Income Tax

Prof. Roin

  1. Structural Overview: The Tax Rate Schedule
  1. Basics
  1. Tax rates are listed in § 1.
  2. Mechanical Steps to Compute Tax (also in HO 1)
  1. Calculate gross income (§ 61)
  2. Subtract above the line deductions (§ 62) = adjusted gross income.
  3. Subtract either standard deduction or below the line deductions (§ 63), as adjusted by the phaseout provisions (§§ 67, 68)
  4. Subtract personal exemptions (§ 151), also adjusted by phaseouts.
  5. Apply tax rate schedule to taxable income.[Excluding capital gains, which are calculated separately.]
  1. Tax Rate schedule is progressive because we think people who earn more ought to pay proportionally more to the federal government.
  1. Marginality
  1. Rates are complicated [5,535 + 28% of excess over 36,900] so that people will not lose money when they get “pushed into a higher tax bracket.”
  2. Under the marginal system, each slice of income is taxed at its own rate.
  3. Still, if rates are too high, it will discourage work: “I’d rather watch TV than earn 50¢ on the $.”
  1. Hidden Rates
  1. IRS can generate more revenue either by raising rates or adjusting basis.
  2. Post-1986, Congress has primarily raised revenue by phasing out deductions.
  3. Rationale for Deductions
  1. Think not everyone w/ the same gross income in the same economic position.
  2. Example: Difference b/n law firm associate and small business owner
  1. In cases where deductions are disallowed for expenses only b/c gross income has increased, has effect of increasing a person’s marginal tax rate. See HO 2B and Problem 1-3 (statutory rate of 36% goes up to 42.2% with phaseouts).
  2. Rationale for Phaseout of Deductions
  1. Only want to co-pay some expenses (like medical) for those w/ lower income.
  2. Can play political games and hide tax increases.
  1. Married People
  1. Congress has provided different tax rates for married and single individuals.
  2. Problem Set 1: Two equal wage-earners will increase their tax burden if they marry (“Marriage Penalty”), but if the husband earns all the income, the tax system confers a “Marriage Bonus.”
  1. Many Congressmen want to give tax break to traditional families.
  2. But this undercuts traditional marriage in 2 wage-earner households
  1. A few possible solutions, but none of them good
  1. Widen the rate brackets so marriage rates are just double the individual rates
  1. Big loss of revenue
  2. Phaseouts also harm married couples and would be unaffected
  1. Double brackets in phaseouts too (Huge Revenue Drain)
  2. Award a flat second-earner deduction
  3. Give taxpayers the option of filing under a single rate structure (Drain)
  1. Income
  1. Receipt (Realization Problems)
  1. § 61: Gross income “means all income from whatever source derived.”
  1. Only counted as income “to the recipients.” § 1.61-2.
  2. If you are viewed as having received a certain benefit, it is income.
  1. Old Colony
  1. Facts: Wood has income taxes of $681K paid for by his company. That $681K is income, and Wood owes tax on that too.
  2. Same result if American Woolen gave 681K to Wood’s 12 year old daughter, or paid for his 18 year old daughter’s college education.
  3. But result would be different if education paid through National Merit Scholarship funded by the company.
  4. Also different if company donates 681K to the Art Institute where Wood serves on the Board. [Note: Even w/ charitable deductions, Wood would be taxed more if he donated himself b/c of phaseouts.]
  1. Principles for Analysis of Receipt
  1. Certainty: less chance of gaming the system with National Merit.
  2. Benefit: Long-term prestige from donation so at least some purpose
  3. BL: Different tax treatment depending on whether Wood receives the money.
  1. Timing: When is Income Received? (Drescher)
  1. Court requires Drescher to include $5000 employer uses to buy an annuity in his income the year purchased.
  1. T: I won’t receive income for 19 years; should pay then.
  2. Importance of deferral based on TVOM (and here also b/c Drescher may be in lower tax bracket in 19 years earning less income.)
  3. If let T do this, vicious cycle of HO 3 occurs w/ T and employer colluding so both pay lower taxes by shifting compensation to non-taxable forms. IRS loses revenue or taxes those who can’t take advantage of annuities.
  1. Rule: Taxable on any cash or property you receive. Since annuity is tangible property with certain value, it is taxed when Drescher receives it.
  1. Fringe Benefits
  1. Valuation Problems
  1. Undertaxing  same as Drescher (HO 3); fear if we let you deduct a business lunch, employers will start paying you with more lunches and less salary.
  2. Overtaxing  If Benaglia must have his hotel manager work in his hotel, then he has no all-cash alternative and will have to pay more cash to get an employee. Don’t want tax system to force people sensibly providing meals and lodging to move away from that for tax reasons.
  3. BL: Don’t want to change taxpayer behavior through under or overtaxation.
  1. Meals & Lodging
  1. Tax can’t be based on reporting subjective value b/c people will underreport.
  2. Benaglia: Are benefits provided for the “convenience of the employer” or as a form of compensation?
  1. Unclear whether necessary for Benaglia to live at hotel (or just near)
  2. NY law firm could provide associates w/ Mid-Town apartments. Too manipulable a test
  1. Statutory Solution: § 119
  1. Meals/lodging must be directly furnished by employer on the employer’s premises. Kowalski.
  2. If meal, must be for convenience of employers
  3. If lodging, must be a condition of employment.
  4. While firm could still provide a restaurant or hotel, it seems unlikely.
  1. BL: Once tax benefit is accidentally created it’s hard to yank. A person’s taxes will suddenly go up as their compensation drops. HO #3-3. So just contain.
  1. Other Fringe Benefits [§ 132]
  1. General rules.
  1. Discount must be less than or equal to 20% if service or the gross profit percentage if property.
  2. Retirees, widows, spouses, and dependents also qualify as employees, as do parents for air transportation only.
  3. Nondiscrimination rule: Fringe benefit can’t go only to highly compensated employees. But toothless if discount is on a Mercedes.
  4. Discount must be in your line-of-business, so a Hilton employee can’t get a benefit from TWA even if both are owned by same conglomerate. But a conglomerate exec could get both.
  5. Only OK to the extent you provide good or service to the public.
  1. No additional cost services like airline tickets are not income.
  2. Can’t get discounts on things like marketable securities that are almost cash.
  1. Income v. Capital Recovery
  1. General Treatment
  1. § 61(a)(3): Income includes wages + gains derived from property.
  2. Gain = Amount Realized – Basis. § 1001(a).
  1. Amount Realized = Cash Received + FMV of other property received. § 1001(b).
  2. Adjusted Basis[§ 1011(a)] = Cost[§ 1012] adjusted by § 1016.
  1. Example: One year Mary earns $400, buys a cow for $150, and sells the cow for $250. Her income is 400 + (250 – 150) = 500.
  1. Disposal in Units Different from Those Purchased
  1. Treas. Reg. § 1.61-6(a): When a taxpayer disposes of only part of a property, he must allocate basis b/n the amount sold and that retained based on relative fair market value.
  2. Example: Mary buys a cow for $150. This year she sells ½ the cow for $100. Next year she sells ½ the cow for $110. In Yr. 1 she gains (100 – 75) = 25. In Yr. 2 she gains (100 – 75) = 35.
  3. Often big difficulties in appraisal: Mary buys 40 acres for $150 and sells 20 acres that are rocky for $100. If she allocates 1/3 of the value to the property, her gain is 50. If she allocates ¼, her gain is 62.50. By allocating more, she can defer TVOM on $12.50.
  1. Treated as Capital Recovery Only
  1. City uses eminent domain to change river and pays T $49,000. T may allocate the entire award to reducing basis of land and none to easement it has gained. Inaja Land Co.
  2. Rationale: FMV difficult to determine and circumstance unlikely to recur.
  3. T gets huge TVOM benefit. Inaja a unique case; always distinguished.
  1. Treated as Income Only
  1. Despite sympathies of the Great Depression, prepaid leases must be treated as income b/c substitute for future income that would ordinarily be received. Cannot be used to offset basis. Hort.
  2. Any money received from a trust must be treated as income and cannot be used to reduce the basis of the trust. Irwin.
  3. No allocation allowed here b/c taxpayers could manipulate and not realize tax by not selling building or trust. TVOM. Contrast Inaja where the situation is fact-based on state action of eminent domain unlikely to recur.
  1. Gifts
  1. General Rule: Gifts not included in gross income. § 102(a).
  2. Limitations
  1. Allowing employers to give employees “gifts’ instead of “compensation” could lead to big rate arbitrage problems, as discussed in HO #6.
  1. If parties taxed at different rates, the employer can give a greater benefit at a lower cost.
  2. Even a limitation on deductibility may still allow some tax arbitrage if employee’s marginal rate is higher than employer’s rate.
  3. BL: Gifts just another form of tax-free benefit where IRS must look out for collusion and arbitrage. Back to Benaglia.
  1. Court initially imposes a “fact-specific” approach based on donor’s intent that proves totally unworkable. Duberstein.
  2. § 274(b): Business gifts are deductible by the business only up to $25/year.
  3. § 102(c): Any amount transferred from employer to employee is not a gift. The employee must include in income (unless de minimis under § 132).
  1. Basis Rules [§ 1015]
  1. § 1015(a): Normally, the donee’s basis in gifted property will be the basis in the hands of the last owner who did not acquire the property by gift. PS # 3.
  2. However, if this basis is greater than FMV of property at time of gift, then for purpose of determining loss, the basis will be the FMV of property at time of gift.
  3. If FMV at transfer < Donee’s Sale Price < Donor’s Basis, no gain or loss is recognized. See PS # 3.
  4. Because of these rules, you should never give away depreciated property. Instead sell it, claim the loss, and gift the cash.
  5. Compare § 1014: The basis for property transferred at death is always the FMV at the date of death.
  1. Usually this will lead to “stepped-up basis” that won’t be taxed.
  2. If property depreciated, there will be “stepped-down basis,” so people usually try to sell these assets before death and avoid disappearing loss
  3. Don’t allow this stepped-up basis for gifts. Taft. Rationale: People would gift property anytime it appreciates to avoid tax consequences. This is too big a loophole.
  4. Alternate solution: Treat a gift as a realization event. This would have really hurt taxpayers though on TVOM.
  5. Congress tried replacing § 1014 w/ a § 1015 rule, but it was repealed b/c often impractical to figure out what the original property basis was.
  1. Nonstatutory Basis (Clark)
  1. Sometimes courts will find a nonstatutory basis that wasn’t purchased, inherited, or gifted.
  2. Example: An accountant error causes  to overpay IRS by $ 19,000. Accountant gives  that amount. Court treats as recovery of capital.
  3. Inconsistent that you can exclude from income but can’t take a loss deduction if your accountant won’t reimburse you. Same problem arises with personal injury awards.
  4. BL: Allow weird quasi-basis to sympathetic taxpayers sometimes.
  1. Gifts of Divided Interests [§ 102(b)]
  1. What happens when you leave a trust to your grandchild and allow your son to draw interest until the grandchild turns 21?
  2. Annual trust income taxable to son, while grandchild will receive gift under normal § 102 rules.
  1. Cancellation of Indebtedness Income
  1. General Mechanics
  1. Loans are not included in income b/c subject to obligation to repay.
  2. But if the obligation is cancelled, there is income at that time. § 61(a)(12).
  3. Example: Borrow $30,000 from bank. 4 years later bank forgives loan. You have $30,000 gain in Year 4.
  4. Example2: Sell $1 million in bonds. Buy bonds back for $862,000. Company recognizes taxable gain of $138,000. Kirby Lumber.
  1. Purchase Price Adjustments [§ 108(e)(5)]
  1. If you purchase property and later haggle and get a reduced price, that may be treated as a purchase price adjustment and not income.
  2. Example: Joan borrows $15,000 to take a trip around the world and has an awful time. She convinces the tour company to refund $10,000. That is not income, although it would be if she borrowed the money from the bank.
  3. Example2 (Zarin): Taxpayer with huge gambling debts held to be haggling over actual price of chips and not recognizing discharge of actual debt.
  4. May also apply if parties are very closely related such as loan companies associated with or referred from car dealers. PS # 4-1.
  1. Insolvent Debtors (PS #4)
  1. Any discharge of debt when T is insolvent is excludable from income.
  2. Any successor corporation cannot use a net operating loss (NOL) unless it first absorbs all of the DOI income.
  1. Transfer of Property Subject to Debt
  1. Loans as Basis
  1. Funds borrowed by T and invested in property (i.e. mortgages) are treated as part of the cost of property and part of basis.
  2. Basis in a house is $100,000 if
  1. I buy it with $100,000 cash
  2. I buy it with $100,000 I borrow from the bank
  3. I buy it with $100,000 I borrow from the seller
  4. I assume the seller’s $100,000 mortgage.
  5. I buy it with $100,000 of nonrecourse debt (lender can only get the property if I default and can’t touch my other assets).
  1. Limitation: If I borrow money secured by property (my house) and invest it in another asset (my boat), the money is allocated to basis of boat, not house. Woodsam.
  2. If we didn’t include loan proceeds in basis, then every loan repayment would require basis and depreciation adjustments. See Crane.
  1. Loans as Amount Realized
  1. When disposing of property, Amount Realized = Cash Received + Mortgages Assumed by the Other Party. Treas. Reg. § 1.1001-2(a)(1).
  2. Example: I sell property w/$60,000 mortgage to J, who pays $40,000 and assumes the mortgage. Amount Realized = $100,000.
  1. The Ambiguity Problem
  1. When interest rates rise, the economic burden of lower interest rate debt falls, but DOI income can screw things up.
  2. Example: T buys house for $100,000 w/ mortgage at 6% interest. The rate rises to 10%. T would be willing to pay $70,000 to pay upfront. But if he does, he will have $30,000 in DOI income.
  3. Possible Solution1: Sell house to J for $30,000 cash + assumption of debt. Now T has $30,000 gain, but no tax on first $250,000 gain from residence, and even if business instead, it would be taxed at low capital gains rate.
  4. J will now have basis of $130,000.
  1. Recourse Loans
  1. Treas. Reg. § 1.1001-2(a)(2) specifically disallows Possible Solution 1; instead T must bifurcate the transaction. Amount realized would be FMV of the property, and T would have DOI income to the extent that such value was less than face amount of the recourse debt. Check this somewhere.
  2. BL: Recourse loans bifurcated into sale of property and DOI income.
  3. By and large though, Treasury doesn’t try to figure out value of assumed loans
  1. Nonrecourse Loans (Tufts)
  1. What happens when T disposes of property subject to a nonrecourse mortgage? Suppose T takes out a $1.85 million nonrecourse loan secured by the property, which falls in value to $1.4 million, and in which (through depreciation deductions) T now has a basis of $1.45 million.
  2. T’s position: Amount realized = FMV of property = $1.4 million. Loss [Amount Realized – Basis] = $50,000
  3. Tax purist position: T is right, but in addition, T has realized DOI income of $450,000 b/c he paid of a $1.85 million debt w/ a $1.4 million property.
  4. BLL (Tufts): Amount realized = (Cash + Mortgages Assumed) = $1.85 million. Gain = Amount realized – Basis = $1.85 - $1.45 = $400,000
  1. Court deems FMV of the property in question irrelevant.
  2. Court basically mashes two transactions together. While purely a loss, this still ends up resulting in a net cash flow gain b/c of TVOM and b/c transaction taxed at capital gains rate. Gets a bit of a break for T, but not as high as he wanted.
  3. Matters because the higher your initial basis in nonrecourse debt, the higher your potential depreciation deductions. (Tax shelter options).
  1. However, if we applied the recourse loan rule to nonrecourse debt, it would change the value of debt/gain every time the property value goes down, which is just administratively infeasible.
  1. Basis of Recipient on Transfer
  1. Usually assumed basis is Value of Mortgages Received.
  2. Occasionally use FMV (Pleasant Hill Summit) or zero (Estate of Franklin) if the value of the property has dropped drastically and we think this is a tax shelter case and debt unlikely to be repaid. See HO #5 and Notes 1/29/1.
  3. If given this lower basis and property declines further in value, amount realized should be limited to this lower basis since this is “cost.”
  4. Wouldn’t be totally irrational to take property whose value is less than that of its mortgages if debt is nonrecourse. If doesn’t appreciate, you can just default and bank eats the loss. Reason Pleasant Hill Summit makes sense.
  1. Gifts
  1. What do you do when you give somebody mortgaged property as a gift or require them to pay your gift tax? Recharacterize as part gift and part sale.
  2. Rule for Charities and “Right Answer” § 1011(b)
  1. Allocate on a percentage basis b/n gift and sale.
  2. Example: Man gives church a $250 piece of property in which he has a $100 basis subject to $200 gift tax liability. Treated as selling 4/5 of the property (w/basis of $80) for $200 and giving $50 gift (w/basis of $20). Therefore, Man has a gain of $120.
  3. Church’s Carryover Basis = Donor’s Basis in Gift + Sale Price = $20 + $200 = $220
  1. Rule of Diedrich
  1. Treated as selling the whole property for amount discharged.
  2. Example: Amount Realized – Basis = Gain. Here $200 - $100 = $100.
  3. Son’s Basis = Sale Price(Gift Tax/Amount Realized) = $200 {or Donor’s Basis, whichever is greater}.
  4. Follows regulations from § 1.1015-4, but lets you defer $20 in taxes.
  5. If the property is mortgaged for less than the basis, you can’t manufacture a loss. See § 1.1015
  1. Timing Issues
  1. Realization
  1. Gains and losses only determined when property is sold to a third party for cash.
  2. Rationale
  1. Difficulty of determining value of property w/out sale.
  2. Fear “forced liquidation” of assets.
  1. But don’t want people going back to barter to avoid taxes.
  2. Cases & Trends
  1. In Eisner, the court found that a 2:1 stock dividend was not a realization event because there was no severance of the asset.
  2. But in Helvering, the court holds that a building attached to the land might have been severable and a new building on land is realized when the tenant defaults.