Fedeal Income Tax – Peroni (rperoni@law.utexas.edu); Spring 2010
UNIT 1: Basic Principles…………………………………………………………………………………………………………………………….. 4
Part 1: Introduction………………………………………………………………………………………………………………………………………. 4
IRS Structure and Government Rules………………………………………………………………………………………………………. 4
Courts: 3 Options, Where to File……………………………………………………………………………………………………………….. 4
Problems………………………………………………………………………………………………………………………………………………………… 5
Part 2: The FIT & The Time Value of Money (Present vs. Future Value)…………………………………………. 5
Problems………………………………………………………………………………………………………………………………………………………… 5
Part 3: Intro to Treatment of Income/Deduction Items; Business v. Investment Activities………. 6
Income Tax vs. Consumption Tax (The base)……………………………………………………………………………………….. 6
2 Alternatives for Taxation……………………………………………………………………………………………………………………….. 6
The 5 Steps [61, 62, 63]………………………………………………………………………………………………………………………………. 7
Basic Framework Governing Business & Investment Deductions…………………………………………………….. 8
Itemized Deductions with Floor tied to AGI & Phase-Outs (67, 68)…………………………………………………. 9
Special Rule for Medical Expenses [213]……………………………………………………………………………………………… 10
Problems……………………………………………………………………………………………………………………………………………………… 11
Part 4: Distinguishing Personal vs. Business/Investment Expenses [162, 212, 274]……………………. 16
P&T Summary on Business Expenses involving Entertainment/Amusement/Recreation……….. 17
Problems……………………………………………………………………………………………………………………………………………………… 18
Part 5: Treatment of Cap Expenditures; Gains/Losses from Dispositions of Property……………… 20
Gains and Losses: Basic Analysis and Basis Provisions…………………………………………………………………….. 20
§ 1245 Recapture………………………………………………………………………………………………………………………………………. 20
§ 1(h)(6) Recapture: Unrecaptured 1250 Gain………………………………………………………………………………….. 21
Problems……………………………………………………………………………………………………………………………………………………… 22
Part 6: More on Current Deductions vs. Capital Expenditures………………………………………………………… 29
263 v. 263A…………………………………………………………………………………………………………………………………………………. 29
The Obnoxious 1.263 Regs………………………………………………………………………………………………………………………. 29
Improvements vs. Repairs (+ Specific Examples)………………………………………………………………………………. 30
Pre-payments à Usually Capital Expense…………………………………………………………………………………………… 31
Takeovers, Advertising & Synergy [Indopco, AE Stanley, Wells Fargo]………………………………………… 31
Problems……………………………………………………………………………………………………………………………………………………… 33
Review of Unit 1 [Peroni Chart]………………………………………………………………………………………………………………… 36
UNIT 2: Tax Policy Considerations—Evaluating §1(h)……………………………………………………… 38
Incidence of Taxation: Who really pays?……………………………………………………………………………………………… 38
Horizontal Equity and Vertical Equity…………………………………………………………………………………………………. 38
Economic Efficiency & Neutrality………………………………………………………………………………………………………….. 39
Complexity vs. Simplicity…………………………………………………………………………………………………………………………. 39
Tax Expenditures………………………………………………………………………………………………………………………………………. 40
Progressive Rate Scheduling…………………………………………………………………………………………………………………… 40
Csbk problems @ 73………………………………………………………………………………………………………………………………….. 40
UNIT 3: The Outer Limits of Gross Income………………………………………………………………………………….. 42
Parts 1, 2, & 3: Tax Treatment of Windfalls [More 61]……………………………………………………………………… 42
Damage Awards (Punitive, Lost Wages, Pain & Suffering, Uninsured Med Expenses)………………. 42
Goodwill………………………………………………………………………………………………………………………………………………………. 42
Statute of Limitations [6501]………………………………………………………………………………………………………………….. 42
Treasure Trove & Cesarini………………………………………………………………………………………………………………………. 42
Bargain Purchases at Arms-Length………………………………………………………………………………………………………. 43
Problems……………………………………………………………………………………………………………………………………………………… 43
Part 4: Illegal and Unethical Activity [More on 162]………………………………………………………………………… 46
Allowances/Disallowances re: Illegal/Criminal Activity (+ Gambling, Treble) [162, 165]……… 46
Specific Rules for Drug Trafficking [§ 280E]……………………………………………………………………………………….. 47
Implications for Damage Awards and Legal Fees in Civil Court…………………………………………………….. 47
Claim of Right Doctrine & N. American Oil v. Burnet [1341]……………………………………………………………. 48
Problems……………………………………………………………………………………………………………………………………………………… 48
Part 5: Introduction to the Realization Requirement……………………………………………………………………….. 50
Corporate Taxation & Dividends: Info & Background……………………………………………………………………… 50
Dividend Summary [§§ 305, 307]…………………………………………………………………………………………………………… 51
Subdivisions of Property and Real Property………………………………………………………………………………………… 52
Lessee Improvements to Property and Realization [Helvering & 109]…………………………………………. 52
Property for Property Exchanges [Cottage & 1031]………………………………………………………………………….. 53
Problems……………………………………………………………………………………………………………………………………………………… 54
Part 6: Nonliquid Property received In-Kind as Compensation [§83]…………………………………………….. 57
Non-Lapse Restrictions à Value…………………………………………………………………………………………………………… 57
“Substantial Risk of Forfeiture” à Timing [+ 83(b) Election]………………………………………………………… 57
Summary: P&T Chart of §83……………………………………………………………………………………………………………………. 59
Problems……………………………………………………………………………………………………………………………………………………… 59
Part 7: Barter Exchanges of Goods and Services [RR 79-24]…………………………………………………………….. 60
Problem……………………………………………………………………………………………………………………………………………………….. 60
Part 8: Imputed Income from Self-Provided Services and Ownership of Consumer Assets……….. 61
Problems……………………………………………………………………………………………………………………………………………………… 62
Unit 4: In-Kind Consumption Benefits, Including Employee Fringe Benefits……. 63
Part 1: Exclusion for Certain Employer-Provided Meals and Lodging [§119]…………………………….. 63
Meals……………………………………………………………………………………………………………………………………………………………. 63
Lodging (Extra Requirement)………………………………………………………………………………………………………………… 63
Problem……………………………………………………………………………………………………………………………………………………….. 64
Part 2: Exclusion for other Employer Provided Fringe Benefits [§132]……………………………………….. 64
General Stuff……………………………………………………………………………………………………………………………………………….. 64
Peurifoy Doctrine………………………………………………………………………………………………………………………………………. 64
Summary Chart on §132………………………………………………………………………………………………………………………….. 65
Peroni Handout on §132………………………………………………………………………………………………………………………….. 67
Problems……………………………………………………………………………………………………………………………………………………… 73
Unit 5: Borrowing & Lending; Methods of Tax Accounting………………………………………….. 77
Part 1: Basic rules relating to Borrowing & Lending…………………………………………………………………………. 77
Straight Borrowing and Loan Repayment Transactions…………………………………………………………………. 77
Below Market Loans [§7872] (to Employees, to Shareholders, Gift)…………………………………………….. 77
Contingent Payment Obligations (e.g., Security Deposits)………………………………………………………………. 79
Problems……………………………………………………………………………………………………………………………………………………… 80
Part 2: Relief of Obligation to a 3rd Party as Income [Old Colony & 1.61-8(c)]…………………………. 82
Problems……………………………………………………………………………………………………………………………………………………… 82
Part 3: Transfer of Property to Satisfy Debt as a Realization Event……………………………………………. 83
Davis, Kenan, Int’l Freighting & Reg 1.83-6…………………………………………………………………………………………. 83
1041: Transfers Between Spouses/Incident to Divorce (Not prenuptially)………………………………… 84
1032: Company’s own stock and the realization requirement……………………………………………………….. 84
Problems……………………………………………………………………………………………………………………………………………………… 84
Part 4: Cancellation of Indebtedness Income and the §108 Exclusion………………………………………….. 86
§§ 108, (b)(5) Election, 1017 Limits, & “Attributes”: Permanent Exclusion or Deferral?…………. 86
Case Authorities: Kirby Lumber (Freeing of Assets), Zarin (Disputed Debt Doctrine)……………… 87
Problems……………………………………………………………………………………………………………………………………………………… 87
Parts 5 & 6: Tax Treatment of Mortgage Relief [Crane and Progeny]…………………………………………… 91
Terms and Basic Principles…………………………………………………………………………………………………………………….. 91
Case Authority: Crane, Woodsom, Est. of Franklin, & Tufts……………………………………………………………… 91
After-Acquired Nonrecourse Debt…………………………………………………………………………………………………………. 93
Judicial and Legislative Developments in Tax Shelter Area [465, 469]………………………………………… 93
Bifurcation: Separating Crane Gain from Cancelation of Debt Income………………………………………… 93
Problems……………………………………………………………………………………………………………………………………………………… 94
Part 7b: Accounting Methods and Bad Debt Losses…………………………………………………………………………….. 98
Worthlessness as a Realization Event [§§ 165 & 166]………………………………………………………………………. 98
Determining Dominant Motive in Loan (Duberstein)………………………………………………………………………. 99
Problems…………………………………………………………………………………………………………………………………………………… 100
Part 8: Interest, The Interest Deduction [163]
ture value
· P is the present value (or present amount)
· i is the interest rate (or discount rate) per period, and
· n is the period
Present value formula is basically the same thing, stated as the inverse: P = A/(1 + i)n
Problems
(1) $1,000. It’s what is owed by Samantha to the government, and that’s the amount the liability is for.
(2) If she defers for 5 years, $1610 is what she would have to pay at 10%. However, because interest has been waved, it is worth $1,000 in 5 years, and worth $620 now. Another way to think about this problem is that if you’re going to owe 1k in 5 years, setting aside $620 now would pay for it (assuming a constant 10% interest rate)
(3) Then it would cost her $1,000 up front, and the $1,610 in 5 years.
(4) That it’s important. Very important.
(5) No, there is still a cost. The present value is still lower than the future value. The more significant question is when the government would be willing to buy her out and how much they would give her at each point. Another important question is who bears the cost.
Conclusions and Analysis of Problems:
1) Basically, taking a deferral of taxes is worth more today because you get the money today rather than having to wait for it.
2) For tax planning you need to know the interest rates and the length of time payment can be deferred.
3) If the timeline for deferment is long enough, it can justify deferment in almost any case. Effectively, the longer it can be deferred the greater the after-tax discount rate, and the closer the deferral comes to acting as an exemption.
4) So timing is a big deal.
5) In problem 2 (and problem 5), the gov’t loses $380. Who pays this off? Arguably China paid for the 2001 Bush tax cuts, and then what happens when they cash in their chips?
a. Alternatively, other taxpayers have to cover it. But we either have to cut spending (fat chance), increase taxes, or deficit spend and finance abroad.
Part 3: Intro to Treatment of Income/Deduction Items; Business v. Investment Activities
Income Tax vs. Consumption Tax (The base)
S-H-S: 3 different economists that came up with this theoretical idea for defining income. Personal income may be defined as “income is equal to consumption plus savings,” or i = c + s (p. 37).
[Cash-Flow] Consumption Tax: Only taxes current consumption. How is this different? Compared to the above formula, here i = c. Savings is removed from the equation. Proponents say this is a simpler system, and since you’re not taxing savings it encourages people to save.
The current US system is really a hybrid. We started closer to a pure income tax system, and have slowly moved towards a consumption system. But what would happen if we were to not tax savings and move to a strict consumption tax system? Studies suggest we wouldn’t actually get a huge increase in savings. So it’s probably not worth making the switch.
2 Alternatives for Taxation
· Value Added Tax (VAT). Imposes a tax on a consumer, but it taxes the increase in value at each stage, which is refunded after the goods are sold. So the taxes are passed on to the buyer in each situation. Virtually no countries have moved to this as a system, and most countries use it as a supplement. Note that no government has ever survived after enacting a Value Added Tax. Because of all the additional steps of taxation, it’s higher in transaction costs.
· Wage Tax. Pretty much a strictly academic suggestion. Not a good idea. It’s simpler, but it exempts people living off of savings and punishes those who are working.
o Note that a wage tax uses as its base wages only, and so it doesn’t fit in with an income tax that taxes savings.
o This would overtax wage earners that make enough to save, but undertax wage earners that supplement their income from savings.
Taxation and Business Form
Simplest form: Sole proprietorship. It’s not a legal entity that’s generally recognized by state law. But it’s the form of business that most individuals use. Taxes are claimed on individual’s personal income return, but they use a different schedule. This is also the default rule.
The 5 Steps [61, 62, 63]
1) Gross Income (§61)
i. Defined in §61(a) as all income [with some exceptions].
ii. Specific Inclusion Provisions (§71-§86): These take an item of income that you would conclude is income in §61, then specifically tell you that it is. Tautological, but they also tell you that some other types aren’t income to be taxed.
iii. Specific Exclusion Provisions (§101-§145). These have mostly good news, but also give caveats like “If you do this, it’s taxable again”
iv. In this step, we do not take deductions into account.
2) Adjusted Gross Income (§62)
i. Gross income minus deductions listed
ii. “Above the Line” deductions are deductions that effect AGI. How do we know if it’s an Above the Line deduction? It’ll appear in §62. These are the ones that Congress favors. In other words, you get them whether or not you itemize or not.
iii. What if I can’t find the deduction or the code section that allows it? Then it’s not deductible!
iv. §62 doesn’t tell you what is and isn’t deductible, it only tells you which are deductible in this step once you have found another code provision that allows for the deduction. E.g., it classifies those deductions.
v. §62(c) requires reimbursement arrangements in businesses to have the employer check employees expenses (like w/ receipts).
3) Taxable Income (§63)
i. Definition: Adjusted Gross Income minus deductions allowed [by section 63]
ii. If you don’t itemize, taxable income is: AGI minus both the standard deduction and the deduction for personal exemptions (in §151, 152).
iii. §63(c) defines “the standard deduction.” SDs are arbitrary deductions set by Congress that it changes over time. E.g., $11.400 for couples that are ‘married filing jointly’ (or $5.700 for singles).
1. Of course, before you take it you want to see if you would have itemized deductions, and what they would be worth.
2. Note that the default rule is the SD. If you want to itemize, you have to elect to do so. And you would of course want to if you get more IDs than SDs.
