Federal Income Taxation – Professor Peroni – Fall 2013
Intro to FIT/Overview of Basic Principles (Including the Capitalization Doctrine)
Basic Principles/Introductory Materials
I. Types of Tax Systems
A) SHS Income Tax System: Taxes consumption + savings. In effect, taxes a person’s “net income” or “profit”—gross receipts reduced by the cost of producing those receipts.
i. Deductions: Business/investment expenses are always deductible. Personal consumption is never deductable.
ii. Borrowing: Borrowed dollars are not taxed.
a. Rat: Assets have gone up by borrowing, but so have liabilities. Liability in debt cancels out the gain.
iii. No “Realization Requirement”: A true SHS system doesn’t require realization. All changes in income are taxed under a “mark-to-market” system.
a. EX: Changes in stock values are “marked-to-market” at the end of each year. Stockholder has income or loss, regardless of if he did anything with the stocks.
iv. Policy: Allocates tax burden based on ability to pay; fairest way to allocate.
B) Cash-Flow Consumption Tax: Taxes consumption only. Tally up all total income, but any savings = deduction at end of year. Savings are not taxed until they are consumed.
i. Policy: Encourages saving.
ii. Borrowing: To be theoretically consistent, must either include borrowed funds in the tax base (if used for consumption) or must disallow interest deductions.
a. Rat: Have to get the timing right. When you consume, you are taxed.
iii. Possible (likely) that any implemented CFC tax will be impure.
iv. Peroni: Likes CFC theories, but the politics suck
C) Hybrid Tax (Current American System): Combination of SHS and CFC.
i. Deductions: Business/investment expenses usually deductible, but not always. Personal expenses usually not deductible, but sometimes are (ex: mortgage stuff, charitable contribution, etc.).
D) Sales Tax: Income/consumption are not taxed. Only purchases are taxed.
i. Value Added Tax: A type of sales tax, collected in stages. Looks the same to ultimate consumer b/c he pays all the taxes at the end, but each person along the way pays a tax until they resell.
a. EX: VAT Rate is 10%. X sells to Y for 400; Y is taxed 40. Y sells to Z for 500; Z is taxed 50. So, 50 goes to the government, and a 40 dollar refund goes to Y. This continues until the last person buys it, then he bears the entire tax burden and the seller to him is refunded.
ii. Moving to a Sales Tax? Some folks have suggested a move to a national sales or VAT to replace the income tax.
a. Problems with Moving to a Sales Tax
1. Very regressive, unless you have all sorts of exemptions.
2. Rate needed to replace income tax would be 30%, which would result in a HUGE price increase in the cost of goods/services
3. Would interfere with state sales tax, which is important source of income for them.
E) Payroll/Wage Taxes: Only labor income (wages + self-employment income) are taxed.
i. EX: Social Security and Medicare taxes
II. Courts for Tax Issues
A) Tax Court: Article I court. Judges have limited terms and are tax specialists.
i. No Pay Before you Go: Taxpayer cannot pay the disputed tax before he goes to court here. If you end up losing, you owe the tax + interest.
a. Rat: Tax court only deals with deficiencies. Once you’ve paid, there’s no longer a deficiency.
ii. Appeals: Go to 1-11th Circuit or D.C. Circuit.
a. Goes to whichever circuit in which the taxpayer resides.
iii. Precedent Followed: Tax court doesn’t have to follow any Circuit’s precedent, but they generally choose to follow the Circuit court from where the taxpayer resides.
iv. Time Limit: Must file within 90 days of notice.
B) District Court: Article III court. Judges are generalists.
i. Pay Before You Go: Taxpayer must pay the tax before challenging it in district court.
a. If you win, can get a refund + interest.
ii. Appeals/Precedent: Circuit Court covering that district court.
iii. Jury Available: Can have a jury trial here (can’t in other two).
C) Court of Fed. Claims: Article III court. Judges are specialists, but not always in tax (some specialists in IP or Gov K’s).
i. Pay Before You Go: Taxpayer must pay the tax before challenging it in district court.
a. If you win, you get a refund + interest.
ii. Appeals/Precedent: Federal Circuit.
iii. Note: Sometimes worth filing in Fed. Claims simply b/c Federal Circuit may have better precedent than your home circuit.
III. Non-Code Sources of Tax Law
A) Regs: Have the force and effect of law. Hard to challenge—must be unreasonable to be overturned.
i. Congress’ Reliance on Regs: Often, Congress will pass a very broad law into the Code and let the IRS flesh it out with regs.
B) Notices: Issued by IRS. Act as stop-gaps for regs when Congress hastily passes legislation. Basically say, “Here is what the regs are going to say when they come out.”
i. Taxpayer Reliance: Taxpayers can rely on notices until the corresponding regs come out.
C) Revenue Rulings: Issued by IRS. Take a factual situation and apply laws to those facts.
i. Weight: Binding on IRS until ruling is revoked. Not binding on taxpayers or courts. Courts may follow if they feel the analysis is proper.
a. But Note: People/courts usually follow them b/c they say what the IRS thinks.
D) Rev Procs: Procedural equivalent of Rev Rulings. Don’t cover substantive issues.
E) Private Letter Rulings: Issued by the IRS to an individual taxpayer.
i. Weight: Only binding on the IRS with respect to that one taxpayer. Not binding on people or on courts.
a. But Note: Other people frequently rely on them b/c they tell what the IRS thinks.
ii. Accurate Facts Req: To be binding on the IRS, the taxpayer must have accurately represented the facts.
iii. Downside to Asking for a PLR: Higher transaction costs, plus the IRS will be looking at you more closely if you get a negative ruling.
F) Technical Advice Memoranda (TMA’s): Internal IRS documents. Can be requested by taxpayer, but IRS must initiate the process.
G) Closing Agreements: Taxpayer and IRS close on an agreement to do certain things. The CA is not released to the public.
i. Weight: Binding on both the IRS and the taxpayer.
IV. Presumption of Taxability
A) Assume income is taxable unless a code provision excludes it.
V. Presumption of Nondeductability
A) If you can’t find code section that allows deduction for something, then it IS NOT DEDUCTIBLE.
B) Rat: Anything not listed for a deduction is personal consumption.
VI. Time Value of Money
A) Definition: Dollar today worth more than dollar in the future.
B) Significance to FIT: Tax planning often involves taking advantage of the time value of money. Deferring payment of taxes reduces the effective rate because of the time value of money.
C) Deferral = Interest-Free Loan: A tax deferral essentially works as an interest-free loan. For all that time you can defer, you can earn interest on that money that you would have used to pay tax. The longer you can defer, the closer the defe
fees, commissions, fringe benefits, and similar items;
ii. Gross income derived from business;
iii. Gains derived from dealings in property;
iv. Interest;
v. Rents;
vi. Royalties;
vii. Dividends;
viii. Alimony and separate maintenance payments;
ix. Annuities;
x. Income from life insurance and endowment contracts;
xi. Pensions;
xii. Income from discharge of indebtedness;
xiii. Distributive share of partnership gross income;
xiv. Income in respect of a decedent; and
xv. Income from an interest in an estate or trust.
C) Catch All–“All Income from Whatever Source Derived”: Even if something doesn’t fall under one of the 15 things above, can still be GI.
i. Because of this language, basically any income must be included unless a specific provision excludes.
ii. Note: This clause defines income circularly by using the word “income.”
D) Inclusion Provisions (§§ 71-86): Confirm certain specific things as GI.
i. EX: Nonliquid property received in kind as compensation.
ii. Sometimes Act as Exclusions: Some includable things may actually be excluded in certain situations by §§ 71-86.
E) Exclusion Provisions (§§ 101-145): Exclude things from GI. Section 61 refers to these provisions with its “Except as otherwise provided” language.
Strictly Construed: Usually strictly construed.
a. Rat: Legislative grace that these provisions even exist.
ii. Random Exclusion #1–Gain from Sale of Principle Residence (§ 121)
a. Rule (seller): Seller may exclude from GI all or part of his gain from the sale of real property that he’s used as a principle residence for at least 2 out of the last 5 years.
1. This is not a deferral—this is permanent.
2. Amount of Exclusion—
· 250k if you’re single
· 500k if you’re married filing jointly.
· No cliff effect: If you go over the amount, you still get the first 250k/first 500k excluded
· No index for inflation: These are the amounts. You don’t have to use the Rev Proc to get more recent amounts.
3. Character of remaining gain: Residence is capital asset, so whatever of the gain isn’t excluded by § 121 is probably LTCG.
b. Rule (purchaser): 121 does not affect purchaser’s basis in the residence. Your basis is still the full tax-cost amount under § 1012.
iii. Random Exclusion #2–“Small Business Stock” Exclusion (§ 1202)
a. Rule: Seller may exclude from GI 50% of the gain from sale/exchange of qualified small business stock held for more than 5 years.
b. BUT—28% Rate: The remainder of the gain is taxed at a 28% — don’t get most preferential rate.
1. So, the effective rate here is 14%–50% taxed at a 28% rate
iv. Random Exclusions #3–Some Other Exclusions: § 102 gift exclusion, § 108 CoD income exclusion
a. These two are covered more below.
