Federal Income Taxation
Professor Susan Cancelosi
Fundamentals of Federal Income Taxation, 16th ed. (Freeland, Lathrope, Lind & Stephens)
I. Chapter 1: Introduction to Federal Income Tax
A. Income Tax and the US Constitution (p10)
– Article 1, Sect 8, clause one provides Congress the power to tax: “power to lay and collect taxes, duties, imports and excises”
– Wesley Snipes is jail for not paying tax (tax protestor) – well settled in courts that fed income tax is const.
– However, Congress must impose direct taxes by the rule of apportionment, and
indirect taxes by the rule of uniformity
o Direct tax: a tax demanded from the very person who is intended to pay it
o Indirect tax: a tax paid primarily by a person who can shift the burden of the tax to someone else or who at least is under no legal compulsion to pay the tax (ex. sales tax)
– Rule of apportionment – total amount needed must be apportioned according to their populations (also applies to num of rep in house of rep)
o Example – 5k tax per Ford Flex, 10k tax per Mazda CX7
§ Is a direct tax (can’t shift)
§ Best arg against – certain places will have higher concentrations of Mazda, going to fail apportionment every time (will never match up)
o If flat tax (everyone pay same exact dollar amount), would not have apportionment problem (self-apportioning)
§ Always going to try to provide exemptions in practice, so not ever going to have a real flat tax
– The rule of uniformity requires that all federal income taxation must be geographically uniform throughout the US: Whenever some manner or mode of taxation is used somewhere in the U.S., the same manner or mode must be used everywhere throughout the US (everyone is taxed the same, can’t have geographic differences)
o Example – 5k tax on Ford Flex owners in MI, $10k tax for TX owners would violate uniformity
– The 16th Amendment (p13) provides that income taxes shall not be subject to the rule of apportionment regardless of the sources from which the taxed income is derived
o Without 16th amend, couldn’t really apply income tax to people because of apportionment
– As a practical matter, unless the Supreme Ct has spoken on the issue, different regions of the US will sometimes apply different tax principles depending on the law as determined by the controlling Ct of Appeals
– Pollock decision: not in accord with apportionment
o Tax on income from property, failed apportionment since land owners not distributed evenly
– Note: Requiring a taxpayer to file an income tax return does not violate his 5th amendment privilege against self-incrimination
B. The Tax Practitioners Tools (p17)
– In any federal tax question the statutory law must be found and the proper meaning must be ascribed to such law
– The law is the “Internal Revenue Code of 1986, as amended (the code)”
o 1939 and 1954 were the earlier revisions – a business client may have had something happen back then, so need to use that rule (cite back to 1954 code, numbering changed)
o Title 26 – reference for litigation (26 USC ….)
– Look to the Code first then to the regulations
– Example – husband wins award in art shows, small amounts, end of year is it all taxable? (not all ask for tax ID number)
o Where to look? IR code, always start with code
§ Section 61 is gross income, but doesn’t answer question (assume IRS is going to win, but do more searching)
§ Section 74 – gross income includes prizes and awards
§ Can’t stop – Exceptions, tax rate, is an art prize really an award or prize?
· IRS is good at looking for substance, not form (can’t just not call it a prize)
§ Look at regulations next (temporary and proposed, proposed never expire, temporary expire after 3 yrs)
· If citing to regulations normally, 26 CFR, but tax regulations aren’t cited this way, Tres Reg 1.XXX (T for temporary)
· Not going to help much here
Mayo Foundation for Medical Education and Research v. United States (p22)
– Highlights that it’s possible to challenge a regulation (best thing is to go after regulation itself sometimes), but not very easy to win with Chevron
– Facts: The Mayo Foundation for Medical Education and Research (“Mayo”) and the University of Minnesota (“University”) sued the United States in a Minnesota federal district court seeking a refund for taxes paid under the Federal Insurance Contributions Act (“FICA”). They argued that payments made to doctors in their residency qualify for FICA’s student exemption. The district court agreed and awarded judgment in favor of Mayo and the University.
o 7.65% total with Medicare, withheld from paycheck and matched by employer (~15% total)
o Code 3121 covers this (not in supplement)
o Reasons for exemption: If didn’t have exemption, may not be as many low paying jobs. Also students may not really get benefits from contributing (earn minimal amount for length of time, etc.) – no value to students.
§ For residents, the arguments go away mostly (earning more money, longer job)
§ Survivor benefits would be available for residents as long as they pay in, many reasons why it’s good for them to get into system
§ Only way systems like this work is if collecting from people who don’t need the benefits yet
– 2004 new regulation excluded full-time employees
– Issue: Can the Treasury Department categorically exclude all medical residents who meet the FICA definition of student and who would be subject to the FICA student exemption?
– Conclusion: Yes. Chief Justice John G. Roberts, Jr. writing for a unanimous Court, upheld the Treasury Department’s rule that treats medical residents as full-time employees, and therefore not exempt from the payment of payroll taxes is a valid interpretation of federal law. Justice Elena Kagan did not take part in the decision.
o Standard of review for treasury regulation is important from this case = Chevron
o Chevron 2 step (deferential):
1. Congress clearly spoken on issue
· Haven’t clearly spoken on this issue, Mayo tried to use dictionary defn
2. Not arbitrary and capricious and reasonable
· Mayo doesn’t even really try to argue this
o National Muffler (older std) – multi-factor analysis, Mayo would prefer:
§ Degree of scrutiny
§ Length of time it’s been in effect
§ Consistency of agency
o Don’t advise client to go against treas reg unless it’s a brand new reg that is clearly wrong
– Revenue rulings are used to discover the IRS’s position on a subject
– Revenue procedures, private letter rulings, etc. offer other guidance
o IRS won’t let anyone rely on PLR except one it’s addressed to (don’t cite to PLR as binding authority) IRS can change their mind
– There are three trial courts for Tax cases: Tax Ct, Federal Claims Court, and the US Dist Ct.
– In the Tax Ct. the taxpayer can file suit to challenge the deficiency w/o paying (provided he responded to the 30 and 90-day letters sent by the IRS)
– In the other two courts, the person must pay the entire deficiency and then file suit for a refund
– NOTE: Most cases go to the tax court who have better qualified judges, the D. Ct. is the only place you can get a jury trial for tax matters
C. Tax Policy
– Tax is a powerful tool, can encourage or discourage activity
o Shift business over time which trickles down
– Tax reform ideas are never as easy to implement as they sound in the news
o Is appealing to say scrap it and do flat tax (broader tax base, lower rate)
o People have relied on current tax to do things like Roth IRA instead of 401k.
– Surrey ideal (p39) – treat everyone as same, if leave behind and benefit or burden should be treated as “expenditure” (technically didn’t really collect it yet, but treat that way – really means gov’t has forgone receipt to provide some benefit)
– Tax policy analysis framework (p39) – policy ideas evaluated on these three bases:
2. Economically efficient
3. Ease of administration
II. Chapter 2: Gross Income
A. Equivocal Receipt of Financial Benefit
– Defn in section 61 is intentionally broad and all inclusive – income from whatever source derived.
– List of specific inclusions, exclusions, but best to assume it’s gross income and work backward
– When employer pays employee, it’s income
– Treasure trove is income
– If someone pays your debt off, it’s income
– Glenshaw defn of income “undeniable accession to wealth” is a good starting point
o Loan isn’t an accession to wealth – not income
– Gross income on 1040 – bottom of 1st page, sum of all sources of income
§ 1.61-1(a) – GI means all income from whatever source derived, unless excluded by law. GI includes income realized in any form, whether in money, property or services. Listing of examples, but not limited to.
a. Probably gross income unless can find some reason to take it out
b. Doesn’t matter what dictionary says income is, only what tax code says
Cesarini v. U.S. – Found $4467 in piano (bought in 1957 and found in 1964). Fi
o Salary is income for sure. Employee realizes the additional $100K of stock as GI as well as the $30K of the car as GI (compensation since he was given remuneration for working there). Realizes additional $130K of GI total. GI of property = fair market value of the property. Even though to spouse, indirect payment to the employee (wouldn’t have been given if he’d not remained with company).
4. Insurance Adjuster refers clients to an auto repair firm that gives Adjuster a kickback of 10% of billings on all referrals.
(a) Does Adjuster have gross income? Yes, compensation for services is GI.
(b) Even if the arrangement violates local law? Still included in GI if illegal activities
5. Owner agrees to rent Tenant her lake house for the summer for $4,000.
(a) How much income does Owner realize if she agrees to charge only $1,000 if Tenant makes $3,000 worth of improvements to the house?
o GI for owner = $4K rent + improvements §1.61-8
o Owner is really just receiving rent in different form (indistinguishable from cash) à same as for bartered exchange
o If tenant voluntarily does it and rent is really only $1k, $1k is FMV, not in exchange for rent. Exception is 109 for improvements.
(b) Is there a difference in result to Owner in (a), above, if Tenant effects exactly the same improvements but does all the labor himself and incurs a total cost of only $500?
o Still $4k of GI for owner/lessor even though only cost tenant $500 (FMV value of the rent is all that matters)
– Look at as an accession to wealth, not what other side is giving.
(c) Are there any tax consequences to Tenant in part (b), above?
o $2,500 reduction in rent, receipt of an economic benefit. Discharging obligation for extra $3k. Got rental worth $4k for $1500.
– If hired someone to do all the work, would cost $3k total
6. Flyer receives frequent flyer mileage credits in the following situations.
Should Flyer have gross income?
(a) Flyer receives the mileage credits as a part of a purchase of ticket
for a personal trip. The credits are assignable.
o No, miles really part of price of the ticket, nothing to do with business context. Some portion of what was bought goes to FF miles. Revenue Ruling 76-96 treats rebate from manuf as reduction in purchase price.
(b) Flyer receives credits from Employer for business ﬂights Flyer
takes for Employer. The credits are assignable.
o Business flights for the employer, since assignable they have value (fair market value). Employer paying for something that benefits employee, so even by that view it would be income.
(c) Flyer receives the credits under the circumstances of (b), above, but
they are nonassignable.
o If non-assignable, do they have value? Maybe not GI, don’t have complete dominion over them. Can’t do as much with them.
(d) Same as (c), above, except Flyer uses the nonassignable Employer-
provided credits to take a trip.
Frequent Flyer Miles (assignable = can give to someone else)
o No authority on point; however if used for personal trip, likely to be classified as GI, since using for personal benefit unless find a employer/employee exclusion.
– In practice, IRS doesn’t bother with FF miles, unless fall into exception. 2002 IRS announced this (too many problems with timing and accounting), but really should be income.
o IRS announcement 2002-18 (can find on IRS web site) can change, so they could in the future
§ If convertible to cash, then don’t want to overlook
§ Sales person receive trip after hitting sales goal, that is still GI
§ Fraud exception (could still go after Charley)