Federal Income Tax
Professor Morrison
Fall 2006
CHAPTER 1: Introduction
A. The Constitution and the Income Tax
A. Tax Payers and Tax Rates
Progressive Rate System: Income-tax rates for individuals and corps have almost always been progressive—i.e., tax on a high income is a larger percentage of the income than the tax on a lower income.
i) Proportional (not used): A tax on the same percentage of all income, i.e., 20% of all income. (A-100K, B-20K, after tax A would have 80K, while B would have 16K, A still has 5X the amount of income as B)
ii) Regressive (not used): A tax on the larger percentage of lower income than of higher incomes, i.e., a tax of 20% of the first 100K, plus 10% of the amount of income over 100K.
*After the progressive rate system is implemented, as a general rule, if A’s before tax income is higher than B’s before tax income, A’s after tax income will also be higher than B’s.
B. Tax-Rate System: The tax-rate schedules of § 1 apply to the taxpayer’s taxable income. Taxable income is computed by subtracting from the taxpayer’s gross income (See § 61) from any allowable deductions.
§61 Gross Income Defined—encompasses only the gross amount of wages, dividends, interest, rent, etc…received by the taxpayer undiminished by any deductions attributable to such income
HYPO: (Progressive Structure) A, single male, has $100K of taxable income.
Rate schedule—Over $53,500 but not over $115, 000…is taxed at $12,107, plus 31% of the excess over $53,500.
•$12,107 is automatic
•With 100K, A is $46,500 over $53,500. This amount is taxed at 31%
(46,500 x .31) and equals $14,415 of additional tax.
•Tax Liability of A: $26,522 ($12,107 + $14,415)
•A’s marginal tax rate is 31%
•A’s average tax rate is 26.522% (divided by 100K)
HYPO: A earns $50K a year, for ten years. B earns nothing in yrs. 1, 3, 5, 7 and 9 and 100K in yrs 2, 4, 6, 8.
Rate Schedule—0% of the first $25K a year of income plus 10% of the amount by which the taxpayer’s income exceeds $25K
•A, each year is taxed $2500. $25K for ten years
•B, is taxed nothing in 1,3,5,7,9. But in years 2,4,6,8,10 is taxed at a rate of 10% on the $75K. $7500 per year, or $37,500K total for years 2,4,6,8,10
D. Tax Controversies: Taxpayers are required to file returns and pay the taxes due. If there is a controversy w/ reportable income, the following procedure is implemented:
(1) Action by the IRS: Most are settled by agreement b/t the taxpayer and Revenue Agent. If not, the IRS will send a 30-day letter explaining its determination/position.•If no action is taken w/in 30 days by the taxpayer (a written protest or payment), a deficiency notice, or 90-day letter will be sent.
•Taxpayer now has 90 days to pay up or file a petition w/ tax court. If neither is done, the IRS will assess the tax and demand payment by certain date, and then seize assets if that order is not complied with.
(2) Action by the Taxpayer: Possible avenues for the taxpayer in a dispute. Taxpayer should, depending on sum of the dispute, do research to determine the best possible course of action and/or venue.
(a) Contest liability in tax court (cannot be availed if taxpayer has paid the tax in full, b/c tax court is Art. I court, only having deficiency jxd) No jury, tax-court judge. Appeal would go to the circuit court of appeals, then to SC, which rarely grants cert. in tax cases.
(b) If you have money, pay it, then sue for refund in the federal
district court. Probably good if you are weak on the Code. You will get jury.
(c) Pay money, sue for a refund in court of fed. claims, appeal to the federal circuit in D.C.
CHAPTER II: The Concept of Income
A. Basic Tax Computations
*Taxable Income: Calculated by subtracting the taxpayer’s deductions from gross income. (If gross income is 200K, and deductions are 50K, taxable income equals 150K)
(1) Individual Taxpayers: Calculations of taxable income involves two steps
(a) Deductions (from § 62—above-the-line deductions) are subtracted from gross income, yielding a figure called adjusted gross income (AGI) *§62 encompasses all business expenses (except most employee business
expenses), investment expenses pertaining to rents.
(b) Next, the taxpayer subtracts deductions for personal exemptions (not tied to actual outlays) and either (i) itemized deductions or (ii) standard deduction from AGI to determine taxable income. (If your itemized exceeds your standard, you deduct the itemized. If your itemized is less than the standard, you deduct the standard)
*All taxpayers will deduct their above-the-line deductions and their personal exemptions.
*Itemized deduction (§63d): deductions other than above-the-line deductions, personal exemptions and the standard deductions, i.e., charitable contributions, home mortgage interest, state and local income taxes, property taxes
*Standard deductions: Statutory Amount (usually 6K for married couple, 3K for individual)
(2) Child Tax Credits (§24) : Low and middle income parents are allowed, as well as their personal exemptions, credits for their US citizen children under the age of seventeen, living w/ taxpayer
•$1,000 for each qualifying child
•Phased out if income exceeds $110K (married filing joint return) or $75K (individual). For each 1K over the statutory amount, the total credit is reduced by 50$.
•Hypo: 2 qualifying kids, income is less than $110K, $2,000 credit
If their income is 115,200, their credit is reduced by $1,100, to $900.
HYPO: Married couple w/ two dependent children has $60K gross income and the following deductions:
(1) $2K loss on the sale of business property
(2) $8K mortgage interest on principal residence
(3) $1K charitable contribution
(4) $4K state and local income taxes
(5) $2K property taxes on principal residence
*(1) is the only above the line deduction (§§ 62(a)(1) & (3), which totals 2K, therefore their AGI is $58K. They will next subtract itemized deductions and personal exemptions
*(2)—(5) are itemized deductions totaling $15K. (58-15=45)
*Personal deductions of 2K each for themselves and kids, totaling $8K. (45-8=35)
•TAXABLE INCOME: $35K.
*Rates: $1,400 plus 15% in excess of $12K. Excess $21K at 15% equals $3150
•TAX LIABILITY: $4550 ($1400 + $3150)
From this amount the couple subtracts their $960 credit for child-care expenses and a $2,000 child tax credit, yielding a tax of $1,590
(An above the line deduction will be worth more to many taxpayers than an identical itemized deduction would be worth. b/c only those whom total itemized deduction exceed their standard deductions will claim itemized deductions on their returns. You always claim above the line deductions).
HYPO (page 38): A, age 67, has 40K gross income, 4K of deductions from rental property, 1K of property taxes on her home, and $2650 of state income taxes.
•AGI: {§ 62} $36K (Above the line deductions-$4K subtracted from gross income-$40K)
i) Itemized Deductions: $3650
ii) Standardized Deductions: $5750 ($3K + $2K + $750)•Standard Deduction of $3000 (see §63(c)(2)(C)) for an individual who is not married and who is not a surviving spouse or head of household.•Over 65 add-on of $750 (see §63(f)(3) this is only for standard deduction) for person whom is not married and is not a surviving spouse. You get $750 instead of $600.
•Personal Exemption: $2000 (see §151(d)(1))
•Taxable Income: $30250 (Gross income, $36K, minus deductions allowed by §63, $5750.) Taxable Income defined in §63.
B. Accessions to Wealth: What is considered income
Gross income- realized accession to wealth over which a taxpayer has control
1. In General: No single conclusive criterion has been found to determine in all situations what is a sufficient gain to support the imposition of an income tax.
Commissioner v. Glenshaw Glass Co.
I: Does $ received as punitive damage count as gross income under §61 which must be reported? Glenshaw didn’t report $324K punitive portion of settlement as income
H: Yes. Taxable income. Undeniable accessions to wealth.
R: Court gives a liberal construction to this broad phraseology in recognition of the intention of Congress to tax all gains (“accessions to wealth”) except those specifically exempted by statute of regulation. (This is a broad statement that probably shouldn’t be taken to an extreme.)
Eisner v. Macomber
I: Does the distribution of a corporate stock dividend (as opposed to a cash dividend, which is obviously income) constitute a realized gain to the shareholder
H: Distributions is not a taxable event, this tax statute violates 16th Amend.
R: Taxpayer received nothing out of the company’s assets for his separate use and benefit. Ms. Macomber never realized any income. In order to realize, Ms. Macomber would have had to sell. Court describes income as the gain derived from capital, from labor, or from both combined.
**T. Reg. § 1.61—14 provides that treasure trove (property found by the T) is income in the year when it is reduced to undisputed possession….(find $20 in hallway, cash in a piano)
**What if C had found a valuable object rather than cash? If C had found the piano is worth $500K, it is not income until it is realized/sold. $10 basis in a $500K piano—gain would be the difference ($499,990)
PO: M renders services to widow, and never charges her. M, with intention of moving to
St. Louis, meets w/ widow, whom gives him $300.
•As no payment for services was ever discussed, M will argue that it is a gift or windfall, not tied to any particular service rendered. The IRS will say compensation for services.
HYPO: C receives a $500 Fed. income-tax refund. Not includable in gross income.
Realization and Recognition: A realized gain is includable in gross income only if it is also recognized. Except as provided in the Code, the entire amount of any realized gain or loss on the sale or exchange of property is recognized for tax purposes. (Read: If not recognized, not taxable)
•Congress has provided for non-recognition of gain (or loss) in some situations § 1001(c). The rationale being that a taxpayer who has engaged in this class of transactions has not changed the nature of his investment sufficiently to warrant a tax being imposes on his realized gain.
•An example of a non-recognition provision is §1031, under which gain from the exchange of business/investment property for other business or investment property of “like kind” is not recognized), corporate mergers.
c. Bargain Purchases; Employee Discounts: When a taxpayer purchases property at arm’s length for less than it is worth, he is ordinarily not taxed on the fruits of his astute dealing. Since the property’s basis is its cost, however, the profit on the advantageous purchase may enter into gain on a later sale of the property.
•In contrast, the bargain element may be taxed immediately if a bargain purchase for less than FMV is not an independent arm’s length transaction, but reflects an extraneous objective, such as the seller’s desire to confer an economic advantage on the buyer.
HYPO: House is for sale: $75K. House is appraised at $100K. Not income per §61 to the buyer.
HYPO: M gives S $10K after bad legal advice which cost her $10K.
•Not income to S. S is just being returned to original position. (This payment served only to restore S’s impaired capital—see Tax Free Recovery of Capital)
3. Compensation for Services/Payment of Taxpayer’s Expenses
Old Colony Trust Co. v. Commissioner
F: Wood, President of American Woolen, was paid salary and commission of $1M in 1918. Company agreed to pay Wood’s fed. income tax of $680K. (Amendment goal was to make sure that tax paid was at the highest progressive rates).
I: Did the payment by the employer of the income taxes assessable against Wood constitute additional taxable income to Wood?
H: Payment by employer constituted income to employee, and Wood (employee) is taxable on the $680K.
R: Voluntary payment was irrelevant, and this was not a gift. Wood’s debt was discharged, making him wealthier. The transaction was in the nature of compensation for services, which is explicitly taxable under §61(a)(1)
Wood’s argument that the $ was never paid to him, it was paid to the IRS directly, was rejected. (Still income although you don’t receive cash in hand)
– Other argument was that there would be no resolution, the company would keep paying the tax on paying the tax for the employee (never ending cycle).
*OLD COLONY PRINCIPLES:
(1) Form of Income does not matter
(2) Income may include discharge of obligation to 3rd party (A’s payment of B’s obligation is tantamount to a payment from A to B)
(3) In employment context, gift argument is last-ditch effort, that probably won’t work. B/c it is still based on something he is still doing for the company (performance).
HYPO: C transfers property w/ an adjusted basis of $40 and a value of $100 to D in exchange for $70 cash and D’s payment of C’s $30 debt to E. What result to C and D?
