Taxation of Individual Income Outline

Logue-Taxation of Individual Income-Fall 2010

I. Introduction

A. General quesitons
1. Three basic questions:

What is the income?
Why tax the income?
What should taxpayer/tax lawyer do when law is uncertain?

2. Tax liability = tax base * tax rate
3. Reasonable basis or substantial authority are the criteria to immunize the tax payer from penalties; these are probabilistic terms: the tax lawyer must make an assessment on whether he could win on the merits

B. Income and other tax basis
1. Principles to examine tax basis: efficiency, administrability, distributive fairness
2. Possible tax bases:

Head = taxing everybody the same amount = lump sum tax

Ø Benefits:(1) does not distort behavior (e.g. surf and work are valued the same); (2) simplicity
Ø Problems: distributive unfair

Ability to pay: ok; narrow view: liquidity; broader view: material well being. Proxies for ability to pay: all 3 are objective bases = reduction of discretion and costs (→ imputed income disregarded)
Consumption = income – savings; All OR Some: ‘sin’ (e.g. tobacco, alcohol); but not enough

Ø Difference: it does not tax savings, return on investments; the problem may be fairness: people with great unused wealth are not taxed;
Ø Income v. consumption: No complexity argument: taxing consumptions is not more complicated than taxing income = income tax with a deduction for savings and a tax on consumption (e.g. IRA)

Wealth – focus on present; not used by Fed Gov (exceptions: gifts and estate tax); used by States and local governments (e.g. real estate, retail sales taxes)

Ø Benefits: (1) reflects ability to pay
Ø Problem: (1) need for an appraisal every tax period = administrative cost; (2) liquidity concern

Income = consume + saving (I = C + S). Strikes the balance b/w fairness and administrative ease

3. Definition of Income
1) Idealized income (economic definition by Haig-Simons): change in wealth b/w 2 points of time; see p. 9-10 (e.g. retirement subsidies (401k) not taxable b/c not counted as income); Sum of taxpayer’s consumption + change in net worth = broader definition (Haig-Simons);

One popular test – increase in net worth

Ø Haig-Simons definition: Income equals the amount of wealth accumulated plus the value of the personal consumption.

It is possible to have negative income (rare for individuals and more common for businesses)
Under the ideal income tax (Haig-Simons income tax), the income is a change of

Ø Wealth, like wages, interest, lottery and damages.
Ø Returns on investment: No requirement for sale; appreciation is enough
Ø Income generating property, like the commercial leasing building and machine
Spend $ 1 million to buy property
Year 1 $80,000/yr income
$20,000/yr appreciation
Year 2 we have a basis of $1020, 000
You will be taxed on the income (cash) and appreciation. Appreciation increases the tax basis: Basis for yr1 is $1 million and Yr2 is $1.02 million
2) Under the IRC, US income tax is realization-based tax.

Appreciation alone is not enough to tax the income. Only the appreciation realized is included in the tax base. There is a formula to compute the taxable income:

Ø Formula
Gross income: IRC 61 (whatever income source) less exclusions
Exclusion is the deduction of your tax base, see §62some itemized income not included in the gross income: gifts are not included in gross income

– Some deductions (Above the line deductions)

Adjusted gross income IRC 62:

– Some more deductions (below the line deduction)

Taxable income IRC 63:

Difference of this formula and the idealized income tax

Ø Gifts are taxable under the idealized tax but not under IRC
Ø Returns on investment is the big difference
Ø Under IRC, it is realization-based income tax.

Realization and recognition

Ø As a general rule, the income realized should be taxable and recognized.
Ø But there are some exceptions, for example, the payment from insurance company for the lost house in a fire is realized after the payment, but for the public policy, it is not recognized until the owner invests it to build a new house.

The goal of income tax law is to strike the balance of efficiency and fairness

4. Deductions, exemptions and credits
o Exclusions
Ø (e.g. interest on State and local bonds):
Ø never included in the tax base, excluded from GI (excluded from § 61)
o Deductions
Ø (e.g. charitable contributions): reduce GI
o Exceptions:
Ø particular kind of deduction; each person is entitled to a personal deduction for themselves; in theory the amount of deductions is supposed to achieve the minimum std of liming
Ø (2) and (3) are ways to reduce the tax basis
o Deferrals (e.g. employer payments on pension plans).
Ø Advantages of deferral: taxpayer can use the amount that would have been spent in taxes = advantage of compound interest
v Amount greater as the N of years of deferral increases
v Discounting present value = calculate the present value of future amounts
v Rule of 72: amount doubles in a N of years determined by dividing 72 by the interest rate
o Credits (e.g. child care credits): reduction in the tax liability
Ø Credit is of the same value to everyone;
v the deduction depends on the personal marginal rates (one with a higher marginal rate can save more)
Ø 100$ deduction reduces my tax base; if I have a 20% tax rate the deduction is reducing my taxes my $20; $100 credit would reduce my tax liability by $ 100.
Ø GI – deduction = taxable income x rate = tax liability

5. Grocery terms
o Marginal rates: the marginal tax rate is the rate that would apply to the last dollar earned for each of these taxpayers.
o Average/effective rates
o Progressive rates: how to define?
Ø You cannot say that the more you earn, the more tax
Ø You should say more accurately: the more you make, the average tax rate will increase with your income: Average tax rate = total tax/ tax base
o Proportional rates: flat tax
o Regressive

II Defining Gross Income

A. In-kind (Non-cash) Compensation
1. Introduction
1) IRC 61 (1)
o Gross income includes income realized in any form, whether in money, property or services. The fair market value of the property is counted.
Ø Eisner v. Macomber: income = gain derived from capital, labor or both
o According to § 61, when an item is unclear, it should be included in the gross income. The default rule is inclusion, except one item is excluded by certain provisions.
2) Whether we should tax the non-cash compensation
o Fairness: Not everybody can take use of such advantage; exacerbation on penalty on savin