Introductory Income Tax Outline

Roin 2002

Table Of Contents

Basics/Misc.
  • Income vs. other taxes
  • Consumption vs. Income Tax
  • Cash vs. Accrual
Income Tax Structure
  • Tax Rates
  • Manipulation
  • Marriage Penalty/Benefit
  • Fringe Benefits
Transfer of Property
  • Capital Recovery
  • Gifts
  • DOI
  • Debt Transfer
When to count Income
  • Realization/Recognition
  • Imputed Income
  • Tax exempt Bonds
/ Deductions
  • Progressivity and Solution
  • Alternative Minimum Tax
  • Business
  • Investment
  • Personal
  • Tax Shelters
Capital Gains
  • What and Why
  • Changing Purposes
  • Hedging
  • Substitutes for OI
Statutes
Terms

Basics/Misc

Income vs. other tax regimes:

  • Low admin costs, but easy to fraud
  • Other possibilities: Consumption, property, social security

Progressive scale:

  • Higher burden on wealthy who 1) can pay more and 2) may benefit more from social programs (roads, etc)
  • Supports desire to keep equality, kill aristocracy; but harms ideal of keeping what you work for.
  • Easier to raise $ on few than many, but potential to “drive off” wealthy either literally or because they stop working.
  • Ongoing tension between capitalism and redistribution

Consumption vs. Income Tax

  • Systems will lead to same economic result, but may differ in adminsterability
  • Debate is over whether consumption tax would increase investment or whether investors would be content with “traditional returns”

Accrual vs. Cash Accounting

  • Cash: Income gained/lost when payment occurs
  • Simpler administration
  • Accrual:Income gained/lost when earned (regardless of when payment occurs)
  • More correct, but tougher to administer
  • Avoids realization problems

Income Tax Structure

Tax Rates

§1Individual Income Taxes

(a)-(d)Tax Rates imposed on a) Joint, b) HOH, c) Unmarried, d) Married but separate filing

(f)Removal of “bracket creep” (see Rev Proc for current amounts)

(i)Introduction of 10% bracket after 2000

  • Reduction in rates after June 30, 2001

§11 Corporation Income Taxes

Manipulation of Tax Base

§61Gross Income = “all income from whatever source derived”

  • §101(a)NO GI from Life Insurance policies

§62Above the line deductions (Adjusted Gross Income (AGI) = §61 - §62)

(a)(1)Trade/Business costs (not as an employee)

(a)(2)(A)Expenses reimbursed by employer

§63Below the line (itemized) deductions which are subject to reductions in §67 and §68

(c)(2)Standard deductions (varies by type of filing – see Rev Proc)

§672% Floor on Misc. Itemized

(a)Only amount over 2% AGI is deductible

(b)Floor does NOT apply to these deductions, including §163 (inv int), § 165 (losses), § 170 (charity), § 213 (med)

§68Overall limitation on Itemized Deductions

(a)Itemized deductions reduced by LOWER of

  • 1) 3% AGI over applicable amount
  • 2) 80% allowable itemized deductions

(b)See Rev Proc for “applicable amount”; note that ½ amount for married filing separates

(c)Limitation does NOT apply to § 163, § 165, § 213

(f)Phase-out of §68(a) beginning in 2005

§151Personal Exemptions

(a)Above the line deduction (???)

(b)-(c)TP + Spouse (if joint filing) + kids

(d)Exemption amount found in Rev Proc

Amount lowered by 2% for each $2500 AGI is over applicable “Threshold amount” - (see Rev Proc)

Effects of Manipulation:

  • Gov’t can increase revenues w/o much “fuss” because TPs don’t notice
  • Actual marginal rates often higher than §1 rates indicate
  • Sometimes $1.00 increase in income will push AGI over threshold and result in $100s tax liability (bracket problem)
  • Bubble: Marginal rates increase as income increase, but then decrease around $800K

Marriage Penalty/Benefit

  • Two single filers, each making ½ of a Joint Filer, will pay less overall taxes (Marriage Penalty)
  • Ex: 2*35K = $12567 (pre 2001 act) ; 1*70K = $13724
  • But as the income of the single filers grows apart, they will pay more than the Joint Filer (Marriage Benefit)
  • Ex: 60K + 10K = $14783 ; 1*70K = 13724

Point: Marriage penalty is a result of progressive tax system. In any progressive tax system you cannot have marriage neutrality. Only solution is a flat tax

Fringe Benefits

§119Benaglia rule incorporated into code where room/board is 1) provide for employer’s convenience and 2) located on premise

§274(n)Businesses can only deduct 50%of cost of meals and entertainment (basically gov’t splits with businesses instead of 100/0 game)

§132Certain fringe benefits excluded from GI

(b)no-additional cost

(c)Qualified employee discount

(d)Working condition fringe

(d)de minimis fringe

(h)Definition of persons qualifying for (b) and (c)

(j)Specialty rules (basically loss of exclusion for (b) and (c) in certain circumstances)

Rationale: Often inexpensive and convenient for business to offer. Little distribution effect if everyone’s business does it

Old Colony: Company pays officer’s income tax. Court holds this payment as taxable income as it discharged an obligation

Drescher.Court finds present taxable interest in future guaranteed annuity (paid for by officer’s company) because there is a current market in which the property interest could be sold.

HypoCompany promises to pay tuition of officer’s daughter. Though no obligation (Old Colony), still taxable income, but tax not paid until interest received because no current market for such interest (Drescher). Thus TP still gains TMV

BenagliaNo taxable income for room/board paid to hotel manager who had to live/eat in hotel as part of job. Though benefit received by manager, tough to value and feel sympathy because he “has” to buy

Transfer of Property

Capital Recovery

§1001Gains/Losses from dealings in property = Amount realized – Adjusted Basis

§1012Basis in property = cost of property

TR 1.61-6Basis equally apportioned among parts sold

§1016Adjusted Basis = Basis – certain adjustments

§1014“Step up in basis”:Basis in donee’s inherited property = value at time of conveyance, NOT donor’s

basis

Point: death is not a realization, probably because of difficult in determining original basis.

Small potential of a “step-down”

§1015“Carry-over basis”:Basis in donee’s inter-vivos gift = basis of donor

Point: Rule only applies to gains, not to losses.

Otherwise easy to evade taxes and larger potential for “step-down”

Also, if donee sells property for less than original basis, but more than FMV, no gain or loss (limbo property)

Org. Basis / FMV at time of gift / Sale price / Gain/Loss
10 / 6 / 5 / (1) - not (5)
10 / 6 / 8 / 0 - limbo
10 / 6 / 14 / 4

Point: Can avoid taxes by giving property with gain to someone in lower tax bracket, but never advantageous to give away property with loss as the loss can’t transfer.

Inaja Land Co.

  • Gov’t condemns and pays for easement. Court rules that basis of easement inseparable from basis of property in gross and so no current taxes. Instead, $ reduces basis and so increase in future taxes. Still, Π gets TVM
  • Note: Courts today would allow apportionment on estimate of value of easement

Hort.Court disallows reduction in value of acquired rental property where tenant defaults.

Rationale: property value increased to amount of rent lost because now possible to get new tenant. It’s a wash.

ClarkΠ sues lawyer for bad tax advice (he pays too much) and wins recovery. Court finds no taxable income in recovery (but in doing so creates an artificial basis)

Gifts

§274Disallowance of certain expenses

(b)Gifts by employers to employees limited to $25.

(j)“Achievement awards” are limited to cap ($400 - $1600)

  • Note that employers can still pay lower taxes on gifts given than employees would if treated as income

Point: Purpose is to disallow arbitrage (incurrence of deductive expense for purpose of generating tax-favored income)

§102Generally, no GI from gifts, inheritance;

(b)Does not exclude income derived from such property (rent, etc)

(c)Gifts from employers to employees now included in GI

Deberstein.Court counts as income car given by employer to employee where employer counts it as a deduction

Point: To be a gift, intent to give must be detached from intent to compensate for services

Note: Still a little importance after §102(3)

Stanton.Court doesn’t count as income a “retirement thank-you” from church to pastor, by looking to “intent of donor”

Note: Case has no influence after §102(3)

DiedrichGift of encumbered property (see Crane-Tufts for sale of encumbered)

Rule: 100K property (20K cash + 80K NRD) given away is a realization event – 80K gain

This gain is taxed to the donor, not donee, so as to avoid transfer of tax to lower bracket payer

Discharge of Indebtedness

Generally, loans are not counted as GI because they will be paid back

§61(a)(12)DOI is GI

§108DOI excluded from GI if TP 1) insolvent or 2) DOI occurs in bankruptcy

(a)(3)For insolvency, tax avoidance only for amount ABOVE insolvency

  • Ex: 100K debt forgiven, but TP has 20K assets. Only 80K tax free
  • Note that for Ch 11, all DOI tax free, even if not 100% insolvent

(b)(2)(A)TP can NOTt carry forward NOL “used up” in DOI – otherwise a double benefit would occur

(e)(5)Solvent debtor DOI can be excluded if “purchase price reduction” – meaning forgiven by seller, NOT byloaner

  • Note: Solvent debtor DOI normally included as GI under Kirby Lumber
  • Note: Technically only applies to real property, though Zarin allows for gambling debt

Secured vs. Non-secured debt (Problem Set #4)

  • NonGain/loss treated as DOI
  • Sec Gain/loss treated as DOI if debt is RD; as Capital gain if debt is NRD
  • Note: both would be forgiven under bankruptcy law

Zarin.Court finds DOI of gambling “debt” is NOT taxable income because no real debt obligation (Casino and TP had settled and IRS wants to include as income difference between debt Casino claims (3.4M) and settlement value(500K))

Transfer of property subject to debt

TR 1.1001-2Where property sold partially/fully for assumption of debt, no DOI where debt was recourse debt (RD)

Example 7For NRD, property and transaction NOT separated at end – thus gain/loss treated as capital gain/loss

Example 8For RD, property and transaction separated at end – thus gain/loss treated as DOI

WoodsamNo realization where owner of property with FMV>Basis mortgages it for NRD.

Ex: 100K basis now worth 250K. NRD mortgage does not yield 150K income to TP

Crane“Amount realized” by seller of mortgaged property (NRD here) includes both cash and face amount of mortgage

Crane + Woodsam:Original NRD is included, but not subsequent NRD on property

TuftsTP mortgages property with NRD, take several years of depreciation, and then sells.

TP position:NRD not real debt. Gain/loss computed from difference in sale price and adjusted basis

(after depreciation). This allows for large Tax Shelter

IRS/Majority position:NRD is an obligation. Gain/loss computed from difference in sale price and original basis (before depreciation). This allows for small Tax Shelter to degree that marginal rates > capital gains rate

O’Conner position:Treat depreciation as DOI instead of capital loss. This makes Tax Shelter unprofitable

Point: O’Conner would treat RD and NRD equally; Majority and IRS still views them as distinct

When to Count Income

Realization and Recognition

Realizationchange in circumstances where gain/loss MIGHT be counted

Recognitionchange in circumstance where gain/loss IS counted

Benefits:

  • Avoids Ability to pay problems
  • Avoids Valuation problems
  • Avoids taxation where no change in taxpayer’s net worth position

Dangers:

  • Who decides? – taxpayers! Thus taxpayers can benefit from system by realizing losses and postponing gains. This creates 1) loss of tax revenue and 2) distorts economic transactions (“lock-in” effect and “lock-out” effect)

§61(a)(3)No income from property until a “dealing” occurs

Ad hoc case history resolved by following congressional acts meant to keep benefits and reduce danger:

§305Stock dividends not included in income

Allocate original basis evenly amongst all shares

  • Response to Macumber (no realization where company divides stocks so TP now has twice as many, but same ownership %)
  • Note: w/o 2) TP will sell “old” shares first (keeping the “new” 0 basis ones) to avoid gains

§109GI does NOT include income (other than rent) derived by a lessor or real property on the termination of a lease

  • Response to Helvering (realization where lessee builds building, defaults, and IRS wants to include building as income to lessor)
  • Point: Tax liability depends on whether income (ex: building) meant as rent or something else
  • Note: If income excluded from GI then also excluded from basis under §1019. Thus §109 allows delay, but not avoidance of income

§1031 (a)Non-recognition of income (or loss) where ALL of the following occur: (Basis stays the same)

1) Must be a trade of property (you can’t sell and reinvest proceeds)

  • Odd in that it allows TP to push of gains, but doesn’t prevent them from putting off losses if they but include cash in between the transactions
  • Jordan Marsh TP sells building w/ 4.8 M basis for 2.3M + 30 year lease. IRS doesn’t allow loss write off on view that lease=fee simple (at some point they must be equal). But court sides with TP, allowing TPs to have this win-win situation under §1031

2) Both properties must be seen as (trade, business or investment) by taxpayer

  • Ex: A trades farm from another farm, but plans to use new farm just for residence; §1031 doesn’t apply.
  • Note: intent of use by other party irrelevant. If A trades farm for residence, but planning to rent residence as a business then §1031 applies

3) Property must be “of like kind”

  • Can’t exchange garage for trucks, even if both needed in your business
  • However, can exchange trucking garage for inner-city parking garage, even though types of businesses are very different

4) Specific exclusions found in:

  • 1031 (a) (2) – stock, bonds, other interests
  • 1031 (e) – animals of different sexes not the same
  • 1031 (f) – family relations and tax avoidance

cont.

“Mixed Property exchanges” (§1031(a) + other property (cash, etc))

(b)Gain from mixed recognized up to FMV of non-§1031(a) property

  • Ex: 75K 1031(a) property traded for 90K 1031(a) property + 10K cash = only 10K recognized (with potential recognition up to 25K of non-1031(a) property)

(c)Loss from mixed NOT recognized

  • Ex: 50K 1031(a) property traded + 10K cash trade for 90K 1031(a) property = no loss recognition of 10K, but basis increased to 60K (§1031(d))

Basis after Mixed:

  • All Non-1031 get basis up to their FMV (apportion if not enough)
  • Then remainder apportioned amongst 1031 property

Imputed Income

Income which can not be seen, but is generally “felt” to exist (also felt is an inequality)

Ex: Homemaker vs. workforce; Homeowner vs. renter

§163Interest

(a)As a general rule, all interest on indebtedness is deductible

(h)No deduction for “personal interest”

  • Exceptions: trade or business, investment, qualified residence, etc.

Solutions:

1) Allow deduction for party hurt

  • Congress does help a little with childcare, other deductions; but many areas do not allow deductions (ex: housekeeping)

2) Allow imputation of income to benefited party

  • No attempt by congress to do

Point: Congress typically ignores the issue.

Rationales:

  • Windfalls are good incentives
  • Huge Valuation problems for either imputation or deductions (do we trust TPs to be reasonable?)

Me on imputed income (homemaking)

  • First, if we impute income to homemaker, don’t we need to subtract the value of the homemaking services?
  • Thus the real problem isn’t that homemaker chooses to make $0 as homemaker instead of $60K in workforce, but the difference between what she could earn ($60K) and what she is choosing to earn now ($20K)
  • Thus the following problems with imputing income:
  • 1) Requires imperfect estimates of what you could make and possibly estimates of the value of the services you currently contribute - if society doesn’t give them an express dollar value (such as with homemakers)
  • 2) Necessarily leads to the conclusion that those to whom we impute income are not rational.
  • 3) Necessarily leads to imputing income to all those who choose to make less than they could, such as:
  • Law Professors
  • Doctors who take sabbaticals to help aids patients in Africa
  • Elementary School Teachers
  • The President
  • Result: If carried to the logical extreme (that all COULD earn what the highest wage earner earns) then imputation results in a per-head tax.

Tax exempt bonds

§103(a) Interest from State/local bonds not included in GI

(b) Exceptions:

  • Private activity bond
  • States can’t pass benefits of lower rate bonds (above a cap set in § 141) on to businesses to encourage them to develop in the state/local. Allowance would lead to net-loss on nation
  • Arbitrage bond
  • States can’t issue bonds to raise money just to invest it in private securities w/ higher rate, though not clear what to do about windfall between time when $ raised and when finally paid to bondholders
  • Non-registered bond

Effect 1: Moves revenue from Federal to State/local governments (maybe inefficiently)

  • States prefer §103 over direct Federal grants to states because it allows them more autonomy over 1) Use and 2) Issuance Amounts within above exceptions. May also enhance inter-state competition

Effect 2:Allows greater savings for higher tax bracket payers because issuers can’t price discriminate and they must appeal to less-than-highest bracket payers to get all the bonds sold

  • Example: State must sell to 40% and 25% brackets so must offer 7.5% return instead of 6% return (where market bears 10%). Here bonds sold to 25% bracket yield 25% to state and 0% to bondholders; those to 40% bracket yield 25% to state and 15% to bond holders – thus inefficient
  • Point: States like §103 because the highest tax bracket payers help lobby congress to keep §103 (because they get extra benefit) and would not help lobby congress to keep direct grants (which don’t help highest bracket at all)

Suggested changes to deal with capitalization problem:

1) Allow cap on # of bonds so that only highest bracket will invest (drives rates down)

2) Allow borrowing of funds to purchase bonds (currently §265(a)(2) prevents this). This will also drive down rates as highest bracket will borrow

Deductions

Effects of Progressivity

Currently, higher brackets get bigger deduction benefit

  • Note: This is less of a concern with baseline deductions (ex. Medical expenses) which do not have a consumption element, than with subsidies (ex. Charitable donations) which do have a consumption element

No way to create parity between both:

  • Intra-bracket TPs (Biglaw attorney vs. Solo practitioner w/ high overhead)
  • Inter-bracket TPs (Lawyer vs. Trashman)

Complicated current solution:

1) Allow deductions, but compensate for discrepancy between brackets by:

  • Partial deductions based on AGI% floors.
  • Phase-outs for highest bracket
  • Allow minimum standard deduction which the lower brackets will use more (around 70% of all taxpayers don’t itemize)

2) Baselines tend to show up as “above the line” deductions, whereas Subsidies show as “below the line”