SCHENK – FEDERAL INCOME TAXATION OUTLINE – FALL 2012
1. Whose income is it?
2. Character of the income (capital or ordinary?)
4. Timing (When is income reportable? When are expenses deductible?)
WHOSE INCOME IS IT?
The Taxable Unit
Taxation of the Family
· Druker: Druker challenged constitutionality of tax burden on married couple (marriage penalty).
o H: Burden on marriage isn’t unconst. under any standard of scrutiny. Disparity b/w filing individually & jointly improving.
o R: Though right to marry is fundamental, reasonable regs that don’t significantly interfere with the decision to marry are ok
§1(g): The Kiddie Tax. Capital gains for children under 18 taxed at their parents’ top marginal rate
· Purpose: Prevent parents from avoiding tax consequences by transferring income to their kids to get in lower tax bracket
o Kids with some income were taxed at a very low rate, got standard deduction, exemptions – sheltered thousands of tax $
Dissolution of the Family (separation/divorce)
· Can’t shift tax consequences from one person to another via private arrangement EXCEPT on separation or divorce
Rev. Rul. 76-255: Married couple gets divorced 12/28 & remarried on 1/2 so status = unmarried?
· §143(a)(1): Determination of whether one is married is determined on 12/31.
· H: Sham like this is NOT recognized.
· Reg. §1.143-1(a) & Reg. §1.6013-4(a): An individual shall be considered married even if living apart from the spouse unless legally separated under a decree of divorce or separate maintenance.
· Estate of Borax v. C: Couple married then separated w/ separation agreement. H and wife #2 went to MX for ex parte divorce. H married wife #2 in MX, then came back and had another ceremony. Wife #1 filed injunction saying she was still married to H.
o H: Payments were deductible even though court said divorce was invalid
o R: SUPERSEDED by Rev. Rul. 67-442: When court recognizes a marriage, IRS respects that. Since they didn’t have a valid divorce, H couldn’t deduct the alimony payments under §215.
Alimony / Support Payments
· Alimony: A deduction to the payor includable in the gross income of the recipient
· §71(a): Gross income includes amounts received as alimony or separate maintenance payments
o (b)(1)(A): Re: payments made under a divorce or separation instrument
o (b)(1)(B): The instrument mustn’t state the payment is not income to the recipient for tax purposes; mustn’t be allowable as a deduction under §215.
· §215: There shall be allowed as a deduction an amount equal to the alimony or separate maintenance payment paid during such individual’s taxable year
o Historically, paying spouse only got this deduction if s/he itemized. Now §62(a)(10) allows the §215 deduction.
o EXCEPTION: If the two live under the same roof, §71 and §215 don’t apply
· Payment of child support generates no deduction to the payor and no income to the recipient
o Parent receiving the funds has obligation to use them to support the kid
o §71(c): Subsection (a) doesn’t apply to funds that are designated child support
o Lester: §71(c) calls for a “fixed” payment for child support. If pmt not explicitly “fixed, it’s not considered child support
· §1041: Transfers of property b/c spouses or incident to divorce
(a) No gain/loss recognized on a transfer or property from an individual to (or in trust for the benefit of)
i. A spouse; or
ii. A former spouse, but only if the transfer is incident to a divorce
(b) Transfer of property described in (a) shall be treated
i. As acquired by the transferee by gift and
ii. The basis of the transferee in the property shall be the AB of the transferor
· U.S. v. Davis: H & W had land, AB = $100k, FMV = $250k. They divorce & have $500k in assets (land + $250k cash).
o I: Is the transfer of property pursuant to a divorce decree a realization transaction?
o H: Any time property transferred to discharge an obligation, it’s a realization transaction.
§ H is discharging his legal obligation under the divorce decree. It’s realization transaction. He has $150k in gain.
· Farid-Es-Sultaneh v. C: Kresge gave W2 (P) stock, divorced W1. After divorce from W1, but before marrying P, Kresge gave P more stock as part of a prenup. In exchange, W2 released dowry and other marital rights (in case they divorced). Kresge’s basis in the stock was $0.15/share, W2’s basis was $10/share. She sells some of the stock.
o I: What is her gain from the sale of the stock? What is W2’s basis in the stock she received?
§ Depends on whether the transfer of stock in exchange for her dowry/marital rights was a “taxable exchange”
o H: The transfer was NOT a gift for income tax purposes, but an “exchange of valuable property interests” Stock for marital rights.
§ So, her basis in the share was $10/share, the FMV when it was transferred.
§ Kresge got something in return. He didn’t want to have to pay her if they divorced, so there was consideration and the court characterized the transaction as a purchase instead of a gift. So, basis is determined by §1012 (not §1015).
§ This is consistent with Davis
o R: CHANGED 20 yrs. later by Rev. Rul. 67-221: There is no gain when marital rights are released
§ If you can’t prove the basis of what you give up, the presumption is that the basis is ZERO.
Assignment of Income
· Income from services
o Lucas v. Earl: Taxed to person who earned the income (can’t K the compensation away)
· Income from income-producing property
o Horst: Taxed on the owner of the property (can’t lop of dividend and give it to someone else)
§ Where donor retains control of trust, property is taxable to him although dividends are paid to the one
· Gain or loss from disposition of income-producing property
o Salvatore: Gain/loss from this is taxed to the owner determined at the time of the sale
o ₪ A & B agree to sell, A gifts property to C at the 11th hour, C sells to B = A is still rightful owner of the property
o Only the owner of the property may report the gain/loss
Income from Services
· The earner is taxed
o CQ: How direct is the benefit from the services rendered? (Giannini & Teschner were not direct enough)
· Lucas v. Earl: H/W entered K saying income earned by either would belong equally to both. In 1920/21 H paid half of his salary to W then tried to only pay taxes on his part saying the other half belonged to his W by K.
o H: Earned income is taxable to the person who earns it (can only K around taxes w/ alimony or child support payments)
· Giannini: President of BOA told BOD to stop paying him (had a lot of $). Said to give money to “worthwhile cause.” BOD gave money to a university to set up a program in the dude’s name.
o I: Does the president have to pay taxes on that money that was donated to the school?
o H: NO. President didn’t tell the BOD what to do with the money, so it isn’t his income. Had no degree of control.
· Teschner: P entered contest, won, designated his daughter to have the $2 prize b/c rules said he had to be <18 yrs old.
o H: He didn’t have income. The right to select the recipient wasn’t sufficient to tax the income to him.
· Rev. Rul. 74-581: Prof paid for representing a client through school’s clinic. His employment K w/ school said he must remit any compensation to the school, so he turns the money in.
o I: Does the prof have to report the fee as income?
o H: No, he doesn’t have income. Prof is merely acting as the agent for the school. School pays taxes on the compensation.
· Hundley: Son said he’d share signing bonus w/dad if he got MLB K (dad helped him learn baseball as a kid).
o I: Can son get a deduction for the amount he paid his dad for services his father rendered when he was younger?
o H: Yes, he can get the deduction.
o Allen: Child didn’t get deduction for giving his mom part of a signing bonus b/c mom didn’t do anything to earn it.
· Rev. Rul. 76-313: TP is memb
im, Blair, Horst, Lucas))
· Estate of Stranahan: TP needed $ to back taxes & interest. Interest was deductible. TP had more deductions that he could use. Wanted to accelerate income that he would otherwise have to report in the future so that he could use his deductions. Owned some stocks that paid dividends. Arranged for his son to receive a right to the dividends in the future in exchange for cash.
o H: TP can accelerate income & sell right to income from IPP & not be taxed as long as the burden of risk is shifted (a sale)
o R: While you can’t assign income w/o consideration, you can accelerate income from income producing property
CHARACTER OF THE INCOME
Capital Gains and Losses
Mechanics and Policy of Capital Treatment
Five Elements of Capital Treatment
1. Capital asset
2. Sale or exchange
3. Holding period
4. Substitute for income
5. Arrowsmith principle
Why characterize gain/loss?
· §1221: How much is deductible currently?
(b) Losses from sales or exchanges of capital assets shall be allowed only to the extent of the gains plus the lower of:
i. $3,000 or
ii. The excess of such losses over such gains
· §1(h): Provides maximum rates on net capital gain
o §1222(3): Net Capital Gain = Net long term capital gain (-) net short term capital loss
§ Net long term capital gain = long term capital gain (-) long term capital loss
· §1222(3): Long Term capital gain = gain from the sale or exchange of a capital asset held for > 1 year + substitute for ordinary income & Arrowsmith principle
· Having long term capital gain gets you the special rate. STCG doesn’t do you any good.
o ₪ TP has wages of $75k and transactions involving stock. One transaction resulted in short term capital gain of $5k, one in long-term capital gain of $8k and another in long term capital loss of $6.5k
§ Wages: $75k
§ Short term gain: $5k
§ Long term gain: $8k Gross income: $88k
§ Long term loss: $6.5k AGI (deduction for losses): $81.5k
· What if the long term loss is $16.5k? §1211(b) limits deductible losses
o §1211(b): Losses from sale or capital assets shall be allowed only to the extent of the gains ($13k) + and additional $3k
§ So, TP can deduct $16k in losses.
o §1212: Allows TP to carry over the remaining $500 indefinitely
§ It would be deductible the next year if there weren’t capital gains b/c §1211(b) allows the $3k deduction
· POLICY for providing lower rate for net capital gains than wage/interest/royalty/other income
o CG are not really income. They aren’t recurring and they partially reflect a change in interest rates
o Capital investments = risk. Incentivizes people to take risks.
o Inflation may cause the value of an investment to go up. People shouldn’t be punished w/ higher taxes b/c of inflation
o Many gains occur over a long period of time.
o Lock-in problem. People won’t sell in order to avoid tax or gain
§ Lower rate = more likely to dispose of that investment and shift to more profitable investment.
o Bunching. If you realize gain over a long period and sell an asset, all that income is bunched in one year
§ You are subject to a higher tax rate when the investment goes up.