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Income Taxation
University of North Carolina School of Law
Simkovic, Michael N.

INCOME TAX

Simkovic, Fall 2014

INTRODUCTION TO FEDERAL INCOME

Income= “all income, from whatever source derived” (61)

Gross Income= the broadest definition of income in the tax code. Limited only by exclusions and the realization requirement (61)

Adjusted Gross Income= Gross income less business expenses, alimony payments, and above the line deductions. (62)

Taxable Income= AGI less various below the line deductions. Taxable income is what actually flows into the tax tables and gets taxed.

The Basic Income Tax Calculation

Gross Income à subtract exclusions (101-137) and above the line deductions (62(a)) à Adjusted Gross Income (§ 62) à subtract WHICH IS GREATER, either standard deduction (63(c)) OR itemized deductions (63(d)); AND subtract personal exemptions (151) à Taxable Income (63) à multiplied by applicable tax rates (1), minus credits (21-41) = taxes due (or refund)

What is the difference between an exclusion and an above the line deduction?

· Exclusions refer to income that is NEVER included in gross income

· Deductions refer to outlays that can be subtracted from gross income to get AGI

What is the difference between an above the line deduction and a below the line deduction?

· Above the Line=

o Subtracted from gross income

o To get AGI

o Mostly consists of trade and business expenses

· Below the Line=

o Subtracted from AGI

o To get Taxable Income

o Mostly consists of personal expenses

What is the “standard deduction?”

· A statutorily defined dollar value

o Amount depends on filing status

o Adjusted for inflation every year

· Alternative to tracking and reporting individual itemized deductions (administrative convenience)

· May be more generous to some TPs than itemizing (that’s why you chooser the greater of the 2)

Filing Status= depends mainly on family structure (some element of choice)—ex= single, married filing jointly, head of household

Inflation= a sustained increase in the general price level of goods and services in an economy over a period of time—when the general price level rises, each unit of currency buys fewer goods and services—a chief measure of price inflation is the inflation rate (the annualized percentage change in a general price index over time)

· A price index is a weighted average of certain prices

What are some of the leading itemized deductions? = State and local taxes, Mortgage Interest, Charitable Contributions

Is an above the line or a below the line deduction more valuable? = an above the line deduction is more valuable because there is no trade-off against the standard deduction and no floor or other limitations

Personal Exemptions= Minimum amount of income excluded from any income tax; value depends on family size and it adjusts for inflation

Tax Rate Schedules= depend on filing status (single, married filing jointly, head of household, etc.) and character of income (capital gains or ordinary income); adjusted for inflation every year

PROBLEMS

Caroline TP is a business consultant who owns and operates her own unincorporated business and uses the cash method of accounting and reports her income on a calendar year basis. She has provided you with the following information concerning her financial affairs during the calendar year and asks you to compute her tax liability.

1. With regard to her consulting business:

a. She received $275K in fees through a combination of cash and checks from clients;

i. Taxable income

1. compensation for services

b. She provided $10K in consulting services to one client, a landscaping company, in exchange for $10K in landscaping services the client provided, at Caroline’s request, for Caroline’s mother;

i. Taxable income

1. 1.61-1: income may be realized, therefore, in the form of services, meals, accommodations, stock, or other property, as well as in cash

c. Clients still owed her $30K for services she provided during the year;

i. NOT taxable income—she is a cash method TP and therefore can only claim when she receives the money

1. 451: the amount of any item of gross income shall be included in the gross income for the taxable year in which received by the TP, unless, under the method of accounting used in computing taxable income, such amount is to be properly accounted for as of a different period

d. She paid an employee $60K in wages during the year;

i. Above the Line Deduction—trade or business expense

1. 162(a): there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business including a reasonable allowance for other compensation for personal services actually rendered

e. She paid $20K for building maintenance, utilities, and office supplies during the year; and

i. Above the Line Deduction—trade or business expense

1. 162(a)(3): business expenses including rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business of property to which the TP has not taken or is not taking title or in which he has no equity

2. 1.162-1: among the items included in business expenses are: . . . supplies, incidental repairs

f. She purchased an office building for $500K, which she expects to use in her business for the next 30 years.

i. Capital Expenditure—Must Capitalize, depreciate over time, deduction equal to depreciation in the current year and for many years into the future (until basis is reduced to 0)

1. 263(a)(1): NO DEDUCTION shall be allowed for any amount paid out for new buildings

2. 1.263(a)-2: amounts paid to acquire or product tangible property—a TP MUST CAPITALIZE amounts paid to acquire or produce a unit of real or personal property including buildings

2. Caroline incurred $5K in commuting costs in travelling from her home to work during the year.

a. NOT a Deduction

i. 262: except as otherwise expressly provided in this chapter, no deduction shall be allowed for personal, living or family expenses

ii. 1.262-1: the TP’s costs of commuting to his place of business or employment are personal expenses and do not qualify as deductible expenses

3. Caroline received $19K in interest income this year from an investment account managed by her bank. She paid the bank $1K for its management services.

a. Taxable Income—Below the Line Deduction for $1K in management fee

i. 61: gross income means all income from whatever source derived including interest

ii. 212: expenses for production of income:

1. there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year for the production or collection of income

4. Caroline owns her home, on which she made mortgage payments in the amount of $24K during the year. Included in the $24K were $18K in interest payments and $6K in principal payments.

a. 18K in interest payments=DEDUCTIBLE Below the Line

i. 163: disallowance for personal interest OTHER THAN any qualified residence interest (exception to personal interest disallowance)

5. Two years ago, Caroline purchased 100 shares of stock in ABC Corporation for $15K. At the end of last year, the stock had a FMV of $25K. This year she received $1K in dividends on the stock. She sold the stock at year-end for $30K.

a. Gain= $30K – $15K = $15K = Taxable Income + $1K dividends = Taxable Income

i. 61: gross income includes . . . (3) gains derived from dealings in property; (7) dividends

6. Caroline made cash contributions of $9K during the year to the church she attends.

a. Below the Line deduction, as long as TP’s AGI > $18K (9K x 2)

i. 61: In the case of an individual, the deduction provided in (a) shall be limited as provided in the succeeding subparagraphs: (a) Any charitable contribution to (i) a church or a convention or association of churches shall be allowed to the extent that the aggregate of such contributions DOES NOT EXCEED 50% OF THE TP’S CONTRIBUTION BASE FOR THE TAXABLE YEAR

7. Caroline paid state and local general sales taxes of $3K on the purchase of various items for personal use or consumption. She also paid real property taxes of $5.2K on her home. She also paid $14K in estimated state income taxes and $40K in estimated federal income taxes with respect to her business.

a. 5.2K is deductible (real property tax); have to choose between $3K and $14K; 40K= CREDIT

i. 164: Except as otherwise provided in this section, the following taxes shall be allowed as a deduction for the taxable year within which paid or accrued:

1. State and local . . . real property taxes AND

2. State and local . . . income . . . taxes

ii. (b)(A) election to deduct state and local sales taxes IN

eneral, bonuses (including Christmas bonuses) are income to the recipients unless excluded by law

c. A walnut bookcase Marcella purchased from the firm for $150. The bookcase was in excellent condition and had a FMV of $400. It was one of 15 bookcases the firm sold when it eliminated a large part of its law library. The other bookcases were sold for the same price to other lawyers and legal assistants of the firm.

i. GROSS INCOME ($400 – $150 = $250)

1. 1.61: gross income includes income realized in any form, whether in money, property, or services—if services are paid for in property, the fair market value of the property taken in payment must be included in income as compensation

2. 1.61(2) if property is transferred by an employer to an employee or if property is transferred to an independent contractor, as compensation for services, for an amount LESS THAN ITS FMV, then regardless of whether the transfer is in the form of a sale or exchange, the difference between the amount paid for the property and the amount of its FVM at the time of the transfer is compensation and shall be included in the gross income of he employee or independent contractor

d. A firm retreat at a popular ski resort in the Rocky Mountains. The firm scheduled the 3-day retreat as an opportunity for all of the partners and associates in the firm’s various offices around the country to come together to meet each other. Firm meetings during the retreat were scheduled in the afternoon to enable firm members to ski during the morning hours. The firm paid all of Marcella’s transportation, meals and lodging expenses. Her expenses amounted to approximately $2,500. All firm partners and associates were required to attend the retreat.

i. PROBABLY NOT—all the firm partners and associates were REQUIRED TO ATTEND

e. A small greenhouse worth $2,500 constructed on Marcella’s property by her brother, Bill. Bill insisted on building the greenhouse for Marcella as a way of thanking her for the legal work she had done for him at no charge. Bill did not charge Marcella for either his labor or the materials he purchased to construct the greenhouse.

i. GROSS INCOME if the greenhouse was compensation for the legal work

f. Marcella represented herself in a lawsuit regarding certain real property she owned. Had Marcella hired an attorney to represent her, she would have paid approximately $10K in legal fees.

i. NOT gross income

1. Imputed Income= 1) from services and 2) imputed income from property—NOT TAXED

2. Mitch purchases stock in XYZ Corporation in Year 1 for $1K. At the end of Year 1, the stock is worth $1,500. In Year 2 when the stock is worth $2K, Albert offers to buy the stock for $2K,but Mitch declines. In Year 3, when the stock is worth $2,500, Mitch borrows $2K from Bank, pledging stock as security for the loan. In Year 4, Mitch repays the $2K he borrowed. In Year 5, when the stock is worth $3K, Mitch gives it to Creditor to satisfy a $3K debt owed to Creditor. Does Mitch have any gross income? When?

a. YES—In Year 5—for $2,000 ($3,000 (amount realized) – $1,000 (basis))

THE EFFECT OF AN OBLIGATION TO REPAY

Borrowed money is NOT income (no deduction upon repayment)—question of fact in determining if it is a loan

· There must be an unconditional obligation on the part of the transferee to repay, and unconditional intention on part of transferor to secure repayment (ie, presence of a debt instrument, collateral securing the purported loan, interest accruing on loan, repayment, and any attributes indicative of enforceable obligation on part of transferee to repay)