Prof. WOOTEN: Federal Income Tax

Federal Income Taxation

  1. Introduction
  2. Gross Income
  3. Obligation to Repay
  4. Gains from Dealings in Property
  5. Gifts, Bequests, Inheritance
  6. Discharge of Indebtedness
  7. Fringe Benefits
  8. Business and Profit Seeking Expenses
  9. Capital Expenditures
  10. Depreciation
  11. Travel Expenses
  12. The Interest Deduction
  13. Cash-Method Accounting
  14. Accrual-Method Accounting
  15. Annual Accounting
  16. Capital Gains and Losses
  17. Quasi-Capital Assets
  18. Recapture of Depreciation
  19. Assignment of Income
  20. Tax Consequences of Divorce
  21. Like Kind Exchanges

Introduction

Five Questions

  1. What items must be included?
  2. What items may be deducted?
  3. When is an item included or deducted?
  4. Whose income or deduction is it?
  5. What is the character of items of income or deductions?

Formula for Taxation

Taxable Income = [(Gross Income – § 62 deductions) – § 63 deductions]

§ 62 and § 63 say when a deduction is applied in the tax formula, but they don’t list when something is deductible or not.

§ 151ff – what you can deduct

§ 261ff – what you cannot deduct.

What is included in Gross Income?

General rule: if something makes you better off, it is income, unless you can find a statutory or judicial exclusion.

DEDUCTIONS

  1. The income tax is a tax on net income. In general a person may deduct from his gross income the costs incurred in producing his gross income.
  1. The most important deductions are for costs incurred to produce gross income. IRC §§ 62(a)(1), 162, 212.
  1. The deduction provisions of the Code begin with § 161.
  1. Deductions are a matter of statutory grace. Every time you have a deduction which you believe is deductible, you must find a specific Code section or case authorizing the deduction.

Above the Line Income: subtracted from gross income pursuant to § 62.

Below the Line Deductions: subtracted from adjusted gross income pursuant to § 63.

Taxable Income

Itemized Deductions: the taxpayer can deduct all of the below the line deductions

Standard Deductions: the taxpayer can deduct a specified amount

Section 67: the 2% Floor on Miscellaneous Itemized Deductions

§ 67: provides that certain itemized deductions may not be deducted except to the extent that in the aggregate such deductions exceed 2% of the taxpayer’s adjusted gross income. But, some deductions (mortgage interest, state tax, real property tax, charity) are not subject to this rule.

Section 68: The Overall Limitation on Itemized Deductions

§ 68: As income increases by a specified amount, itemized deductions are reduced by 3%

Personal Exemptions

Under § 151, the Taxpayers can claim exemptions for each dependent and for themselves.

Note: The personal exemption and the standard deduction provide a floor assuring that taxpayers will not be taxed unless they have income greater than the combined amount of the personal exemptions allowed and the standard deduction.

Gross Income

  1. The Search for a Definition of Income
  2. IRC § 61(a): Gross Income is all income from whatever source derived. While 61(a) includes a list of what counts as gross income, that list is not exhaustive.
  3. For a variety of policy reasons, Congress has specifically excluded certain items from gross income.
  4. § 102: excludes gifs and bequests.
  5. § 102(c): the exclusion for gifts shall not include any amount transferred from an employer to an employee.
  6. Basically, income generally includes items which add to the taxpayer’s net worth.
  7. Income Realized in Any Form
  8. Reg. § 1.61-1(a): Gross income may be realized in any form, whether money, property, or services.
  9. Reg. § 1.61-2(d)(1): If services are paid for in property, the fair market value of the property is the measure of compensation. If paid for in the form services, the value of the services received is the amount of compensation.
  10. Comm’r v. Glenshaw Glass Co., Supreme Court (1955) (GROSS INCOME)

TEST:

There is gross income when there are instances of
(1) ACCESSIONS TO WEALTH,
(2) CLEARLY REALIZED (realization rule), AND
(3) over which the taxpayers have COMPLETE DOMINION.

Money received as part of punitive damages counts as gross income.

Holding: The mere fact that the payments were extracted from the wrongdoers as punishment for unlawful conduct cannot detract from their character as taxable income to the recipients.

  1. Cesarini v. U.S., US District Court of OH (1969) (WINDFALL)

According to Reg. § 1.61-14, treasure, or found money, is taxable for the year in which the finder has undisputed possession of it. The finder has undisputed possession only when he actually has found the money and not when he merely bought something with money hidden in it, without finding the money.

Income from all sources is taxed unless the taxpayer can point to an express exemption.

Facts: In 1957, Δ bought a piano. In 1964, they discovered $4,467 in the piano.

  1. Old Colony Trust Co. v. Comm’r, Supreme Court (1929) (PAYMENT OF BILLS)

Rule: If an employer pays an employee’s tax as consideration for services rendered by the employee, then the amount that the employer pays is gross income for the employee.

You view this as if the employer actually paid the employee and then the employee paid the tax.

Facts: The president of a company did not pay taxes on his income because the company had a policy to pay all of the taxes that were due on the salaries of the company’s officers.

  1. Revenue Ruling 79-24 (1979) (BARTER)

Reg. § 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 the income.

  • Hence, if a lawyer and a painter trade services, then the fair market value of each of those services should be included in their gross incomes. In other words, the lawyer is taxed as if she provided services, was paid in cash, then paid the painter with the cash.
  1. McCann v. US, US Court of Claims (1981) (ALL EXPENSE PAID TRIPS)

The Supreme Court has said that Congress intended to tax all gains, except those specifically exempted (Glenshaw Glass), and that the term “income” includes any economic or financial benefit conferred as compensation, however accomplished (Comm’r v. Smith).

Thus, in a situation where an employer pays an employee’s expenses on an OPTIONAL trip that is a reward for services rendered by the employee, the value of the reward must be regarded as income to the employee.

Facts: The Δ and her husband went on an all-expenses paid trip to Las Vegas, paid for by the Δ’s employer, as a reward for good work performed by the Δ. The Δ was able to attend and bring his spouse, but was not required to. The trip included cocktail parties along with business seminars.

Holding: The all-expenses paid trip was an economic benefit to the Δ, as the Δ received the benefit as a reward for her good work in increasing her sales..

  1. Realization, Imputed Income and Bargain Purchases
  2. Realization Requirement:
  3. Mere appreciation in the value of property or stocks is not taxed.
  4. There are administrative difficulties in measuring the appreciation. At the time people sell something, the values are known.
  5. People may not be able to pay the taxes on appreciated property unless they sell, or realize, it!
  6. Realization is fundamentally a matter of timing – when you realize the gain, you allow yourself to be taxed.
  7. Imputed Income
  8. SELF PROVIDED SERVICES ARE NOT TAXED
  9. This is an incentive to do things yourself.
  10. Imputed Income from Owning Property
  11. If you buy a house for $100,000 which has a rental value of $10,000, you don’t have to pay rent, but you gain a $10,000 benefit by living in it. You don’t have to pay any taxes on that benefit.
  12. Imputed Income from Performing Services for Oneself
  13. You can pay someone to mow your lawn for $8, but with a 20% tax rate, you really need to earn $10, paying a $2 tax, to pay for that service.
  14. But, you can mow the lawn yourself, get an $8 value out of the lawn mowing, without paying any taxes.
  15. The tax questions related to imputed income tend to arise in self-employment activities.
  16. Morris v. Comm’r: the value of farm products consumed by the farmer is not income.
  17. Bargain Purchases
  18. Bargain purchases are not income (Pellar v. Comm’r)

Pellar v. Comm’r, US Tax Court (1955)

Bargain purchases DO NOT count as Gross Income!

If someone buys a property at below fair market value or receives services at below fair market value, the benefit he gets is not gross income, unless the benefit was given to him in exchange for services that he was legally obligated to perform.

Facts: The Δ entered into an agreement with a construction company to build a house on property that they owned. The company gave the Δ a good deal, as he wanted to keep the Δ’s goodwill in the hope of future business. The Δ ended up paying $55,000 for services worth $70,000.

Holding: Since the Δ was not obligated to return the favor, the benefit that he received from the company was not in exchange for any services that he was obligated to render. Hence, the benefit was not income.

  1. Compensation for services is income.
  2. Reg. § 1.61-2(d)(2): If property is transferred as compensation for services in an amount less than fair market value, the difference between the fair market value and purchase price is gross income.
  3. EXAMPLE: If A gives B, his employee, stock worth $500 in return for payment of $100, then B clearly has a gross income of $400, even though the stock has yet to be realized.
  4. The property was given to the employee as compensation and it is the fair market value of that property that must be used in order to measure the compensatory element in the transaction.

Two competing theories of Income:

SOURCES VIEW:

  • If there is a trip that is for the employer’s convenience, then the trip is not included. Under the sources theory, compensation is a result of labor.

USES VIEW:

  • According to the “uses” or Haig-Simon theory, if something makes you better off, it is included in income, unless there is a specific exclusion.
  • The trip is valuable and therefore must be included under this theory.

The law has been moving from the Sources view to the Uses view. Under the sources view, when an employee receives something from an employer that is not derived from labor, then it is not compensation that can be included. Under the Uses view, the trip can be a fringe benefit, and must be included unless there is exclusion.

Effect of an Obligation to Repay

  1. Loans
  1. Loans are not gross income because the borrower has an obligation to repay the loan. Therefore, they are not an “accession to wealth.”
  1. Repayment is not a deductible expense. Similarly, the lender has no income when the loan is repaid because the repayment is merely a recovery of capital.
  1. Claim of Right
  1. §1341 is the relevant provision.
  2. Money received under a claim of right, without restriction as to disposition, is income; the contingent repayment obligation does not allow the receipt to be treated as a loan.
  3. North American Oil Consolidated v. Burnet, US Supreme Court, 1932, p54

Rule: Money received under a claim of right, without restriction as to disposition, is income; the contingent repayment obligation does not allow the receipt to be treated as a loan.

There is no obligation, however, to claim profits that have not yet been received.

Facts: In 1916, the money made from the oil property was paid to a receiver and not NAO. In 1917, the US government loses in the trial court. At that point, the receiver pays the money it was collecting to NAO. In 1920, the US government loses its appeal.

Class Notes: The Court said that if you receive money under a claim of right, even if it is a contingent claim, it is included! In a claim of right, you receive the money but you MAY have to pay it back. Hence, it is different than a loan, where you MUST pay it back. Therefore, it is not like a loan and must be included.

  1. Illegal Income
  1. Deductions: Repayment of illegal income entitles the taxpayer to a deduction.
  1. Loan vs. Illegal Income: In distinguishing between a loan and illegal income, courts have taken into consideration whether the taxpayer intended to repay the money. A person who takes out a loan has the intent to repay.
  1. Rights of the Victim: creditors, not victims, get first dibs on illegally acquired income.

James v. United States, US Supreme Court, 1961, p59

Rule: Embezzled funds constitute 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.

Class Notes: Should embezzled money count as income? There isn’t a contractual obligation to repay – there is a legal obligation, but no contract was made that if you embezzle funds you must repay them. There is no mutual understanding between embezzler and victim. Hence, it is not like a loan and the money must be included.

  1. Deposits
  1. Reg. § 1.61-8(b): Rent paid in advance constitutes gross income in the year it is received regardless of the period covered or the taxpayer’s method of accounting.
  1. Whether security and other such deposits constitute income is unclear.

Commissioner v. Indianapolis Power & Light Co., US Supreme Court, 1990, p63

Rule: Whether a deposit constitutes income turns upon the nature of the rights and obligations assumed by the receiver of such deposits when they were made—not upon whether the receiver realized some economic benefit.

Facts: IPL requires certain customers to make deposits to ensure payment of future bills. The Commission argues that these deposits are advance payments for electricity and therefore constitute taxable income. IPL contends that the deposits, because they are returned with interest to the customer, are similar to loans.

Holding: The individual who makes an advance payment receives no right to insist upon the return of funds. The customer who submits a deposit, retains the right to insist upon repayment in cash. IPL’s right to retain the money is contingent upon events outside its control, namely whether the customer insists on a refund of the deposit  they are not taxed.

Notes: If deposits look like a loan, they are not income. If they look like advance payments, they are income.

The effect of an Obligation to Repay

Transaction / Description / Taxation
Loan / Accession to wealth with a consensual obligation to repay / No inclusion
Deposit / Accession to wealth with a consensual obligation to repay / No inclusion
Receipt under a claim of right / Accession to wealth with a contingent obligation to repay / Inclusion
Embezzlement / Accession to wealth with a legal (but not consensual) obligation to repay / Inclusion
Extortion / Accession to wealth with a legal (but not consensual) obligation to repay / Inclusion

Loan (no inclusion) ------Repayment (no deduction)

TAX PLANNING: With a loan, you accelerate deductions. You take the money you borrow and buy something that gets a deduction. This is important for tax planning purposes:

EXAMPLE: I want to give a gift to my alma mater. It is the end of 2003. I don’t have $25,000 to give to them. At the end of the year, I borrow $25,000 and give it to my alma mater. I get a deduction for my charitable contribution in 2003. I am going to earn the money to repay the loan in later years. I do not get a deduction for repaying the loan. I earn $25,000 and pay the loan back in later years. So, in effect, I can take a $25,000 charitable donation deduction BEFORE I pay taxes on the income I earn to repay the loan. By taking out the loan, I can give a charity and take the deduction earlier.

Gains Derived From Dealings in Property

  1. OVERVIEW

Defining Gain

IRC § 1001(a):

Gain: If amount realized > adjusted basis, then:

Gain = amount realized – adjusted basis

Loss: If adjusted basis > amount realized, then:

Loss = adjusted basis – amount realized

IRC § 1001(b)

Amount realized = sum of any money received + fair market value of property other than money received.

REG. § 1.1001-2(a)(1):

The amount realized includes the amount of liabilities from which the transferor is discharged as a result of the sale or disposition. When I owe money on property and someone else assumes that debt, I realize the amount of loan. The amount of my debt that someone else assumes is money to me. The amount of debt someone assumes is included in the basis.

Defining Basis And Adjusted Basis:

  1. IRC §1012: Definition of Basis

(a)Basis = Cost (except as otherwise provided).

(b)Cost refers to the amount paid for an item.

  1. IRC § 1016(a): Basis should be adjusted for

(1): expenditures, receipts, losses, or other items
(2)(A): for deductions of depreciations

(a)Adjusted basis reflects the impact of events subsequent to property acquisition on the amount of one’s investment.

(b)When there has been an addition to property or a depreciation of the property, the basis will be adjusted.

Recovery Of Capital Or Return Of Capital:

  1. A fundamental principle in our income tax system is that the taxpayer must recover tax-free her investment (capital) in property before being charged with income from a disposition of the property. ONLY REAL GAIN WILL COUNT AS INCOME.
  1. No Double Tax: Basis prevents dollars that have already been taxed from being taxed again.
  1. TAX COST BASIS
  1. EXAMPLE: T receives car from employer in lieu of cash compensation. The fair market value of the car is $5,000. He later sells the car for $5,500. T reported $5,000 of income. His tax cost basis in the car is $5,000. When T sells the car for $5,500, his gain will only be $500. The total income from the receipt and sale of the car is thus $5,500, just as though T received $5,000 in cash, purchased the car for that amount, and sold the car for $500.
  1. TR §1.61-2(d)(2)(i): Property transferred to employee or independent contractor: 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 gross income of the employee or independent contractor.In computing the gain or loss from the subsequent sale of such property, its basis shall be the amount paid for the property increased by the amount of such difference included in gross income.
  1. IMPACT OF LIABILITIES
  1. Impact on Basis
  1. Recourse liabilities (loans that must be repaid) assumed by a taxpayer in the acquisition of property are included in the taxpayer’s basis in that property.
  1. RULES:

(1)Loan Amount = Basis: Because of the obligation to repay, the taxpayer is entitled to include the amount of a loan in computing his basis in the property. The loan is part of the cost of the property. (Tufts). It makes no difference whether the lender is also the seller.