Income Tax Quirk – Fall 2013
I. Basics of Income Tax
a. Income taxes are designed to redistribute wealth by region and among classes.
b. Three Types of Income Tax:
c. What happens if you or your clients don’t pay/evade taxes?
i. § 7201. Attempt to evade or defeat tax.
1. Any person who willfully attempts in any manner to evade or defeat any tax imposed by this title or the payment thereof shall, in addition to other penalties provided by law, be guilty of a felony and, upon conviction thereof, shall be fined not more than $100,000 ($500,000 in the case of a corporation), or imprisoned not more than 5 years, or both, together with the costs of prosecution.
II. What is Income?
a. § 61. Defined as all income from whatever source derived.
i. Differing Opinions:
1. Gain derived or Accession of Wealth?
a. Income (Narrow): Gain derived from capital, from labor, or from both combined. Results in something of exchangeable value proceeding from the property, severed from the capital. Eisner v. Macomber.
b. Income (Broad): All “accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.” Commissioner v. Glenshaw Glass.
ii. What is included:
1. Wages, interest, dividends, rents, and gains from dealings in property. (§ 61) – Not exclusive.
2. Personal, living and family expenses (§ 262), unless otherwise provided, are not deductible.
3. Capital expenditures (§ 263)
a. Exceptions apply
4. Discharge of Indebtedness – § 61(a) (12) – If a loan is discharged for less than the amount owed, the borrower must include in income the amount of the discount.
a. The amount owed less amount paid to discharge debt.
b. Not considered income:
i. Gifts (§ 102)
ii. Tools of the Trade – Think: Workers tools.
iii. No cost to the employer (fringe benefits)
iv. Residual gain (“doesn’t feel like income”)
c. How is Income Taxed?
i. Is it income?
ii. Whose income is it? Who can be taxed?
iii. How do you value it?
1. Basis (§ 1001(a)-(b))
a. Determines the Fair Market Value of What you Received.
i. § 1001(a) à Amount Realized – Adjusted Basis = Gain/Loss
b. Cost (§ 1012)
c. Gift (§ 1015) – Carry-over basis; step in shoes of the person providing the gift and it is the basis at the time the person first acquired the property.
i. Sale of Gifted property: Dual-Basis Problem (Chirlstein pp 66)
1. If gift provided has gained value at time of conveyance then you use the carry-over basis (original cost) as your adjusted basis.
2. If gift provided has lost value at time of the conveyance then you use the FMV at time of conveyance as the adjusted basis.
3. If, at time of sale, the price is between the original cost and the FMV at time of conveyance…then no gain or loss.
4. If, at time of sale, the price is greater than the original cost…then use original cost as basis.
ii. Duberstein (pp 127)
1. Provides business associate a car and deducted as a business expense.
2. Rule: A gift is determined based on the donor’s objective intent and is generally a question of fact.
3. Intent here was to provide a business transaction and therefore taxable.
iii. Employer’s gift to employee (102(c))
1. There is no such thing as a gift from employer to employee and considered compensation.
2. Excluding de minimis fringes, see 132(e).
d. Inheritance (§ 1014) – Stepped-up basis; FMV at the time of the conveyance.
e. § 1011 – Defines Adjusted Basis
f. § 1016 – Defines Adjusted
2. Realized Gain
a. Realization event: A transaction – a sale, exchange, or other disposition for value – in which TP receives something materially different from that which he or she had before the exchange. To be materially different, the property received must confer different legal interests or entitlements on the TP. This is an easy standard to meet.
b. Eisner v. Macomber (pp 72)
i. Issue: is a stock dividend a realized gain or a capital investment?
1. Stockholder does not realize a gain in income because nothing was taken from the company and nothing was added to the value of the shareholder’s ownership in the company. – Later overruled.
2. Gain: Income derived from capital, from labor, or from both combined. Results in something of exchangeable value proceeding from the property, severed from the capital.
a. Tree and Fruit analogy.
c. Helvering v. Brun (Supp.)
i. Improvements to land in leasehold become realized gain to the lessor at the termination of the lease and repossession of the property by the lessor.
1. Later superseded by §§ 109 & 1019. No longer considered a gain until the property is sold…viewed as a capital investment.
d. Old Colony (pp 68) – Employer paid employee’s income taxes pursuant to a contract for salary + commissions only, not his total income from all sources.
i. TP argued that IRS could not impose a tax on a tax and, alternatively, that the payment was a gift.
ii. Rule: If someone pays your obligation, it is as if you had received the money as income.
e. Reuben’s Rule – (derivative suit) SH bringing derivative action on behalf of corporation against the corporation and the dominant SHs, saying they were looting company.
i. Corp’s payment in full settlement of claims against corp resulting in release of claims against TPs who were stockholders was not a taxable distribution of a dividend by the corporation to stockholder because company was pursuing it’s own ends.
ii. Issue: S/Hs received indirect/incidental benefit.
1. Court held this was not the same as Old Colony. Affix
ii. Are scholarships considered gifts or income if this § is repealed?
iii. If requirement of services, then taxable.
iv. Room and Board are always taxable.
3. Losses (§ 165)
a. Loss is limited to the Adjusted Basis (not the FMV).
i. Trade or Business & Transaction entered into for profit.
ii. Casualty gains and losses (i.e., fire, storm, etc.)
1. Limited to ONLY $100.
iii. Gambling losses (§ 165(d))
1. Can only be deducted from the winnings.
iv. §165(g) – Worthless securities (prob LTCL)
b. T/P Preference in losses
i. Ordinary Loss – Taken against ordinary income.
ii. STCL – Can offset STCG (taxed as ord. income)
iii. LTCL – Can offset LTCG
c. § 166. Bad Debts à (a) Business; (d) Non-Business
d. § 183. Hobby Loss – Amazon Execs bought Washington post.
i. Desguised for profit enterprise incurred for generating loss to offset ordinary income.
ii. Safe harbor: When gross income exceeds your deduction for:
1. Generally 3 of 5 years
2. Horses 2 out of 7
e. James v. U.S. (pp 172)
i. Employee embezzled approx. $740K between 1951 – 1954 and plead guilty.
1. Agreed to pay back $13,500 in 1958.
ii. Issue: Is the embezzled money income for the years it was embezzled.
1. Majority – Yes, embezzler has received value.
2. Dissent – No, treat like a loan and obligation to repay so no actualized gain and can tax when the obligation disappears. In this case, he would be taxed on difference between 740K and 13,500.
a. Consensual Recognition Test
b. Contra 165(c)(2): subsequent repayment of embezzled money qualifies as loss deduction.