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Federal Income Tax
University of North Carolina School of Law
Thomas, Kathleen DeLaney

 
 
Income Tax
Thomas
Spring 2015
 
 
 
Introduction
·         Basic Income Tax Structure
o    Gross Income (§61) = Income  – Exclusions (§101-127)
o    – ATL Deductions (§62)
o    = ADJUSTED GROSS INCOME (§62)
o    – Personal Exemptions
o    – Itemized OR Standard Deductions
o    = TAXABLE INCOME (Tax base)
o    Apply Tax Rates (distinguish between ordinary income and capital gains)
o    – Tax Credits (Dollar for dollar)
o    – Taxes already paid
o    = TAX TO BE PAID/ REFUND (Taxable income)
o    Alternative Minimum Tax (AMT) required?
§  Based on income, AMT must be paid if it exceeds the calculated tax (§55)
·         Details of Computation
o    Compute Gross Income:
§  Include items listed under section 61 and on lines 7-22 of Form 1040 (including net business income, from Schedule C, on line 12).
§  Do not include specific exclusions allowed by specific sections of the Code (such as gifts under section 102, interest on municipal bonds under section 103).
·         Exclusions benefit taxpayer but are not counted in gross income.  Policy behind exclusions:
o    Administrative/ practical reasons (e.g. fringe benefits)
o    Encourage certain types of behavior
·         Exclusions are amounts not included in gross income.  Deductions are amounts subtracted once you’ve computed gross income.
§  Remember that section 61(a)(3) includes “gains derived from dealings in property.”  Gains are included only when they are “realized” (such as upon a sale of property), and are computed by subtracting the cost (basis) of the property from total sales proceeds.       
o    Subtract deductions listed in section 62 (mostly business related – and sometimes referred to as Above the Line deductions – lines 23-35 on 1040) to reach Adjusted Gross Income (AGI). 
§  AGI is used in determining floors for some itemized deductions, such as medical expenses, casualty losses, and other miscellaneous itemized deductions, and so is a necessary initial computation. (See fn. 76, page 34.)
o    Now compute Taxable Income.  From AGI, subtract: 
§  The greater of: 
·         Total itemized deductions from Schedule A, or
o    Medical expenses, state taxes, charitable contributions, interest on mortgage…
·         The standard deduction (see line 40 and related box).
§  AND Total personal exemptions (see lines 6 and 42).
o    The final figure is Taxable Income.
o    Apply the tax rates (including the lower capital gains rate on long-term capital gains if applicable) to determine tax. 
o    Subtract credits to determine total tax (line 63).
o    Subtract taxes already paid (through withholding or estimated tax payments) to determine if taxpayer is entitled to a refund or owes additional tax.  
o    Miscellaneous
§  ATL deductions v. BTL deductions
·         ATL deductions: generally for business expenses to get to AGI, which is better approximation of persons’ income.
·         BTL deductions: generally related to consumption
·         It’s preferred to have a deduction above-the-line because if its below-the-line (itemized deduction), it may do you no good if you don’t have enough itemized deductions to exceed the standard deduction. 
o    That’s why certain deductions are put above the line to encourage certain behavior more than if they were itemized deductions (so that everyone can take advantage of them)
§  Credits v. Deductions
·         Credits differ from deductions b/c credits reduce tax owed dollar-for-dollar while deductions work to decrease income which is then multiplied by the rate. 
§  AGI is used for: Separating the deductions that everyone gets (e.g. business costs) from the deductions only allowed for people who itemize (e.g. charity)
§  Why standard deduction?
·         Relieving average ppl of record-keeping nuisance
·         Ensuring that ppl with income below the SD pay no taxes
·         Realization vs. Recognition
o    Realization: something happens that would constitute a gain or loss for tax purposes
o    Recognition: the event was realized and there is no statutory rule that prevents it from affecting your taxes
o    RealizationààRecognition
·         Theory & Policy
o    Economic Consequences
§  Raise revenue
§  Income effects: changes in behavior induced by the fact that tax reduces the money available to the taxpayer
·         Ex. you work more hours to make up for the income you lose due to taxes
§  Substitution effects: changes in behavior that arise from a change in the relative attractiveness of different commodities or activities due to taxation
·         Ex. higher tax on green applesàmore people eat fuji over granny smith
·         Ex. higher tax on wagesàmore people take leisure time or stay home with family
§  Tax scheme indicates what activities are favored in society
·         Ex. tax benefits to employer-provided health care benefits (not taxed)àencourage employers to compensate employees with health care and encourage americans to have health insurance
·         Sometimes govt changes a tax even when it’s less efficient then direct govt expenditure, because it is viewed as more favorable as a tax cut instead of the govt spending money on something
·         Deductions allowed for education, home mortgage interest, charitable contributions, contributions to IRA, etc. to incentivizes these types of activities
o    Why Income?: “ Ability to Pay” Philosophy (Progressive)
§  Narrow interpretation à convenience in paying (people who hold onto cash, rather than holding illiquid assets like houses or paintings)
·         Problem à may encourage people to lower their tax bills by holding onto illiquid assets for no good reason.
§  Broader view à People’s material well-being without regard to liquidity
·         Declining marginal utility of money àThe rich should pay more than the average tax, and the poor less
§  Broadest view à encompass “ability” or “wage rate” – the opportunity to earn wealth whether or not it is exercised
·         Taxing people for exercising their earning power (the reverse) could discourage such exercise and mistakenly classify people who earn and spend at a given level as better off than those who have the same opportunities but happen to prefer to work and spend less
o    Look at increase in economic power during that period to define ability to pay. 
§  One way to define economic power is using Haig-Simons definition (Y (income) = C (consumption) + ∆W (change in net worth)
§  Because income includes a consumption component, the difference between income tax and consumption tax is essentially a debate about how to tax savings/investments
§  Expenses incurred in running a business is not savings or consumption, so we have to include a deduction for business expenses.
o    Tax Incidence: Incidence is on the party who bears the ultimate economic burden of the tax
§  Ex: a business can pass along a tax hike to customers (incidence is on customers)
o    Implicit or Putative Tax
§  If one type of investment is favored over another, there will be tax benefits.  But often there will be decreased interest from that investment in response to the added tax burden to make up the difference
§  Ex. state and local bonds are exempted from taxation.  But, the rate of return is less than the rate of return for taxable bonds, because more people want to buy them.  So it ends up a wash.
o    Tax Expenditures (pg 17 for foregone revenue): Govt can frame an increase in deduction as a subsidy—we’re subsidizing certain behavior—“spending through the tax code”
§  §262(a): Except as otherwise expressly provided in this chapter, no deduction shall be allowed for personal, living, or family expenses.
§  But there are some deductions, generally in itemized deduction section, that are allowed to be subtracted.  These deviations from theoretical definition of income are tax expenditures (this doesn’t include deviations we can justify on administrative/ practical grounds, so coffee provided by employer isn’t expenditure). 
·         Ex. of tax expenditure; deduct interest on mortgage
·         These are exceptions to the theoretical rule that people are taxed on consumption + Δsavings
§  Debate that we should “broaden the base” in order to be able to afford to lower tax rate for everyone—that means get rid of the deductions so that the income used to calculate tax payment is higher and more close to the true definition of income
§  Debate that the tax preferences may have bad repercussions: deduction for health care may have raised the cost of health care (dead weight loss), deduction for mortgage payment may have caused too many people to buy single family homes
§  Govt can frame a decrease in deductions as a savings to the govt—we’re paying more taxes to balance the budget
·         Tax Rate Overview
o    Schedular Approach: Different types of income are taxed at different rates and deductions are applied based on specific category
o    Our income tax is progressive
§  Marginal rate:  rate that applies to the last dollar of taxable income (or next tax dollar – usually the same, but not always)
§  Effective rate – actual tax/ actual income (this is the weighted average or the percentage of your income that you pay in tax)
§  Marginal rate is always greater than effective rate
§  Phase-out:  if AGI gets high enough we take away itemized deductions and personal exemptions– (151 (Hidden tax))
o    Regressive Taxes:  On average the poor pay a much higher percentage of their income through Sales tax.
o    Proportional tax: same tax rate for everyone
o    Policy reason for progressive rate structure
§  Marginal utility of dollar decreases with increased income
§  So try to equalize the burden
§  Also has to do with our ideas of necessity to redistribute the wealth
o    Argument against progressive tax:
§  Discourages people from working hard
§  Also may inhibit people from selling investment, which may not be beneficial for market
o    Horizontal equity—want people in same economic situation (same increase in wealth over year) to pay same amount of taxes
o    Vertical equity—looks at how we treat people at top of income scale compared to people at bottom of income scale
§  This is where progressive tax system comes into play (you pay a higher percentage of your income in tax if you are in a higher earning class).  This is opposite of regressive tax system.  An example of a regressive tax system in this country is social security
o    Filing statuses
§  (1) Married filing separately
·         Least-favorable filing status
§  (2) Married filing jointly
·         Especially favorable for single-earner marriages
o    Allows for imputed income, stay at home Mom.
·         Note marriage penalty
o    Penalizes married couples where both spouses earn roughly the same amount. (Subjects “secondary” worker to highest marginal rate. 
§   (3) Single
§  (4) Head of Households
§  Implications:
·         Married people who file jointly only have one chance to count income from the lowest rate tier, whereas if they were single each partner would get to start from the lowest tier and work upward
·         Married people who file separately can get two chances to start at the bottom tier, but they are in the least favorable schedule already
·         BUT married couples who don’t earn income beyond the lowest rate tier are in a more favorable schedule than unmarried, so same-sex couples are deprived the opportunity to benefit from the best tax rate
·         Capital Gain and Dividend Income
o    Capital gains and dividends are subject to special, lower rates
§  Rationale:            
·         Maybe adjustment for inflation
·         Maybe to encourage investment
·         Maybe to have a less chilling effect on selling
§  Some people argue against this because benefits go primarily to wealthy people.
o    Use Schedule D for computing gains and losses.
o    3 components
§  Applies to sale or exchange of an asset—not compensation, interest, rental income, etc.
·         Dividends is an exception
§  Asset being exchanged must be a capital asset (not business assets or inventory)
·         Investment assets (stock, invest. property, car, house) and personal use assets
·         §1221 defines capital assets
§  Must have held the asset at least one year (to be a long-term asset)
o    Other income that isn’t capital gains or dividends = “ordinary income”
o    Certain types of income can be defined as capital gain even if it doesn’t meet 3 components.  Ex: dividends.  Other types of gains categorized this way are generally from investment assets.
o    Capital losses are limited.  Can use them to offset all capital gains but if you end up with more losses than gains, you can deduct only $3K from ordinary income. 
·         Calculating gain/ loss on sale/ exchange of property
o    Amount Realized – Adjusted Basis = Gain/ Loss (§1001(a))
·         Deferral
o    Benefit of deferring tax liability can be s

asional meals for working late or through lunch)
§  Rules
·         May be extended to spouse and dependents.
·         119 is not a fringe benefit that is subject to a lot of abuse because you have to:
o    live on the business premises
o    eat on the business premises
§  Policy Rationale for This Rule:
·         This is forced consumption; he is not there to enjoy the food he is there to work.
·         Difficult to value.
o    IRS Analogies/ Guidance:
§  More examples: Reg. 1.119-1(end of section)
§  Furnished:
§  Groceries: The question here, Is this furnished? Some courts hold that groceries purchased in employer’s commissary count as “meals” and some don’t
§  Some courts hold that where employer provides cash for meals instead of directly providing food, that is not “furnished” and must be included as income (but in the case of fireman’s mess, that came out opposite)
§  Jurisdiction for Police Employeesà the business premises for the state police include the entire jurisdiction BUT since meals aren’t furnished by the employer, no dice.
·          119 does not extend to reimbursement of meals while police are on the clock. (See Travel and Business Expense?)
·         Cash provided to obtain meals à inconsistent case law as to whether this falls within the definition of “furnished” for the purposes of exclusion. If its deducted as de minimis (e.g. meal money for working late occasionally) then the reimbursement is excludible.
§  Fireman case: A fireman required to pay $3 a day for lunch buffet.  Yes this is furnished.
§  Defining Meals for the Convenience of your employer (Reg. 1.119-1(a)(2) – pgs. 540-541)
§  Meals furnished by an employer without charge to the employee will be regarded as furnished for the convenience of the employer if such meals are furnished for a substantial non-compensatory business reason for the employer…Generally meals, furnished before or after the working hours of the employee will not be regarded as furnished for the convenience of the employer.
·         Examples
o    Meals furnished to the employee to have the employee available for an emergency business call
o    Employee is restricted to a short lunch period for business reasons
§  BUT if such a short lunch period exists only to let the employer off earlier in the day – then taxable
o    Employee could not otherwise secure proper meals within a reasonable meal period
§  “Convenience of the Employer”
·         Provisions of an employment contract are not determinative as to whether the meals or lodging are intended as compensation (119(b)(1))
·         Factual test – turns on whether the housing of the employee on the premises is necessary for the running of the business
§  Non-compensatory & compensatory reasons à still excludable
·         If a meal would have been furnished during business hours within this rule, but his duties prevented him from eating at that time, a meal furnished immediately after business hours is excludable
·         Restaurant worker: can eat before or after your meal period as long as you’re serving during that meal period
o    Examples of lodging tax benefit
§  What if offer is either we’ll give you $50K value via free apartment or $50K apartment via cash. 
§  What if you get free apartment that you value only at $40K but IRS is including full $50K in your income (objective value even if you value it less), then you have to pay $10K in taxes, so you’re left with $30K benefit.  Here, better option would be to take $50K and pay $10K in taxes, so you’re left with $40K benefit.
§  Cost of taking something, even if it’s taxed, is greater than 0!
o    Benaglia v. Commissioner:  Taxpayer, hotel manager, and his wife occupied a suite at the Royal Hawaiian Hotel and received their meals at the hotel.
§  Illustrates §119
§  Argument à Tax commissioner argued that the fair market value of the rooms and meals furnished by the employer needed to be included in gross income as compensation
§  Holding à advantage to the employee was merely an incident of the performance of his duty and the occupation of the premises was imposed upon him for the convenience of the employer. He could not have performed his duties as manager if he lived off-premises.  The hotel didn’t keep any record of B’s meals or lodging.
·         A taxpayer employee may exclude the value of food and lodging received from his employer, if he receives it solely for the convenience of his employer and as a necessary incident of the proper performance of his duty
 
·         Health Care
o    Deductible for employers (162 a) ; excludable for employees (105/106)
§  Employers’ may deduct the cost of insurance or any amount paid to an employee to reimburse them for out of pocket medical expenses. (162(a))
§  These payments are excludable by employees under 105/106.
o    Self-employed à deduction for health insurance costs rather than an exclusion of the benefit (162(l)(1)(A))
o    213 individuals may deduct health care expenses in excess of 7.5% of their AGI.
§  Workers Compensation excluded.  (104(a)(1))
§  Effect à disincentive for high-deductible health insurance plans because the deductible may not be deductible from gross income