees are not taxed on these payments (except to the extent that they have been deducted by the employee) §105(d)
o       Medical reimbursement plans are not to discriminate in favor of “highly compensated” employees or the amounts received will