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Federal Income Tax
University of Iowa School of Law
Ward, Larry D.

Chapter 1: Introduction

I. The constitution and the income tax
a. Art. I s.8 allows congress to “lay and collect Taxes, Duties, Imposts and Excises.”
i. Limited in three ways:
1. Direct taxes through states
2. Bills for raising revenues from House of Reps.
3. Taxes must be uniform throughout the US.
b. 16th Amendment
i. allowed Congress to tax incomes (so the direct question is moot).
c. Apportionment of Direct taxes
i. Art I, §2
1. Representatives and direct Taxes shall be apportioned among the several States…according to their respective Numbers…
2. Art I, §9
3. No Capitation, or other direct, Tax shall be laid, unless in Proportion to the Census or Enumeration herein before directed to be taken.
I. Income-tax legislation and regulations
a. Regulations are either legislative or interpretive, legislative ones being issued under a specific statutory grant.
i. Regulations are the law as long as they uphold the congressional mandate.
b. Also are temporary regulations
III. The Internal Revenue Service
a. Provides revenue rulings to provide additional guidance
IV. Tax controversies
a. Service may asses a tax within 3 years of a due date or actual filing date. Whichever is later. If false though no time limit. S.6501
V. Taxpayers and Tax Rates
a. Progressive Rate System
i. Tax on a high income is a larger percentage of the income than the tax on a low income.
ii. Arguments “For” Progressive taxation
1. Diminishing marginal utility of money
a. Additional money for high-income earners is worth less b/c they can give up luxuries easier than a poor person can give up necessities which all their money goes towards
b. Economists say this is not a valid argument b/c you can’t make interpersonal utility comparisons
1. Ability to Pay
a. Those that are more able to pay should bear more of the tax burden.
1. Fairness
a. Some say the market outcomes are unfair & progressive taxes correct this unfairness

i. Arguments “Against” progressive taxation
1. Wealth is a reward for those who’ve earned it and this class shouldn’t be punished via a heavier tax rate
2. Why tax a productive person but not a non-productive person?
3. Social Darwinism—why punish those who’ve “won” in the market?
4. Hurts Incentive to work
a. Leisure becomes more valuable than earning income
b. Proportional:
i. (Whereas a proportional system takes the same tax rate from all income levels).
c. Regressive tax systems take a larger percentage from lower incomes and lower taxes from higher incomes.

Income

Tax on purchases

Tax / Income

A

$10,000

500

5%

B

$100,000

2500

2.5%

i. Sales tax is regressive b/c:
1. Applied equally across the board
2. But higher incomes don’t spend all their money on consumption so a tax is less of a percentage of their total income
d. Does not mean though that high income people will pay less tax then poorer people, they just aren’t paying it at as high a rate (depending of course on the regression system).
e. Tax code in s.1 lays out marginal rates
i. Creates brackets incomes above certain levels and the tax then applies only to the amount above that amount.
1. Ie; 50% applies only to the amount above 50,000.
f. Tax liability = amount due in taxes
g. Marginal tax rate = % of taxes due in the given tax bracket.
h. Average tax rate = taxes paid/taxable income
i. Horizontal equity – if people are in the same circumstances they should be taxed equally.
i. But its not always clear when people are equally situation economically.
ii. Difference may be superficial.
j. Vertical equity – taxing those similarly who are situated differently, rejected in the US, those who are better off pay more.
k. Intergenerational equity – are we being fair to people who are in different stages of their life?
l. Incidence of a Tax
i. Legal incidence: Who physically pays the tax
ii. Economic incidence: who bears the burden of the tax
iii. Example: Social Security taxes directed at an employer are often shifted to the employee (ie. The employee offers to work for less money so the employer will make the hire eventhough the tax on employment exists) The legal incidence is on the employer, the economic incidence is on the employee.
iv. Luxury item tax? – They taxed luxury boats and people stopped buying them and the people who built the boats lost their jobs. So the legal incidents were a good idea, but the economic incidents were completely different.
v. Excess taxes – such as a tax on alcohol tax, not based on the selling price of the product, but based on the amount of alcohol in the product. Designed to raise the price of the product more then just the MPC – increase the cost of something to equal the MSC (marginal social cost) instead of just the marginal production cost, to correct the efficiency in the competitive m

e case, and within the taxpayers control.
b. Gross Income from Sales
1. Tax system usually doesn’t tax appreciation (or allow deduction for losses) until the TP disposes of the property/realizes the loss or gain.
a) Reason: administrative feasibility
2. §61(a)(3)—provides that “gains derived from dealings in property” are included in gross income.
3. §1001—Computation of gain or loss
a) Defines how to find the amount realized (AR)
4. §1011 & § 1012
a) Explains how to calculate basis of property
b) Basis generally reflects your previously taxed income/investment in the property and thus it is not taxed again
c. Compensation for Services
i. In General
1. Old Colony
a. The company paid income to an employee to compensate him for the amount he paid in taxes, was this income to the employee?
i. The court held that is was income. It is compensation for services
ii. Income and Basis when Property is Received for Services
1. If A received a car for 30 and then sells it for 30 does she recognize a gain? No, we read 1012 to say that there is a tax cost basis of 30 since there was work put in and it was income. This means that A receives the car at a cost of 30 and then recognizes no gain on the sale of the car.
2. So we make the value of the car equivalent to cash and look as if A had invested the cash in the car making the cost of that investment the basis.
3. Note: A’s investment does not come from his labor
iii. Transfers of Property as Compensation for Services: Section 83
1. §83—Property transferred in connection with performance of services
a. The income is includable in the 1st year the property is transferable by TP or not subject to a substantial risk of forfeiture
b. §83(a)—taxed on the excess of fair market value (at the first time it is transferrable or not at risk of forfeiture) less the amount paid for the property
c. §83(h)—employer gets the deduction in the same year the employee includes it as income.
1. Example: E takes stock for $10 and after 6 years gets it fully from employer when its worth $35 she takes $25 in income and her $10 basis becomes $35 is she sells it. Employer deducts $25 as a biz exspense