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

Income Tax


Fall 2014

Income Tax Outline

A. Introduction

1. Income as Tax Base, Tax Terms and Computation

i) Code Sections: 61, 262(a)

ii) Taxation

(1) Definition: The process by which the government collects revenues from the private sector to the public realm (private resources for public use)

(a) Tax is meant to be grounded in notions of fairness (in the ability to pay—to some extent)

(b) Tax system is designed to encourage people, through lower tax incentives, to spend their money on things deemed socially desirable (charity, education, retirement savings)

(i) **Allowing deductions is a way of govt. spending (i.e. govt. foregoes revenue they would have otherwise collected)

(c) **Computation: Tax Base (taxable income) x Tax Rate = Tax Debt

iii) Vocabulary:

(1) Income: competing definitions:

(a) Haig-Simons Definition:“personal income may be defined as the algebraic sum of (1) the market value of rights exercised in consumption and (2) the change in the value of the store of property rights between the beginning and the end of the period in question.”

(b) Economic Change: change in your economic power from the beginning to the end of a taxable period can be measured by :

(i) how much you spend on consumption (personal purposes)

(ii) PLUS the change in net worth (how much you have available for savings and future consumption)

(c) Accounting Definition: Receipts (MINUS) cost of producing those receipts

(2) Gross Income: things that come in; economic value, to the taxpayer.

(a) Not only cash, can also be the value of property you get as a bonus (ex. car or services)

(i) §1.61-1(a)(2): “gross income includes wages, not only those received in cash, but property goods and services as well”

(b) §61 Gross Income: “Gross income means all income from whatever source derived, including (but not limited to) the following items . . .”

(c) 1040: gross income is listed on lines 7-21

(3) Adjusted Gross Income: permissible subtractions of “business related expenses (above the line)” from the gross income computation

(a) AGI is the floor from which we calculate certain itemized deductions (i.e. medical expenses, unreimbursed business expenses, and casualty losses)

(4) Exclusions: amounts that come in, enjoyed by the person, but are Congressionally excluded from gross income (don’t have to count them)

(a) Exclusion Provisions: §102 (gifts), §103 (interest on state/local bonds), §104 (comp. for injury/sickness), §106 (employer provided health insurance), §119 (meal lodging furnished for convenience of employer), §132 (certain fringe benefits)

(5) Deductions: allow you to subtract certain expenses or payments that you have already made (outlay)—(subject to tax rate)

(a) Above the line: deductions are listed on 1040 lines 23-35 (all are listed in Section 62)

(i) Better for taxpayers who do not itemize, because they get the benefit of BOTH above the line deductions AND the standardized deduction

(b) Itemized Deductions: Below the line deductions (compared to the standard deduction—pick the larger of the two)

(i) people at a higher marginal rate save more with deductions

(c) Standard Deduction: **used more often by less wealthy people (often higher than itemized deductions would be)—**also reduces audit burden

(6) Personal Exemptions:An amount that is deductible (subtracted) for each of the “people who are supported” by the income

(7) Credit: dollar for dollar deduction of the tax (not subject to tax rate)—better than even above the line deductions

iv) Computation:

Compute Gross Income (Income – exclusions)

(-)§62 deductions

Adjusted Gross Income

(-) the greater of the itemized deductions or the standard deduction

(-) personal exemptions

Taxable Income

(*) tax Rate under §1or rate tables

Tax Liability

(-) credits

(-) taxes previously paid

Amount Owed or Refunded

2. Tax Rate (Introduction to Capital Gains and Losses)

i) **Code Sections: 1(a-e), (h); 1221(a) and 1222(1)-(8)

ii) Progressive Tax System

(1) Horizontal Equity: Tries to equally tax people who have the same increase in economic power (whether through cash or property)

(2) Vertical equity: how do we tax people who earn more income in contrast with those who earn less

(a) The progressive rate structure was adopted as a kind of vertical equity—we want to tax those who earn more at a higher rate of tax than those who earn less

(b) The progressive income tax rises as income rises: taxes a greater proportion of income (higher percentage of income is paid as well as higher raw dollar value)

(3) Progressive Rate structure Pro v. Con:

(a) Pro: People making more money don’t “feel” the tax as much (marginal utility of the dollar is less at the top

(i) goes to notions of fairness—redistribution of wealth to ease growing disparities of wealth

(b) Con: may discourage increasing net wealth (if tax rate gets too high, people may actively try NOT to earn/invest that next dollar)

iii) Effective Rate vs. Marginal Rate

(1) Marginal Rate: the tax rate applied to the last dollar you earned

(a) income is taxed at a series of rates

(2) Effective Rate: the percentage of your income that you actually pay in tax—lower than the marginal rate because it is an average of the constantly rising series of marginal tax rates

(a) FORMULA: Effective Rate = (Tax liability) /(Taxable Income)

(3) EXAMPLES (Using 2007 Rate Schedule):

(i) Single Taxpayer w/ 20,000 Taxable income

1. Tax liability:782.50 + 15% of amount over 7,825 = 2,608.75

2. Marginal Rate: 15%

3. Effective Rate: 2,608.75 / 20,000 = 13%

(ii) 2 Taxpayers, earning 150,000 each, get married

1. MARRIAGE PENALTYRULE: When 2 taxpayers marry, who earn about equal amounts, the amount of tax paid is greater than if each were paying taxes as singles (effective rate is higher even though marginal rate is the same)

2. Singles: Tax Liability = 36,110.75 (each)

a. Marginal Rate = 33%

b. Effective Rate = 36,110.75 / 150,000 = 24%

3. Married (same rates if filed separately or joint):

a. Filed Separately/Joint: 39,100 (each)/78,200 (total)

b. Marginal Rate = 33%

c. Effective Rate = 26%

(iii) Single Taxpayer, earning 300,000 marries someone w/ no income and files joint return

1. MARRIAGE BONUSRULE: When one spouse makes a lot and the other earns very little, the higher

r pays the debt of employee (taxes, rent, etc.), that is considered economic benefit to the employee, and will be treated as any other compensation (i.e. included in taxable income)

(ii) Taxpayer is treated as if he was paid cash and they took that cash to pay debt

(b) Benaglia v. Commissioner

(i) Taxpayer hotel manager received free room/board; didn’t report value to IRS

1. Relied on Reg. 77, stating that when non-cash compensation was given for the convenience of the employer, value is not income

(ii) Court held that the taxpayer’s housing was completely for the convenience of the employer and should not be included (P was “on call” 24 hours a day)

(iii) Dissent: should have to include the value he would have had to pay if he wasn’t living at the hotel (difficult to value)

(2) §119 was enacted after Old ColonyTrust and Benaglia wrath

(a) RULE: If an employee receives food and lodging on the business premises for the convenience of the employer, it may be excluded from income, even thoughit would normally treated as compensation

(3) 119 was intended to cdover situations in which the employee is constrained in his or her choice of food or eating place.

(4) §119 RULE- Meals and Lodging are Excludable to the Employee, Spouse, and Dependents if:

(a) Meals are (1) furnished on the business premises of the employer; AND (2) for the convenience of the employer

(b) The lodging is (1) furnished on the business premises of the employer; (2) for the convenience of the employer; AND (3) The employee is require to accet such lodging as a condition of employment

(i) **RULE: The requisite to show “for the employer’s convenience” is usually established by proof that employee is on call outside of business hours

(5) 119 does not extend to reimbursement of meals

(6) Definitions (still up in the air even after 119):

(a) Meals

(i) Jacob v. U.S.: meals also included groceries and toilet paper, soap, etc. all fell within the exclusion

(ii) BUT SEE: Tougher v. Comm’r: groceries NOT within the meaning of “meals” and held includable

(b) Furnished (meals):

(i) Comm’r v. Kowlaski: meal allowance to state troopers NOT excludable

(ii) Silba v. Comm’r: $3 a day allowance to fireman at station mess hall IS excluded

(c) On Business Premises:

(i) Has been held to be slightly broad. Lindeman v. Commissioner: beachfront hotel property included house across the street

(d) Employee:

(i) Section 119 DOES NOT include the self-employed or independent contractors

(ii) BUT SEE (Grant Farms v. Comm’r)—Owner of farm formed a corp., owning all shares—transferred lease of house to corp. and corp. required him to live there (could exclude rent under 119 AND take depreciation deductions)