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Federal Income Tax
Washington & Lee University School of Law
Drumbl, Michelle L.

Professor Michelle Drumbl

Federal Income Taxation of Individuals, Spring 2014

1. Gross Income

16th Amendment allows Congress to “lay and collect taxes on incomes, from whatever source derived, without apportionment among the several states and without regard to any census or enumeration.”

Definitions of Income:

· Haig-Simons Definition of “income”: Income = Consumption + Change in Wealth

o NOT the definition of income for tax purposes

· § 61 definition: “all income, from whatever source derived . . .”

o Includes income from international sources

o DOES NOT include “paper gains” such as increases in the value of stock b/c not “realized”

§ Some income also may not be counted because it is not “recognized” (different from realization) (e.g. deferrals for some types of income)

Eisner v. Macomber (1920)

Supreme Court

Facts: Standard Oil of California, a publicly traded company, declared a 50% stock dividend. Macomber, the taxpayer, owned 2,200 shares of Standard’s stock. She received 1,100 additional shares pursuant to the distribution, bringing her total ownership to 3,300. Because all Standard shareholders participated proportionately in the stock dividend distribution, the receipt of additional shares did not affect her proportionate interest in Standard’s assets or profits.

Question: Does the taxpayer have gross income from the receipt of 1,100 additional shares of Standard stock pursuant to the distribution?

Holding: No.

Rule: In order for a taxpayer to have income from property, the taxpayer must receive some right or asset that is sufficiently distinct from the property (i.e. “realization” of the profits).

· Income = “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”

Reasoning: Although the Income Tax Act of 1916 expressly included stock dividends as part of “net income” (the statutory predecessor of gross income), a stock dividend was not within the meaning of “income” as used in the Sixteenth Amendment. A stock dividend did not alter the pre-existing proportionate interest of the stockholder or increase the intrinsic value of his holding or of the aggregate holdings of the other stockholders, but merely increased the number of shares, with consequent dilution of the value of each share. The stockholder receives nothing from the company’s assets for his personal use and benefit—everything he has invested remains the property of the company, subject to business risks that may result in wiping out the entire investment.

Commissioner v. Glenshaw Glass Company (1955)

Supreme Court

Facts: (two consolidated appeals)

· Glenshaw Glass sued Hartford-Empire, its supplier, seeking treble damages for injury to its business based on violation of federal antitrust law. The parties settled the dispute for $800,000. It was ultimately determined by the Tax Court that $352,529.94 represented payment for punitive damages for fraud and antitrust violations. Glenshaw did not report this portion of the settlement as income for the tax year involved. The Commissioner determined a deficiency claiming as taxable the entire sum, less only deductible legal fees.

· Goldman Theatres, a Delaware corporation operating a theater in Pennsylvania, sued Loew’s, Inc., alleging a violation of the federal antitrust laws and seeking treble damages. It was determined that a violation had occurred, and that Goldman had suffered a loss of profits equal to $125,000 and was entitled to treble damages amounting to $375,000. Goldman reported only $125,000 as gross income and claimed that the $250,000 balance constituted punitive damages that was not taxable. The Tax Court agreed, and the Court of Appeals affirmed.

Question: Must money received as exemplary damages for fraud or as the punitive 2/3rds portion of a treble damage antitrust recovery be reported by a taxpayer as gross income under 61(a)?

Holding: Yes.

Rule: Income = (1) undeniable accessions to wealth, (2) clearly realized, and over which the taxpayer has (3) complete dominion or control

Reasoning: Eisner’s characterization of income as “the gain derived from capital, from labor, or from both combined” was distinguishable because in that case the court was endeavoring to determine whether the distribution of corporate dividends constituted a realized gain to the shareholder (i.e. distinguishing gain from capital). Here, there were undeniable accessions to wealth, clearly realized, and over which the taxpayers had complete dominion. The mere fact that the payments were extracted as punishment for wrongdoing did not detract from their character as taxable income, whether or not such payments constituted punitive damages or compensated for damages actually incurred.

Cesarini v. United States (1969)

District Court, Northern District of Ohio

Facts: Plaintiffs bought a piano for their daughter for $15.00 at a garage sale in 1957. In 1964, while cleaning the piano, they discovered $4,467 in old currency, which they reported on their 1964 joint income tax return as ordinary income from other sources. In 1965, plaintiffs filed an amended return with the District Director of Internal Revenue in Ohio, eliminating the sum of $4,467 from the gross income computation and requesting a refund of $836.51, the amount allegedly overpaid. In 1966, the IRS rejected the refund claim entirely and plaintiffs filed suit, arguing three alternative theories: (1) that the money found in the piano was not includable as gross income under section 61, (2) that even if the retention of the money constituted realization of ordinary income under section 61, it was due and owing in 1957 and the SoL provided by section 6501 had elapsed, and (3) that if the treasure trove money was gross income for 1964, it should be taxed as capital gains under 1221, not ordinary income.

Question: Is treasure trove taxable as ordinary income under section 61? Were plaintiffs entitled to a refund?

Holding: Yes. No.

Rule: Treasury Reg. section 1.61-14. Income from all sources is taxed under section 61, unless the taxpayer can point to an express exemption.

Treasure Trove:

· 1.61-14

o Distinguishing Treasure Trove from Bargain Purchase:

§ Treasure trove must be included in GI immediately

§ Bargain purchase must be included in gross income only when sold

2. Barter Exchanges, Illegal Income, and Imputed Income

Treasury Reg. 1.61-2(d)(1): Except as otherwise provided in paragraph, if services are paid for in property, the fair market value of the property taken in payment must be included in income as compensation. If services are paid for in exchange for other services, the fair market value of such other services taken in payment must be included in income as compensation. If the services are rendered at a stipulated price, such price will be presumed to be the fair market value of the compensation received in the absence of evidence to the contrary.

Revenue Ruling 79-24 (barter income)

· Hypothetical Facts: (1) Lawyer performs legal services for painter, who in return paints lawyer’s personal residence. (2) Owner of apartment building provides rent-free use of an apartment for six months in return for a work of art created by professional artist.

· Applicable Code/Regulation: IRC 61(a)/1.61-2(d)(1)—if services are paid for other than in money, the fair market value of the property or services taken in payment must be included in income. If the services were rendered at a stipulated price, such price will be presumed to be the fair market value of the compensation received in the absence of evidence to the contrary.

· Holdings: (1) The fair market value of the services rendered by the lawyer and the housepainter are includable in their gross incomes under section 61 of the Code. (2) The fair market value of the work of art and the six months fair rental value of the apartment are includable in the gross incomes of the apartment-owner and the artist under section 61 of the code.

o *Revenue rulings are not entitled to Chevron deference, but may receive Skidmore deference according to their persuasiveness

Imputed Income

· Income resulting from the taxpayer’s personal efforts—not taxable

o Example: the value of labor when an individual renovates their own house, performs repairs on their own car, growing garden vegetables, etc.

Illegal Income

James v. United States (1961)

Supreme Court

Facts: James, a Union official, embezzled over $738,000 over a period of 4 years from his employer union and from an insurance company doing business with the union. James failed to report these amounts in his gross income during those years, and was convicted for willfully attempting to evade the federal income tax for each of the years. He was sentenced to 3 years’ imprisonment.

Question: Must embezzled funds be included in the gross income of the embezzler in the year in which the funds are misappropriated? (i.e. are unlawful gains includable in gross income?)

Holding: Yes.

Rule: Both lawful and unlawful income is includable as gross income.

· When a taxpayer acquires earnings, lawfully or unlawfully, without the consensual recognition, express or implied, of an obligation to repay and without restriction as to their disposition, he has received income

Reasoning: The honest taxpayer should not see his lawful income taxed while the embezzler’s or extortionist’s income remains immune. When Congress amended the Income Tax Act in 1916, it intentionally removed the word “lawful” in its description of gains that were taxable as net income, indicating Congress’ intent to tax income derived from both legal and illegal sources.

Dissent: An embezzler has no “claim of right” to the funds he embezzles; forcing the embezzler to pay taxes on income to which he has no legal claim merely allows the IRS to place a lien on funds that rightly belong to the embezzler’s victim (thus subordinating the victim’s claim to its own embezzled money). Embezzlers should pay taxes on their income only if the embezzler’s victim condones or forgives part of the indebtedness.

· Glenshaw Glass definition of income applies even to illegal income

· Repayment of illegal income entitles the taxpayer to a deduction (Rev. Rul. 65-254)

o Treats embezzled funds like loans, which are not taxable

3. Compensation/3rd Party Payments

Treasury Reg. 1.61-2(a)(1): Wages, salaries, commissions paid salesmen, compensation for services on the basis of a percentage of profits, commissions on insurance premiums, tips, bonuses (including Christmas bonuses), termination or severance pay, rewards, jury fees, marriage fees and other contributions received by a clergyman for services, pay of persons in the military or naval forces of the United States, retired pay of employees, pensions, and retirement allowances are income to the recipients unless excluded by law.

Treasury Reg. 1.61-2(d)(2)(i): . . . if property is transferred by an employer to an employee or if property is transferred to an independent contractor, as compensation for services, for an amount less than its fair market value, then regardless of whether the transfer is in the form of a sale or exchange, the difference between the amount paid for the property and the amount of its fair market value at the time of the transfer is compensation and shall be included in the g

t gross income under most circumstances

IRC 102: Gifts and Inheritances

· (a) General Rule: gross income does not include the value of property acquired by gift, bequest, devise, or inheritance

· (b) Income: subsection (a) shall not exclude from gross income:

o (1) income derived from any property referred to in (a); or

o (2) where the gift, bequest, devise, or inheritance is of income from property, the amt. of such income

· (c) Employee Gifts: (a) does not exclude from gross income any amt. transferred by an employer to an employee

o *Note 1: (c) does not apply to payments made to former employees, non-employees such as independent contractors, or survivors of employees (i.e. the 102(a) exclusion still applies to these individuals)

o *Note 2: (c) does not apply to an employer’s transfers to “natural object of employer’s bounty” (i.e. related employees) if the employee can show that the transfer was not made in recognition of the employee’s employment (Prop. Reg. 1.102-1(f)(2))

IRC 274(j): Definition of Employee Achievement Award

· (3) Employee Achievement Award = an item of tangible personal property which is—

o (i) transferred by an employer to an employee for length of service achievement or safety achievement;

o (ii) awarded as part of a meaningful presentation; and

o (iii) awarded under conditions and circumstances that do not create a significant likelihood of the payment of disguised compensation.

Policy Reasons for the Gift Exclusion (IRC 102)

· No consensus—some commentators argue there is no justification

· Administrative convenience: gift transactions difficult to track

· Because most gifts occur within families, would interpose government in family affairs

· Other provisions in the IRC already tax transfers of wealth at death (estate tax) and substantial inter vivos transfers, thus too harsh to impose additional tax on the gift recipient (BUT less than 2% of taxpayers subject to estate and gift taxes)

· Vehicle to encourage generosity

Tax Consequences for the Donor

· Gift seen as personal consumption, so no deduction for gift transfers

· BUT, transfer of appreciated property does not give rise to any income tax liability

Question in Following Cases and Under IRC 102: bona fide gift or disguised compensation?

Commissioner v. Duberstein (1960)—what is a gift? (undefined in IRC/Regs)

Supreme Court

Facts: Consolidated Appeal: (1) Duberstein was president of a metal company and had done business for a number of years with Berman, president of another metal company. Occasionally, in telephone conversations, Berman would ask Duberstein whether Duberstein knew of potential customers for products of Berman’s company in which Duberstein would not be interested. Duberstein provided names of potential customers. Berman subsequently gave Duberstein a Cadillac as a “gift” for his help. Duberstein accepted the car, but did not report it on his tax return. Berman’s company deducted the car as a business expense. Duberstein testified that he did not think Berman would have given him the car if he had not provided information on customers. The Tax Court found the car was not a gift and the Sixth Circuit reversed. (2) Stanton was employed for 10 years by the Trinity Church as comptroller of the Church corporation and president of subsidiary company created to manage the Church’s property. Stanton earned $22,500 a year by the time he retired to start his own business. The Church’s directors voted to grant him a gratuity for $20,000, which he did not include as gross income. The 2nd Circuit held that the $20,000 was not a gift.

Question: Were the transactions gifts?

Holding: (1) No—the Tax Court’s decision was not “clearly erroneous” (2) Judgment vacated and remanded due to conclusory reasoning by the district court.

Rule: Gifts in the statutory sense proceed from a “detached and disinterested generosity . . . out of affection, respect, admiration, charity, or like impulses.” The most critical consideration is the transferor’s intent. If payment proceeds from donor’s moral or legal obligation, not a gift.

· Decisions must ultimately be based on the “totality of the facts” of each case

Frankfurter Dissent: In these two situations (“value given to employees by their employers upon termination of employment and payments entangled in a business relation occasioned by the performance of some service”) the “strong implication” is that the payments are of a business nature. The opposite implication obtains where payment is made from one family member to another.