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Income Taxation
University of North Carolina School of Law
Thomas, Kathleen DeLaney

Income Tax

Kathleen Thomas

Spring 2014


Haig – Simons definition of income

Income = consumption + change in wealth

· Basically this just means that you add together what you spent and what you saved in order to get to income for that year. The change in wealth means any amount by which your wealth increases over the year.

o Example: A makes 30k in a year. Spends 20 of it. Therefore I= 20k +10k.

o Inversion is C= I – change in W.

I. Calculating Tax

1. § 61(a) Gross Income

– § 62(a) Above the Line Deductions (preferable to Itemized)

(T/b deduction; Reimbursed T/B expenses of Employees; Losses from Sale or Exchange of Property; Rents + Royalties; Life Tenants; Pension or Annuity Plans of Self-Employed; Retirement Savings; Alimony; Moving Expenses; Interest on Education Loans; Higher Ed Expenses)


=Adjusted Gross Income

– § 63(d) Itemized Deductions (or)

(Home Mortgage Interest; State and Local Taxes; Charitable Contributions; MIDS subject to 2% floor—Unreimbursed employee expenses, job travel, tax prep fees, investment expenses, hobby losses—Medical Expenses; Casualty Losses) (Phased out up to 80% for wealthy)

– § 63(c) Standard Deduction (and)

– Personal Exemptions


=Taxable Income x Rates à Tax – Credits (preferable to deduction) – Amounts Paid = Refund/Check

2. Consumption (personal, living, family expenses) + Change in Net Worth = Tax Base

3. Exclusions from Gross Income

a. Gifts, inheritances, damages, interest on state and local bonds

4. Deductions

a. Types

i. Outlay by Taxpayer

ii. Realized Loss

b. Steps in Subtracting Deductions

i. Business related outlays (§62(a))

c. Itemized versus Standard

i. Itemized à Listed on Schedule A (extraordinary medical expenses, charitable contributions, casualty losses, interest expenses, state taxes)–if exceed standard deduction

d. Personal Exemption

i. Per your self, spouse, each dependent

e. Deduction vs Credit

i. Choose credit b/c it comes directly off amount owed

f. Items not Allowable for Deduction

i. § 262(a): Personal, living, and family expenses

5. Amount realized – Basis = Gain/Loss

i. If you receive property and property is included in your gross income, the amount you include becomes a part of your basis

ii. Amount Realized à § 1001(b)= Sum of any money received + Fair Market Value of the Property (other than money) received

a. Don’t take into account any money received as reimbursement for real property taxes which are imposed on the purchaser (§ 164(d))

b. Don’t take into account amounts representing real property taxes treated under § 164(d) as imposed on the taxpayer if such taxes are paid by the purchaser

II. Tax Structure

1. Progressive

=Pay a higher % of your taxes with wealth

2. Marginal Rate

=the rate that applies to your last $ earned

3. Effective Rate

=% of your income you pay in tax

4. Capital Gain/Loss

i. From the sale or exchange

ii. Of a capital Asset

iii. Holding period à If more than 1 year: long term; If less: short


TEST for income:

1. Realized?

-Sale of property; exchange or property; satisfy debt

2. Recognized?

-Realized + No exception applies

3. If loss à is deduction allowed under 165(c)?

-No personal losses

-Losses for individuals must be in t/b, investment for profit, casualty

4. What is the character? (ordinary income v. capital gain/loss à long or short term)

*§ 61(a) Gross Income = All income from whatever source derived à Usually measured by an “undeniable accession in wealth, clearly realized, and over which the taxpayer has complete dominion” under Glenshaw Glass à Must have exception to exclude

So three questions when trying to figure out whether something is income..

• 1. Look at section 61

• 2. Go through glenshaw glass requirements

• 3. Then look at other sections of code such as 119 or 132 to see if another exclusion applies. (only go to section 119 and 132 if it passes the first 2 requirements).


=Included in gross income unless can be excluded

a. If services are paid for in property, included in income

b. If employer pays debt of employee, treated as compensation

1. Exclusions

a. § 119: Meals and Lodging to Employees

i. Meals furnished on premises of employer for employer benefit

ii. Housing if on employer premises + condition of employment

x. How does housing benefit employer à May be able to reduce the amount paid to the employee for salary and can recruit top talent b/c employee is better off b/c receiving tax free benefit

xi. If employee has choice of accepting housing, it must be treated as income; not income if employer requires it

b. § 132: Certain Fringe Benefits

i. No-Additional Cost Service

x. TEST: 1) offered by employer to employee; 2) Service; 3) That’s offered for sale to customers; 4) service is in the same line of business that employee works; 5) Employer incurs no substantial additional cost (including foregone revenue); 6) Not offered on discriminatory basis à may extend to spouse and children

x. Not available to highly compensated employee

x. Example= free seating for airline employees on flights that would otherwise not have sold out; can have reciprocals (ie across airlines)

ii. Qualified employee discount

x. One must work in the line of business in which the item at issue is ordinarily offered for sale to customers; not available to highly compensated employees à Discount cannot be more than gross profit % or 20% off services

iii. Working condition fringe

x. Property or services provided to employee are excludable if they would have been deductible to employee under § 162 (t/b) or § 167 (Depreciation)

x. Example: Employer paying for trade journal in t/b

iv. De Minimis fringe

x. Sufficiently low value to make accounting for them “unreasonable or administratively impractical” (used to justify eating facilities)

x. CANNOT be cash

v. Qualified transportation fringe

x. Ie employer-provided parking à limits on this

vi. Qualified moving expense reimbursement

vii. Qualified retirement planning services, or qualified military base realignment

à No additional cost services, qualified employee discounts, and qualified reduction may be provided tax free to employee’s spouse, surviving spouse, or dependent children but not to others (ie no same sex domestic partner)

2. Valuation of Non-Tax Benefits

a. Amount included = fair market value

b. Cafeteria plans (§ 125)

i. = plan under which an employee may choose among a variety of noncash nontaxable benefits or may choose to take the cash (cash would be taxable)

ii. Limited permissible benefits à group term life insurance (up to 50k), dependent care assistance, adoption assistance, excludable accident and health benefits, and elective contributions

iii. Use it Or Lose It à If part of the benefit is taken and not used, the employee loses that amount

3. Miscellaneous Issues under Non-Cash Benefits

a. Frequent flyer miles à No taxation on miles accumulated through business travel paid by employer but used for personal reasons by employee

b. Benefits from other than employer (ie principal receives books from publisher) à only taxable if the taxpayer donated them to charity and claimed a deduction for the donation

c. Health insurance à employers are allowed to deduct the cost of medical insurance they buy for their employees; benefits received by employees are excluded from their gross income

d. Approaches to Include Fringe Benefits in Taxable Income

i. Items wholly excludable under §§ 119, 132

eived – basis in item traded. Check to see if it is a capital expenditure (or inventory so ordinary expense) and in connection w/ t/b (then can receive depreciation deductions)…same effect as if customer paid in cash and then taxpayer returned the cash to buy the traded item

2. § 72: Annuities and Pensions

a. Arises when a K w/ an insurance company under which the person makes a current payment in return for the promise of a single larger payment by the insurance company in the future

i. Type of tax avoidance device

b. Calculate exclusion ratio à investment in K is divided by the expected return. Ratio is applied to each payment received.

i. Example: Investment in K= $100,000 DIVIDED by expected return (from life expectancy table)= 180,000 or 55% à If receive $9,000 payment a year under K, 55% or $5,000= NONTAXABLE recovery of investment; $4000 taxed as gross income

ii. Investment/Expected Return X Amount Received/Payment = Amount excluded

c. If a person dies before full investment recovered, the unrecovered portion can be deducted on final tax return

d. If person lives past life expectancy, each amount after investment is recovered is taxed fully as gross income

e. Life insurance proceeds are not taxable as income


· Deductions for losses are limited ONLY to:

o Losses incurred in a trade or business

o Losses incurred in any investment

o Losses arising from fire, storm, theft, or shipwreck (casualty loss)

1. Business

a. Damage awards for lost profits are includable in income in year received

b. Punitive damages taxed in year received

c. Damages for destroyed or damaged property à taxed in year received to extent it exceeds basis/cost of property

i. Exception: Can defer taxation provided the amounts are reinvested in similar or related use

2. Individuals

a. § 104: Damages are tax-free if payment attributable to personal injury

b. TEST= ARISE from physical injury (compensation for injury, med expenses if not already deducted, past wages, pain suffering, future wages) (includes spouse consortium if origin in physical injury)

à Is something a physical injury? à observable bodily harm that occurred from direct unwanted contact

c. All medical expenses are excludable as long as they had not been deducted previously (could only have done this if they exceeded 10% AGI)

d. Includable= punitive damages (must be included) (unless wrongful death action) (Glenshaw Glass)

e. Non-Personal Injury (Includable)

i. Amounts received to compensate lost profits taxed in year received

ii. Amount received as damages to property taxed to extent > basis à can defer tax on gain if proceeds are reinvested in similar property (treated for tax purposes like you liquidated the asset…taxed to extent damages exceed basis in asset)

à If involuntarily converted under 1033 and reinvests in similar property, mandatory non-recognition and defer recognition of gain

iii. Pain/Suffering or Emotional distress non-personal injury

**UNLESS emotional trauma resulted from a physical injury (applies even if the emotional trauma was suffered by a different person than who was physical injured