Individual Income Tax Outline — Lyons —Fall 2010
Chapter 1 – Introduction to Federal Income taxation
A. Introduction and Background
1. Sources of Tax Law:
a. Internal Revenue Code (The Code): The code cannot be complete and self-contained. There isn’t a code for every section. We have statutes that require help and interpretation.
b. Treasury Regulations: Can be challenged, but are accorded great deference.
i. Two Types:
1. Interpretive: Opinion of the tax collector as to what Congress meant, tries to determine what Congress meant. Most common form of regulation; courts give enormous deference. They aren’t making law, they’re simply interpreting it. These are available for every taxpayer and practitioner, but they don’t bind us. They are the IRS’s opinion about what the law is, but they might be wrong. We can challenge them.
2. Law-Making: Congressional delegation of authority to make laws. These are unusual since admin landscape today may permit Treasury to make laws based on an idea put forth by Congress.
c. IRS Materials:
i. Revenue Rulings & Procedures: Memos, basically. Facts, law, analysis. Revenue Procedures may describe process on how to comply with a certain rule.
1. Not Precedent: Can’t be liable for violating revenue ruling, but they are helpful guidance.
ii. Private Letter Rulings: Directed to individual taxpayer.
1. Not precedent: But may be used as guidance for others. Available through FOIA.
d. Case Law/Forum Shopping:
i. Tax Court:
1. Article I court, unlike other courts; Judges appointed for 14 years; No right to trial by jury; Specialized court, helpful in complex cases; appealable to the circuit in which taxpayer lives; a national court.
2. There’s a strategy that looks ahead to an appeal in tax court. The appeal will be to the circuit court that covers the area where you live. So if you lose a tax court here in Lincoln, you go to the circuit here, 8th circuit. You might want to go to the tax court depending on what your circuit has said about a similar issue. The tax court will follow the circuit precedent.
3. Only court wherein you can challenge the ruling before you are required to pay. But if you lose, you’ll have to pay the tax plus interest, so you’re rolling the dice.
ii. District Court: An Article 3 court: Judges are there for life.For where the taxpayer lives.
1. Jury: Only court where taxpayer can have a trial by jury.
2. Requires that you pay the tax first, ask the IRS for a refund (which will be denied), and then sue for the refund.
3. Suing the government (U.S.) in this court, not the IRS.
iii. Court of Claims: Sits only in Washington DC and has original jurisdiction over tax claims.
1. Art I Court: Similar to tax court. Judges are appointed for 14-year terms.
2. Concurrent Jurisdiction: With tax court over tax cases.
3. Only file here if: If you have a sympathetic case, but not much law. Hope for the best.
4. Requires that you pay the tax first, ask the IRS for a refund (which will be denied), and then sue for the refund.
5. Suing the government (U.S.) in this court, not the IRS.
iv. Bankruptcy Court: Taxpayer can’t use this unless he is in bankruptcy.
1. Bankruptcy court has limited jurisdiction but is a quick way for taxpayers to settle claims.
2. Types of Income Tax
a. Regular Tax
b. Alternative Minimum Tax (AMT): Parallel tax system.
i. Two Calculations: perform two calculations of tax liability, and then pay the higher of the two.
ii. Takes Away: Deductions and exemptions available under the regular tax.
iii. Policy:
1. Originally: Was originally a tool to increase tax liability of very wealthy.
2. Today: Many people in the middle class end up paying AMT.
3. Revenue Measure: Significant source of revenue, so even fiscal conservatives won’t get rid of it, even though it no longer serves its original function.
3. Why A Tax on Income?
a. Early Economists: Thought property/excise taxes were insufficient.
b. Consumption-Based Tax: Some European countries have this.
i. Examples:
1. Value-Added Tax: tax added in each stage of manufacturing or distribution. In its simplest form, value-added tax is a sales tax.
2. Sales Tax: tax imposed upon consumption.
ii. Concerns:
1. Prices: will go up too rapidly.
2. Purchaser: ignores the financial condition of the purchaser.
3. The risk with a consumption tax is that some people are paying a heavier burden than people who have a lot of money. The argument against a consumption tax is that it is regressive, meaning that it falls more heavily on people with lower levels of economic income than people with more disposable income.
4. With a consumption tax, the consumer himself will get to decide how much tax to pay. If you decide not to consume, you decide not to pay taxes and you also save money. Our income tax discourages savings.
iii. Existing Consumption Taxes: We have some forms of consumption tax
1. Luxury Tax
2. Retirement Income: largest source of consumption-based tax in the U.S.
c. 16th Amendment: Ratified in 1913 and permitted a tax on income. At the time, it was considered to be the fairest way to generate revenue.
4. Four Big-Picture Questions:
a. What is income? (This is the most basic question. A related question is: What is a deduction?)
b. Timing: When is income reported? When must you report, when must you deduct? Which year gets the income? Which year gets the deduction?
i. Time value of money: delaying tax liability is important because taxpayer can invest it.
c. Whose income is it? Would a family be a better taxable unit rather than four separate taxpayers?
d. What kind of income is it?
i. Example: Capital gain v. non-capital gain
5. Tax Expenditure Analysis: Congress hasn’t thought about the reductions in tax revenue as expenditures. Stan Surry said you should think about reductions in revenue as expenditures. Anyone who buys a home and uses borrowed money can deduct the home mortgage interest against income. Surry said, that’s great, but the home mortgage interest deduction means that the federal government is giving up that amount of money.
6. Graduated Rate vs. Progressive Rate: A progressive tax is a tax by which the tax rate increases as the taxable base amount increases. We have a graduated rate system in IRC 1.
Tax Flow Chart
A. Tax Flow Chart
1. Step 1 – Identify Gross Income:
a. Defined – § 61(a): Except as otherwise provided in this subtitle, gross income means all income from whatever source derived including . . .
i. Income Not Defined: Income is not defined anywhere in the code. This was done intentionally by Congress to avoid leaving anything out.
ii. Exceptions in Subtitle A: “as provided in this subtitle.” Don’t look to the entire code for exceptions, only those in Subtitle A.
b. Inclusion/Exclusion Cross Reference – § 61(b): Cross references to the important items included/excluded from gross income.
c. Specifically Included in 61(a):
i. (1) compensation for services, including fees, commissions, fringe benefits, and similar items.
ii. (2) gross income derived from business
iii. (3) gain derived from dealings in property
iv. (4) Interest; (5) rents; (6) royalties; (7) dividends; (8) alimony; (9) annuities; (10) income from life insurance; (11) pensions; etc.
2. Step 2 – Adjustments to I
capital, from labor, or from both combined.”
2. Although the Court used this characterization in Eisner v. Macomber, it “was not meant to provide a touchstone to all future gross income questions.”
3. Instead, income is realized whenever there are “instances of [1] undeniable accessions to wealth, [2] clearly realized, and [3] over which the taxpayers have complete dominion.”
4. Under this definition, punitive damages qualify as “income” — even though they are not derived from capital or from labor.
iii. No Source Requirement: Unlike Eisner, there is no source requirement.
iv. Broad: Defines “income” much more broadly than Eisner did.
1. Consistent w/ 16 Amendment: Permits Congress to collect taxes “from whatever source derived.”
2. Consistent with §61(a): Which includes all income “from whatever source derived.”
v. Most Cases – § 61(a): This will tell us 95% of what is income. However, sometimes it is necessary to review the outer limits of income.
3. Philosophic Definitions of Income:
a. Haig & Simons (H&S): 20th Century philosophers with great influence over the modern definition of income.
i. Two Components:
1. Consumption: Income is measured by how much money you spend.
2. Net Increase/Decrease in Wealth: Measure wealth at beginning and end of the year (or other arbitrary time period) to determine increase/decrease.
ii. Pure Income: Consumption amount + Net Increase = Income.
iii. This approach comes up with a very pure definition of income, but our system has never tried to reach that perfect of a level, identifying everything as income.
b. H&S Important For Two Reasons:
i. Covers Things Congress Doesn’t
1. Example: Gifts would be income according to H&S.
ii. No Severance/Realization Requirement: Only look at whether there was a net increase/decrease in wealth.
1. Example: Stocks that appreciate in value would constitute income, even though the gain has not been severed from the asset.
2. Realization: Congress requires some “realization event.”
B. Equivocal Receipt of Financial Benefit
1. Clear v. Equivocal: When a financial benefit is clearly received, it is clearly income. When receipt is equivocal (open to two or more interpretations), it may still be income, even if less clear.
a. Example: Paycheck from employer is clearly an accession of wealth, realized, over which employee has complete dominion.
2. Repayment of Debt by 3rd Party: A debtor who has debt paid on his behalf by someone else realizes income equal to the amount of the debt repaid.
a. Example – Old Colony Trust Co. v Commissioner: Employer paid employee’s income taxes on his behalf. Held: Payment of income tax by employer was income to employee.
b. Exceptions:
i. Gifts: Lyons paid his son’s dentist bill after he chipped his tooth on porcelain toilet.
1. Old Colony: Would classify this as income.
Congress Exempted: Congress exempted gifts
