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Taxation of Individual Income
Villanova University School of Law
Book, Leslie M.

Intro to Federal Taxation

Book

Spring 2013

I. Basic Structure of Federal Income Tax

Gross Income (§61)

LESS Above the line deductions (§62)

EQUALS Adjusted Gross Income (§62)

LESS The Greater of: (§63)

Itemized deductions plus deduction for personal exemptions (§151, 152)

OR

Standard Deduction plus deduction for personal exemptions (§151, 152)

EQUALS Taxable Income (§63)

TIMES Tax Rates (§1)

EQUALS Amount of Tentative Tax

LESS Tax Credits (§21-53)

EQUALS Tax Due

II. Approach to Determine Tax Liability

a. Determine all items of gross income

i. assess applicability of any exclusions or non-recognition provisions

b. Determine all deductions

i. assess applicability of any deduction limitations

c. Determine which, if any, deductions are above the line and subtract ATL deductions from gross income = Adjusted Gross Income

d. Decide whether to take standard deductions or itemized deductions

i. Basic standard deduction: $11,400 (joint return)

ii. Regarding itemized deductions: §§67 and 68 apply

e. Subtract greater of standard deduction or itemized deductions from adjusted gross income

f. Subtract personal exemptions = Taxable income!

g. Multiply taxable income by applicable tax rate

h. Subtract Tax Credits= Tax due! (this course ignores tax credits)

III. Example (p.9-20)

a. Calculating gross income:

i. Gross receipts from business (§61) $275,000

ii. Landscaping Services (1.61-2(d)(1)) $10,000

iii. Interest Income (§61(a)(4)) $19,000

iv. LT capital gain (§61(a)(3)) $15,000

v. Dividend (§61(a)(7)) $1,000

vi. TOTAL $320,000 Gross Income

b. Calculating adjusted gross income:

i. Above the line deductions: (§62)

1. Wages (§162(a)(1) $60,000

2. Office Supplies (§162(a) $20,000

3. Depreciation (§167/168) $10,000

4. TOTAL $90,000

ii. Adjusted Gross Income = Gross Income – Above the Line Deductions

1. AGI = $320,00 – $90,000 = $230,000 Adjusted Gross Income

c. Calculating Taxable Income:

i. Below the line deductions:

1. Management fee (§212) $1,000

2. Interest (§163(a)) $18,000

3. State income tax §164(a)(3) $8,000

4. Real Property tax §164(a)(2)$3,800

5. Charitable contributions $9,000 (§170)

6. TOTAL $39,800

ii. §67 provides that certain itemized deductions (ex. miscellaneous items) may not be deducted except to the extent that in the aggregate such deductions exceed 2% of the TP’s AGI

1. 2% of TP’s AGI = $4,600 (AGI here is $230,000 x .02= 4600)

2. $1,000 management fee (miscellaneous) does not exceed 2% of TP’s AGI

3. TP’s itemized deductions are reduced to $38,800 under §67

iii. 68 reduces itemized deductions if your AGI exceeds a certain amount (reduces benefit of itemized deductions for wealthy tax payers)

iv. Personal Exemptions

1. 151 provides that there will be a deduction for personal exemptions

a. §151(d) provides that the exemption amount is reduced by 2% for each $2,500 by which the TP’s AGI exceeds the threshold amount (adjusted for inflation)

b. $230,000 AGI does not exceed the threshold so not reduced under §151

2. §152 provides exemption for dependents

a. $3,400 is the current inflation-adjusted exemption for a child

b. $3,400 x two children x two parents (joint return) = $13,600

v. Taxable Income = AGI – itemized deductions – personal exemptions

1. Taxable income = $230,000 – $36,700 – $13,600 = $179,700 Taxable Income

d. Calculating Tax Due

i. §1 provides that a taxable income is determined according to the tax rate table

ii. Rev. Proc. 2006-53: Table 1 – Section 1 (a) – Married Individuals Filing Joint Returns and Surviving Spouses provides that if the taxable income is over $128,500 but not over $195,850, the tax is $24,972.50 plus 28% of the excess over $128,500. (FOR 2007—DIFF IN OUR BOOK)

1. Preliminary Tax = (Taxable Income – $128,500) x 28% + $24,972.50

2. Preliminary Tax = ($179,700 – $128,500=51,200) x .28 + $24,972.50 = $39,308.50

iii. However, §1(h) provides preferential tax rates for net capital gain:

1. $1,000 dividend + $15,000 long term capital gain = $16,000 net capital gain (51,200-16000=35,200)

2. $16,000 net capital gain is taxed at 15%

3. $24,972.50 + $35,200 x 28% + $16,000 x 15% = $37,228.50 Tax Liability

IV. Accounting/Timing Methods

a. Cash Method – TP must include items in income in the year in which the item is actually or constructively received. Inclusion is required whether the item of income is received in the form of cash, property, or services. Cash method TP generally deduct an item of expense when it is paid.

i. Actual Receipt – TP must include income when it is received.

ii. Constructive Receipt – An item of income is constructively received if it is made available to the TP, so that he could receive it, but he chooses not to receive it; relatively easily accessible.

iii. Cash Equivalent Doctrine- certain items have such a clear market value that you cannot deter reporting income.

iv. Promise to Pay- not generally considered cash actually received unless it meets 5 things: (unconditional, solvent person etc.)

b. Accrual Method – TP includes items of income when all the events have occurred that fix the right to receive the income and the amount thereof can be determined with reasonable accuracy. This is generally thought to be a more accurate measure of income and expense than cash method, so most companies use it. Income is included at the earliest of: date due, date earned, or date paid.

GROSS INCOME

I. Concepts and Limitations (Chapter 2)

a. Code – § 61; skim §§ 31, 85, 86

b. Reg – §§ 1.61-1, 1.61-2(a)(1), 1.61-2(d)(1), 1.61-2(d)(2)(i), 1.61-8(a), 1.61-9(a), 1.61-11(a), 1.61-14(a)

c. Definition of Income

1. Gross Income- §61(a)- “Gross income means all income from whatever source derived, including (but not limited to) the following items:

a. (1) compensation for services, including fees, commissions, fringe benefits, and similar items;

b. (2) gross income derived from business;

c. (3) gains derived from dealings in property;

d. (4) interest;

e. (5) rents;

f. (6) royalties;

g. (7) dividends;

h. (8) alimony and separate maintenance payments;

i. (9) annuities;

j. (10) income from life insurance and endowment contracts;

k. (11) pensions;

l. (12) income from discharge of indebtedness;

m. (13) distributive share of partnership gross income;

n. (14) income in respect of a decedent; and

o. (15) income from an interest in an estate or trust.”

2. Eisner v. Macomber – Court described income as “the gain derived from capital, from labor, or from both combined, provided it be understood to include profit gained through a sale or conversion of capital assets…”

3. Commissioner v. Glenshaw Glass- GG settled a lawsuit for $800,000, a portion of which it sought to exclude from gross income as punitive damages for fraud. Court held that money received as punitive damages must be included as gross income – it is an undeniable accession to wealth. Emphasized that Congress intended to exert “the full measure of its taxing power.” Eisner definition is still good law – Court just expands it here.

4. Cesarini v. United States – Ps, found money in a piano and tried to get it removed from their gross income. Court held this money was includable as gross income. П’s tried to argue that no reg. said they had to include it but because stat says “all income from whatever source” ct holds that taxpayer must pt to a specific statute that says its not included otherwise presumed gross income.

a. Reg. § 1.61-14 – Treasure trove – constitutes gross income for the taxable year in which it is reduced to undisputed possession.

5. Old Colony Trust Co. v. Commissioner –Пs taxes were paid by his company. Commissioner argued that this was additional income to Wood and thus taxable. Court held that the payment by an employer of the income taxes assessed against him constituted additional taxable income; they were in consideration of the servs rendered by the employee and was a gain derived by the employee for his labor.

a. Reg. § 1.61-14(a)- Another person’s payment of the taxpayer’s income taxes constitutes gross income to the taxpayer unless excluded by law.

6. McCann v. United States – Ps received an all-expense paid trip as a reward for wife’s job performance, but they did not include the value of the tri

s compensation for services in an amount less than the FMV, the difference between the FMV and the amount paid is gross income. (ex. give stock worth $400 for pmt of $100= $300 gross income)

II. INCLUDED IN GROSS INCOME

a. GAINS DERIVED FROM DEALINGS IN PROPERTY (CHAPTER 4)

1. Code – §§ 61(a)(3), 1001(a), 1001(b), 1001(c), 1011(a), 1012; skim §§ 1016(a)(1), 1016(a)(2), 1031(a)(1)

2. Reg – §§ 1.61-6(a), 1.1001-1(a), 1.1001-2(a)(1), 1.1001-2(a)(3)

3. Approach to Gains Derived from Dealings in Property:

a. Do we have a realization event? (e.g. sale or other disposition/trade etc.)

b. If yes, calculate Section 1001 gain realized

i. Gain= AR-AB

c. Is the gain recognized (i.e. included in gross income)?à §1001(c) except as otherwise provided the entire amount of gain or loss under this section shall be recognized

i. or is there an applicable exclusion?

a) Ex. Sale of principal residence, there is a “realization of income” but not a “recognition” because it is excluded under §121.

ii. or is there an applicable non-recognition/partial recognition provision/

d. If gain, what is the character of the gain? (ordinary? capital?)

4. § 61(a)(3) – gross income includes “gains derived from dealings in property”

5. Reg. § 1.61-6(a) – “gain is the excess of the amount realized over the un-recovered cost or other basis for the property sold or exchanged.”

a. Subdivided Property- if property is subdivided then the basis of the entire prop shall be equitably apportioned among the parts and gain realized/loss sustained on the part of the entire prop sold is difference btwn sale price and basis of each part.

i. Treat each sale as a separate transaction for gain/loss purposes

b. § 1001(a) – The gain from the sale or other disposition of property shall be the excess of the amount realized over the adjusted basis provided in § 1001

c. § 1001(b) – Amount Realized – equals the sum of any money received plus the FMV of any other property received

d. § 1012 – Basis equals cost “except as otherwise provided…”

i. Cost= your investment in the property

e. § 1016 – Adjusted Basis – requires a TP to adjust her basis in property to reflect 1) any recovery of her investment or 2) any additional investment made in the property.

i. Ex. recovery- depreciation deduction

ii. If you spend $10 on comic book and sell for $10 no gain/no tax—you’ve already been taxed on your purchase not going to double tax you if no gain.

f. GAIN = AMOUNT REALIZED – ADJUSTED BASIS

6. Impact of Liabilities:

a. Impact on Basis

i. A TP’s basis is clear when no liabilities encumber the property and the TP pays cash for the property.

ii. But this is complicated when the TP remains obligated to the seller for part of the purchase price, assumes a liability of the seller, takes the property subject to the liability, or borrows money from a third party.

iii. § 1012 provides that a loan is part of the TP’s cost in the property

b. Impact on Amount Realized

i. Reg. § 1.001-2(a)(1) – a necessary corollary to the inclusion of liabilities in basis is the inclusion in amount realized of those liabilities of the TP assumed by the purchaser.

ii. Liabilities of a seller, assumed by a purchaser, are included in the seller’s amount realized.

a) Ex. If seller receives $450,000 for her home and buyer takes over $30,000 mortgage then her amount realized would be $480,000 ($+liability discharged).