Basic Federal Income Tax Outline
Gross income is from any source.
General rule is that a realized gain is included and recognizes in income. §1001(c)
After computing gross income, next step is computing adjusted gross income, or gross income less certain costs of earning income
Next step is computing taxable income under §63, which is AGI less the sum of (i) the taxpayer’s personal exemptions plus (ii) the greater of (a) the taxpayer’s standard deduction or (b) the taxpayer’s itemized deductions.
After computing taxable income, you must compute the amount of tax due on the taxpayer’s taxable income. Taxed at rated specified in §1(a)-(d)
o Rates are progressive, meaning that as the taxpayer’s income increases, the rate of tax increases by a marginal rate.
o Lower rates are paid on capital gain than on short-term capital gain
After applying appropriate tax rates, the next step is to reduce the tax by the credits for which the taxpayer is eligible. Credits are direct reduction in tax, while deductions or exclusions reduce the taxpayer’s taxable income.
Tax deferral is advantageous to a taxpayer because they can invest the deferred tax and earn income on it until it is paid to the government. We use present value calculations to determine what amount we should set aside.
Some people want a consumption tax which would involve taxing on gross income but allow a deduction for income that is invested. The net income left will be the amount spent for personal consumption.
o Issues with this.
Others like the VAT (value added tax) which involves a levy on the value added to goods and services by those who manufacture, distribute, and sell those goods or services. Basically a form of sales tax instead of income tax.
o Believed that VAT or consumption tax would increase savings, because you are only taxed on goods. This is debated.
o Another issue is those with high incomes would benefit the most from exemption of savings.
o Regressive tax.
a. Section 61 à gross income includes “all income from whatever source derived.”
b. Thus, source is ALWAYS irrelevant.
i. Windfalls received as exemplary damages for fraud as part of antitrust recovery are taxable. Glenshaw Glass.
ii. Treasure trove is taxable to the extent of its value in the year in which it is reduced to undisputed possession. Cesarini v. United States.
c. Haig-Simons Definition à Sum of (1) the taxpayer’s personal expenditures plus (or minus) (2) the increase (or decrease) in the taxpayer’s wealth.
i. With this system, taxpayer would be taxed on appreciation in year it occurred rather than in year property was sold. Taxed on your annual increase in wealth.
ii. Doesn’t work due to serious liquidity and valuation problems.
d. Does not have to be cash to be taxable: Law partnership that could collect service fees decided to be reimbursed through services provided by their client’s businesses. Only deducted from the clients’ tabs the amount they ‘felt’ the services were worth.
i. Court held FMV was the amount to be charged off, which equaled the prices charged by the clients to their retail customers. Firm couldn’t discount services by the amount they felt they were overcharged compared with price elsewhere. Rooney v. Commissioner.
II. Statutory Exclusions to Gross Income
a. Gifts and Bequests:
i. Donee excludes gifts from income under §102.
1. Gifts are generally included in the donor’s tax base (nondeductible) and excluded from the donee’s base.
2. Rationale: Most gifts are made to family members.
ii. §1015 – donee steps into the donor’s basis shoes.
1. If the property has appreciated so that FMV > the donor’s basis, the donee takes the donor’s basis. If the property has depreciated so that FMV < the donor’s basis, for determining gain on subsequent disposition, donee takes the donor’s basis, but for determining loss, the donee takes a basis equal to FMV at the time of transfer à Examples: page 11 of Tax Notes. 2. Property acquired as a result of bequest upon death gives the donee a basis of the FMV of the property at the date of death. Appreciation during the decedent’s lifetime is never taxed. iii. Part-Gift-Part-Sale Transactions 1. Adjusted Basis for Determining Gain = basis(Amount Realized/FMV property) 2. Gain realized = Sale price – Adjusted Basis 3. Page 11-12 of Tax Notes iv. Duberstein test: A gift proceeds from a “detached and disinterested generosity” of the donor. Look to the donor’s intent and reason for giving the gift. 1. Exceptions: a. §102(c) – transfer from employer to employee cannot be a gift. i. Unless another exclusion applies, such as §132 de minimis fringe, the detached and disinterested generosity is taxable compensation to the employee. b. Goodwin – pastor receiving “special occasion gifts” from members of the congregation three times a year deemed to be receiving compensation for services rather than gifts. b. Damages on Account of Personal Physical Injuries: i. §104(a)(2) excludes damages on account of personal physical injuries or physical sickness (excluding punitive damages) 1. Applies to medical expenses, lost wages, and pain and suffering. ii. Amos v. Commissioner: Dennis Rodman kicked cameraman and parties settled. Part of the settlement amount was held to be taxable because it was paid not for physical damage, but for the purposes of keeping the cameraman quiet. c. Life Insurance: i. Insured who lives out the term of their policy is not allowed to deduct its cost, but §101 does provide that a beneficiary receives the insurance proceeds tax-free. ii. Rationale: We want to encourage people to take care of their dependents, minimizes risk, and helps the middle class develop estates. III. Non-Statutory Exclusions for Non-Cash Economic Benefits: a. Imputed Income: i. Non-cash benefits you create for yourself aren’t taxable. If you paint your own home instead of hiring someone else to do it, you are not taxed for the value of your own services. ii. Not taxed for the fair rental value of your home because you choose to live in it. iii. However, if there is an exchange of services, or a barter of services for cash, that should go into your gross income. If you paint your neighbor’s home and he pays you in return, that should be included. b. Unrealized Appreciation: i. No tax for appreciation of your property or stock until it is actually sold. ii. We only tax the gains you realize: amount realized – basis. IV. Annual Accounting: a. §441, for individuals: taxable year = calendar year. For corporations,
e value of the property at time of vesting less the amount (if any) that the employee paid for the property.
2. Taxed as ordinary income.
ii. Even if nonvested, taxpayer can elect to pay tax on the value of the property, with anything made after taxed as capital gains (lesser rate than compensation).
b. Alves v. Commissioner: §83(a) applies ever where full market value is paid for the stock transferred from employer to employee.
i. Still considered as obtained in connection with performance of services because only available to select employees, such as officers, directors, CEOS, partially to ensure personnel would remain with the company.
VIII. §132 Fringe Benefits
a. No-additional-cost service à service must not impose a substantial additional cost on the employer: service must be offered for sale in the ordinary course of the line of business of the employer in which the employee is performing services.
i. Subject to nondiscrimination provision of §132(j)(1)
b. Employee discount à employee purchasing goods can exclude a discount up to the employer’s gross profit percentage; employee purchasing services can exclude up to 20 percent discount.
i. Subject to nondiscrimination provision of §132(j)(1)
c. Working condition fringe benefit à item that could be deducted as a business expense if paid directly by the employee; ie: costs of subscription to a professional journal.
d. De minimis fringe benefit à any property or service the value of which is so small as to make accounting for it unreasonable or administratively impracticable, ie: occasional theater or sporting event tickets, donuts, coffee, soft drinks.
i. Eating facility operated by employers for employees de minimis fringe if on or near the business premises and revenuew generally equals or exceeds the employer’s costs of operation. §132(e)(7)
e. Qualified transportation fringe benefits à qualified parking, bus passes, transportation in commuter vehicle, bicycle commuting. Exclusion is capped.
f. Qualified moving expense reimbursement à Any amount received by an individual from an employer as a payments for or reimbursement of expenses which would be deductible as moving expenses under Section 217 if directly paid or incurred by the individual.
g. Qualified retirement planning services à retirement planning advice or information provided to employee by employer with plan.
h. Special Rules:
i. Use of air transportation by a parent of an employee is treated as use by the employee.
ii. Use by spouse or a dependent child of the employee is treated as use by the employee.
iii. Reciprocal agreements between different employers providing services for the other company’s employees.