A. Introductory Nuts and Bolts
1. A Quick Look at a Tax Computation: Income, Deductions and Credits
Exclusions, Income and Deductions
· §1 – Individual income tax is imposed on taxable income
· §63 – Defines taxable income
o AGI less the higher of:
§ Standard deduction or itemized deductions
o Less personal exemptions
· §62 – Defines AGI:
o Gross Income less above the line deductions
o AGI is only a definitional term – §62 does not authorize any deductions it only describes those which are authorized elsewhere
· §61 – Defines gross income
o Lines 7 through 22 on 1040
o Except for line 8(b) we do not report excludible items (e.g. muni interest)
o First start with exclusions then GI per § 61(“except”)
o “except” as otherwise provided (in this subtitle – i.e. Subtitle A) GI is all income from whatever source derived including but not limited to…then there is a list of specifics – but it is NOT all inclusive
o Items of GI are included even if they are not listed
o “except” means mainly exclusions from GI (§§101, 102, 103, etc.)
§ §101 – life insurance benefits
§ §102 – gifts and bequests
§ §103 – municipal bond interest
§ §104 – damage awards for personal injury
· TAXABLE INCOME multiplied by tax rate = TENTATIVE TAX LIABILITY
· Exclusions (listed on return, except line 8(b)) (§§ 101-135)
· Gross Income (Lines 7 thru 21)
· Less: Above the line deductions:
o Lines 23 to 31(a) and those inherent elsewhere (e.g.: business deductions)
o They are authorized elsewhere – deductible even though do not itemize
o E.g.: student loan interest, medical savings, moving, SE tax, alimony
o Many are not listed between these lines (E.g.: business income per line 12 also includes business deductions) – also deductible in arriving at AGI (business interest, rent, utilities, wages) – Schedule C, E, etc.
· AGI – Line 33 and 34
· Less: Below the line deductions – higher of (Line 36):
o Itemized deductions – Schedule A
§ May be limited as income increases (Line 28) at $137,300 or $68,650
o Standard deductions (MFJ – $7,850)
o Personal exemptions – Line 38 ($3,000)
· Taxable Income – Line 39
· Tentative tax – Line 40
o Per tax rate schedules (up to $100,000) or tax tables (up to almost 39.6%)
· Less: Tax Credits
o Reduces taxes dollar for dollar
o Note: Value of a deduction depends upon the taxpayer’s marginal tax rate, and a tax credit is always the same
o E.g.: Withholding taxes (Line 58), estimated taxes, earned income credit, foreign tax credit, child care expenses, elderly or disables, etc.
· Tax due or overpayment – Line 69 or 66, respectively
· Note: if you get too much benefit from deduction, Congress decided that people should still pay some tax (AMT – alternative minimum tax).
2. Authorities: Statutes, Regulations, Rulings, etc.
Authority for Tax Law:
· SC and lower court decisions
o Historically court does not like individual income tax matter and therefore there are relatively few decisions
o NOTE: Tax Court:
§ Old view: Since it hears cases all over the country and is an independent court then any decision which is contrary to decisions in a Federal Circuit court
§ Golsen Rule [78-79]: Tax Court now defers to Federal Circuit to which the case is appealable, even though it may reach a different decision in a different circuit – therefore Tax Court no longer issued contrary opinions
§ Tax Court binds itself only if the pertinent circuit decision is ON POINT – usually cases can be distinguished therefore the rule can be manipulated
o §7805: Congress had delegated to the Treasury Dept authority to issue Regs. interpreting the code.
o 2 kinds:
§ (1) Legislative
· Congress has specifically delegated to Treasury – the authority to write the law – E.g.: Consolidated returns
· §385 –secretary is authorized to prescribe regs that may be necessary or appropriate to determine whether an interest in a corp. is to be treated as stock or indebtedness.
§ (2) Interpretative
· Most Regs are interpretative
· Some cases rely on regs that have been enforced for a long period of time after a reenactment and therefore the argument is that Congress knew what the interpretation was and therefore regulations are treated with the force of law – almost akin to legislative regulation
· Revenue Ruling
o IRS takes a particular fact situation that the Treasury or service believes is common and then gives their official interpretation of resolution
o Published in IRB (Internal Revenue Bulletin) and twice a year are collected in a cumulative bulletin
o E.g.: Rev. Rul. 85-4, 1985-1 Cumm. Bulletin
o For major tax bills there may be a 3rd bulletin including committee reports
o They are approved by Treasury official and by Commissioner – therefore high level of approval and therefore high level of authority
o IRS Agents MUST follow Rev. Rulings – therefore if one against the taxpayers position then must issue a letter of deficiency or vice versa
· Private Letter Rulings (PLR’s):
o Individual TP or company asks the service to rule on a particular fact pattern where they want a particular result
o NOT approved at a high level, nor are they approved by Treasury therefore they are NOT authoritative and cannot be used a precedent
o Rulings issued to a particular taxpayer and only he can rely on it
· Revenue Procedures
o Also included in Cumulative Bi-Annual Bulletins
o They are procedural
o Every year one is issued to show to apply for a ruling, areas that service will NOT rule, areas that service will not ordinarily rule and areas that are under examination
· Acquiesces or Non-acquiesces
o Issued in tax court cases and are published also in the cumulative bulletins
o Service issues and say that we are going to follow (acquiesce) or not follow the Tax Court’s decisions
History of U.S. Taxes- From Regressive Excise Taxes to Progressive Income Taxes
· Constitution Reserved Import and Export Taxes to Federal government
· First Income Tax Introduced by President Abraham Lincoln to Help Finance the Civil War
· Income Tax Held Unconstitutional in 1895 by Conservative Supreme Court (Pollack)
· Corporate Income Tax in 1909 and Personal Income Tax in 1913
Goals of Taxation- Raising Revenue for Government Purposes
· Raise revenue necessary to fund government expenditures
o In short run, surplus or deficit may be use for economic policy reasons
o In the long term, the revenue must come from taxes, borrowing or printing money.
· Raise the revenue in ways that are fair, efficient, and impose minimum administrative costs.
Fairness in Taxation- When is a tax system fair?
· Traditions goals: horizontal and vertical equity
o Horizontal equity means treating people in the same circumstances the same
o Vertical equity means treating people in different circumstances appropriately different
· Some people conclude that vertical equity requires progressive tax rates.
· Any tax system, to achieve fairness, needs to have some measure of “same circumstances.” One possibility is “income.”
Horizontal Equity- Sorting Taxpayers by Income
· To achieve horizontal equity, a tax system requires “sorting rules.”
· Types of Sorting Rules
o Tax base rules — defining taxable income
o Taxable person rules — defining the taxable person or persons and assigning income to the taxable person (family taxation rules)
o Taxable period rules — defining the taxable period (typically the year) and assigning income to that period (tax accounting rules)
Vertical Equity- Imposing tax on taxable persons
· Tax is imposed on taxable persons with respect to their taxable income for the taxable year.
· Rates and credits are the typical imposition rules
o Rates may be flat, graduated, or regressive
o Some deductions, such as the standard deduction, work like a zero tax bracket, providing some degree of progressivity
o Credits can also provide progressivity
5. Tax Law and the Constitution
Article I, § 8
The Congress shall have Power To lay and collect Taxes, Duties, Imposts and Excises, to pay the Debts and provide for the common Defence and general Welfare of the United States; but all Duties, Imposts and Excises shall be uniform throughout the United States;
The Congress shall have power 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.
6. IRS as a Collection Agency
B. Basic Policy Choices: How to Finance Government Expenditure
1. Non-Tax Options
2. Tax Options
a) Head Tax
b) Benefits Tax
c) Ability to Pay: The Maharajah and the Beggar
d) Alternatives to the Income Tax Base
3. Progressive Rates vs. Flat Rates
Graduated Rates- U.S. Income Tax Rates have Always Been Graduated
· Marginal Tax Rate — the rate at which additional income is taxed. It is important for economic incentive reasons.
· Effective Tax Rate — the average tax rate applicable to the taxpayer’s entire income. It is important for fairness.
4. How to Do a Policy Analysis of a Tax Provision
Income as the Tax Base- Measuring Taxable Capacity by Income
· Income is a good measure of taxable capacity
· Other measures would include:
· No single measure is complete.
· In general, the tax system is fairer when income is an important part of the tax mix.
Taxing the Poor- How to Exempt the Poor from Taxes
· The poor can be exempted from the income tax by having a zero rate on the first major slab of income.
· They could be exempt from the FICA tax by making part of FICA earnings exempt.
· Exempting the poor from a sales tax is very difficult.
· It is trivially easy to exempt the poor from an estate and gift tax.
Taxing the Very Rich- Should the Rich Pay at Hi
nsferred by or for an employer to, or for the benefit of, an employee.
Code: §1001, §1012
Realization Requirement- See Code §§ 1001, 1012
· Income Must be Realized
o Claimed Advantages
· Liquidity (no money to pay the tax) [can sell some shares to pay the tax] · Valuation (difficult to value property other than money or money equivalents) [can look up publicly trade shares on stock exchange, hire valuation expert if closely-held, know how to value property for tax purposes] o Claimed Disadvantages
· Unfair (allows deferral of tax)
· Hard to Define Realization Event
§ Find money, realization
§ Find diamond ring, probably realization
§ Find oil on your land, no realization
· Constitutional and Code Dimension
§ 1001- Gain Realized
· (a) Computation of gain or loss
o The gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis provided in section 1011 for determining gain.
· (b) Amount realized
o The amount realized from the sale or other disposition of property shall be the sum of any money received plus the fair market value of the property (other than money) received.
Problem, Page 29- Joe Has Parcel of Land
· 1990. Buys land for $25,000.
o This is Joe’s basis.
· Sec. 1012. Basis of property–cost
o The basis of property shall be the cost of such property, except as otherwise provided . . . .
· What is “cost” of finding a diamond ring?
· What is “cost” of earning a wage of $1,000 paid in Snickers bars?
Problem, Page 29, continued- Code Sections on Adjustment to Basis
· Sec. 1011. Adjusted basis for determining gain or loss
o (a) General rule.– The adjusted basis for determining the gain or loss from the sale or other disposition of property, . . . shall be the basis (determined under section 1012 or other applicable sections. . . . adjusted as provided in section 1016.
· Sec. 1016. Adjustments to basis
o (a) General rule.– Proper adjustment in respect of the property shall in all cases be made —
Problem, Page 29, Continued- Joe Disposes of Land
· 1994. Land worth $100,000
o If no sale, has unrealized gain and no tax due
o If he sells, has gain of $75,000 ($100,000 minus $25,000).
· What about Inflation?
o No adjustment under Code
o What about in Haig-Simons? Unclear.
o Income is reported when it is realized
o G/L reported when asset is disposed of (incl. if becomes worthless)
o §1001(a): the gain from the sale or other disposition of property shall be the excess of amount realized over the basis.
§ Reg 1.1001-1(a): except as otherwise provided, G/L realized from the conversion of property into cash or for the exchange of property that differs from property that you are giving up is treated as income or loss sustained.
b) Bargains and Frequent Flyer Programs
· Frequent Flier Tickets:
o Technically they should be included in GI but in practice they are not
o There is no exclusionary rule that applies to these tickets
o Government does not require that these tickets be reported – this is another form of an exclusion but that there is not statute on point
o Argument is that ticket has been paid for by purchases of several other tickets at higher prices and therefore there is no economic benefit received by the frequent flier tickets – more difficult to make argument when ER has paid for tickets directly (probably not a working condition FB b/c not for business purpose and not needed in ordinary course of their lives (Turner).
Bargains- Sales, Coupons, Etc.
· Blue Light Special on Bananas. Income?
· Two for One Sale on Bananas? Income
· Dollar off Coupon for Bananas?
o Does it matter where coupon came from? From prior purchase? From newspaper? From employer?
Frequent-flyer Miles- Taxable? Deductible?
· Uses of Frequent-flyer Miles — Does it matter how they are used?
o Visiting family members — what if you don’t like them?
o Business trip