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Income Taxation
University of South Carolina School of Law
Handel, Richard

Handel Income Tax Spring 2012

I. Gross Income – all income from whatever source derived. §61.

“An undeniable accession to wealth, clearly realized, and over which the taxpayer has complete dominion” Commissioner v. Glenshaw Glass. GI maybe realized in any form weather money, property or services; when some event occurs that, by explicit rule or common practice, causes the tax system to take account of income that previously existed in a form too inchoate to tax, i.e., “potential income” rather than “realized income.” If services are paid for in property, the fair market value of the property is the measure of compensation; if paid for in the form of services, the value of the services received is the amount of compensation. FMV is defined as the price a willing buyer would pay a willing seller, with neither under a compulsion to buy or sell, and both having reasonable knowledge of relevant facts. As income is not found in cash alone, so realization events are not limited to sales. The concept of realization is founded on administrative convenience and is fundamentally a matter of timing. Imputed Income, e.g. money saved by mowing one’s lawn instead of hiring somebody to do it, is not taxed even though the Code does not contain specific provision excluding it. There are two categories of imputed income: from property – living in one’s house instead of renting it, and from services – mowing one’s lawn. Borderline cases are those involving compensation in the form of commission, e.g. real estate broker buying a house for himself or life insurance broker buying his own insurance and collecting a commission; they were held as having taxable income, and not non-taxable imputed income – the difference, presence of another party (insurance co. or real estate broker, seller). Bargain purchases might create income where there is no indication that the sale/purchase was an arm’s length transaction; that is when bargain element represents compensation for services; if property is transferred as compensation for services in an amount less than its FMV, the difference between FMV and the amount paid is GI. Effect of Obligation to repay: Loans and Claim of Right. Loan proceeds are not income b/c they do not represent accession to wealth since they are subject to obligation to repay. It logically follows then that the repayment of the loan is not a deductible expense. Since the rationale for not treating the loan as income was the taxpayer’s offsetting obligation to repay the loan, a failure to repay it may generate tax consequences. In Old Colony Trust Co. v. Commissioner the Court held that the compensatory payment of the employee’s tax liability by his employer gave rise to gross income; payment of one’s liabilities by another may give rise to gross income. If, however, all or part of one’s debt is forgiven by the lender, this is functionally equivalent to the lender’s making payment to itself on behalf of the borrower to the extent of the amount forgiven. If the lender is also an employer, applying the principles of Old Colony Trust will result in discharge-of- indebtedness income to the employee. The loan remains a loan; it is the forgiveness that constitutes income. Claim of Right: money or property received subject to contingent repayment obligation is income; the contingency of the repayment obligation does not transform the receipt of income into a loan. “If a taxpayer receives earnings under a claim of right and without restriction as to its disposition, he has received income which he is required to return [that is, to report on his tax return], even though it may still be claimed that he is not entitled to retain the money, and even though he may still be adjudged liable to restore its equivalent.” North American Oil Consolidated v. Burnet. Money received under a claim of right, without restrictions as to disposition, is income; the contingent repayment obligation does not allow the receipt to be treated as a loan. Gains from Illegal business may be taxed. The Supreme Court’s 1961 decision in James v. United States holds embezzled funds includable in gross income, and it is the rule today. The James case suggests, and the IRS concedes, that repayment of illegal income entitles the taxpayer to a deduction. Advanced payment of money not yet owed is current income, e.g.: rent paid in advance generally constitutes gross income in the year it is received regardless of the period covered or the taxpayer’s method of accounting. Treasure Trove, to the extent of its value in USD, constitutes gross income for the taxable year in which it is reduced to undisputed possession- See Cesarini.

1. Inclusions §§ 71-86

1.1. Alimony, Separate Maintenance Payments and Property Settlements. §71(a) & §61(a)(8).

Under §71(a) and §61(a)(8), amounts received as alimony or separate maintenance payments are specifically includible in GI. §215 provides an above-the-line deduction for such payments actually made, in effect mandating a cash method of accounting for deduction purposes. A payment must meet the following requirements to constitute alimony: (1) The payment must be in cash (payment in property or services does not qualify as alimony); (2) must be received by “or on behalf of” the spouse or former spouse (cash payments to third parties may in certain circumstances qualify as alimony, e.g. mortgage payment, made by one spouse with respect to property owned by the other spouse, may be deductible as alimony; so does insurance premium payment on policy held by the spouse); (3) must be made under divorce or separation instrument (payments made pursuant to oral agreement, not reduced to writing, do not qualify); (4) the divorce or separation instrument must not designate the cash payment as one that is excludable for gross income of the recipient and nondeductible to the payor (absent such a provision, cash payments intended to be part of a property settlement agreement would be taxed as alimony); (5) if the spouses are legally separated under decree of divorce or separate maintenance, they must not me members of the same household at the time the payment is made; (6) the payor spouse must have no obligation to make payments for any period after death of the payee spouse (alimony is in the nature of the spousal support; payments continuing beyond death of the payee spouse smack of property settlements, for which no inclusion is required and deduction allowed; the statute is satisfied if such post-death liability is barred pursuant to local law; either the language of the divorce decree itself or condition imposed by state law can satisfy §71(b)(1)(D). §71(b)(1)(D) also requires that there be no liability to make any other payment as a substitute therefor.

1.1.1. Child Support. §71(c).

A cash payment must also avoid classification as child support in order to qualify as alimony. Child support payments reflect pre-existing parental support responsibilities for which code does not grant deduction (except dependents exemption); the continuing parent-children relationship, unlike the marital relationship, is not terminated by the divorce decree. Thus, a payment “fixed” as child support by the divorce or separation instrument is not alimony. The tax court held that where a divorce decree provided for $150 per week “alimony” payments to “continue to her death, remarriage or until the youngest child reaches 18 years, whichever first occurs,” and thereafter cease, such payments did not constitute alimony. This reflect a policy decision that spouses should be able to deny alimony status to payments that would otherwise qualify, but not create alimony out of payments that manifest too clearly a purpose other than spousal support. Under §71(c)(2), if payment is to be reduced upon contingencies related to a child, then amount of such reduction is treated as amount fixed as payable for the support of the children. The regulations identify two situations in which payments will be presumed to be reduced at a time clearly associated with the happening of a contingency related to a child of the payor: (1) where payments are to be reduced not more than 6 months before or after the date the child is to attain 18, 21, or the local age of majority; (2) where the payments are to be reduced on two or more occasions which occur not more than one year before or after a different child of the payor spouse attains a certain age between the ages of 18 and 24. The presumptions are rebuttable by showing that the time at which the payments are to be reduced was determined independently of any contingencies relating to the children of the payor.

1.1.2. Recapture of the excessively front-loaded alimony payments. §71(f).

Taxpayer-payor of alimony might have an incentive, b/c of significant income in a given year, to pay the much greater amount in the first year than in subsequent years in order to have a deduction capable of offsetting most of the income in such year. In order to counter such practices, §71(f) pr

108(a)(1)(E).

Discharge of up to $2 million of indebtedness secured by the taxpayer’s principal residence is excluded from income so long as the indebtedness is acquisition indebtedness. Taxpayer taking the exclusion must reduce correspondingly (but not below zero) his basis in his principal residence. The exclusion was passed by Congress to provide relief to taxpayer modifying their mortgages or short selling properties, or having deficiency waived in the foreclosure actions.

1.5.4. Purchase-Money Debt Reduction treated as price reduction. §108(e)(5).

Purchase Price Adjustment – §108(e)(5) codifies judicially created exclusion. When taxpayer buys a house (or any other property) under installment contract and before the price is fully paid he refuses to pay the balance b/c of some irregularities regarding the deal or the property itself, and then after the resolution the seller agrees to lower the balance, there is a cancellation of indebtedness; the courts however treat it as retroactive price reduction – no income for the taxpayer/purchaser and lower taxpayer/purchaser’s basis in the acquired property.

1.5.5. Discharge of Deductible Debt Exclusion. §108(e)(2).

If the forgiven debt stems from purchase of goods or services expense of which would constitute deductible as e.g. a business expense, etc. then amount forgiven is excluded from income to the extent of otherwise available deduction.

1.5.6. Disputed or Contested Debts

If the amount of a debt is disputed, settlement of the amount does not constitute a discharge of indebtedness. “[T]o implicate the contested liability doctrine, the original amount of debt must be unliquidated.” Presslar v. Commissioner. According to the Third Circuit in Zarin v. Commissioner, a liquidated debt, if unenforceable, would implicate the contested liability doctrine.

1.5.7. Cancellation of Debt as Gift or Compensation.

In certain contexts the cancellation of indebtedness can be an excludable gift. If parent lends money to a child and subsequently forgives the debt, the forgiveness of the debt would likely be considered a gift excludable under §102(a). In some circumstances cancellation may represent a form of compensation or some other form of payment and should not be treated as income within the meaning of §61(a)(12).

1.6. Damages.

Damage awards other than those specifically excluded under §§104 and 105 are taxed as the underlying item they are replacing would have been taxed. The question to be asked is “in lieu of what were the damages awarded?” Rayethon v. Commissioner. Damages awarded on account of lost profits would be taxable; a recovery for property damage would be measured against the basis in the property to determine the taxpayer’s realized gain or loss. To the extent excluded by §104(a)(2), damages on account of personal injury are gross income under §61. Punitive damages, other than those recovered in wrongful death action, are income. B/c punitive damages are included in income, injured party to a tort settlement may seek to allocate all amount to compensatory damages even though it sought punitive damages in its complaint. It is uncertain if IRS will respect the settlement agreement’s characterization of the damages; IRS is likely to scrutinize the agreement and dispute allocations resulting from settlement negotiations it does not consider to be arms-length. Amount of damages or insurance benefits corresponding the previously deducted medical expenses under 213, are included in income; to exclude them would result in double tax benefit to the taxpayer.