I. Introduction
• Tax liability = tax base x tax rate
• tax base usually features the name of the tax
- i.e. the base of a real property tax is the value of real property. Base of a sales tax is the dollar amount of retail purchase
• §63 – Taxable Income
• 62 AGI
- defined as gross income minus the deductions listed in 62(a).
• taxpayer may claim the standard deduction or their itemized deductions, but not both
• itemized deductions are found at 63(d) – which are defined as all allowable deductions except above the line deductions (i.e. deductions allowed in arriving at AGI) and deductions for personal exemptions
• Forms and instructions of personal income tax reflect the law, but have no official legal status
• concept of basis is simply a way of keeping track of amounts that have already been taxed, in order to prevent double taxation.
ex: bought stock for 8,000. Sold for 13,0000. When stock sold for 13,000 most of the amount realized, 8000, constituted recovery of previously taxed dollars. Only 5000 was never realized before.
• unrealized appreciation – is not included in gross income. Tax one pays at the sale of the item is the price one pays for having been allowed to ignore the appreciation until the sale. The sale itself does not produce an economic gain. It is the trigger for taxing the gain that the tax system had disregarded before the sale.
• Realization event – the sale that triggered the tax is the realization event.
E & E
A. An Introduction to Terminology and Structure
Steps
1) First step is computing tax payers gross income
• Amount realized - §1001(a) – the amount a taxpayer receives on the sale or exchange.
• adjusted basis – the taxpayers unrecovered investment in the property. §§1011-1016.
• Technically, a taxpayers realized gain equals the amount realized less the taxpayer’s adjusted basis in the property sold, and a taxpayer’s realized loss equals the taxpayer’s adjusted basis less the taxpayer’s amount realized.
• a realized gain is included in gross income only if the gain is also recognized
• the general rule is that realized gain is recognized gain and includable in gross income. §1001(c)
• But realized gain is not recognized if a nonrecognition rule in the code applies to the sale or exchange
• nonrecognition rules generally apply to transaction in which the taxpayer has exchanged property but has continued her investment in another form. ex: §1031 like kind exchange
2) Next step is to compute AGI
• §62 defines AGI as gross income less certain costs of earning income and a hodgepodge of other items, such as alimony
3) Next compute taxable income
• §63 defines taxable income as the taxpayer’s adjusted gross income less the sum of (i) the taxpayer’s personal exemptions plus (ii) the greater of (a) the taxpayers standard deduction or (b) the taxpayer’s itemized deductions.
• § 151 - a taxpayer is allowed one personal exemption for each of the following: (i) the taxpayer; (ii) the taxpayer’s spouse; (iii) each of the taxpayer’s dependents.
• Itemized deductions include all deductions other than the personal exemption deduction and the deductions allowable in computing adjusted gross income under §62
• many expenses incurred in business or in the production of income are deducted in the year in which they are incurred
• but – if expense is incurred to purchase an income producing asset that will be used in the business and has limited useful life, the taxpayers expense is allocated across the years in which the asset is expected to produce income. The expense must be capitalized
• each year the taxpayer will deduct a portion of the cost of the asset – in the form of a depreciation deduction
• if the asset purchased does not have a limited useful life (ex: raw land), the taxpayer is not permitted to recover her investment in the asset until she sells or exchanges it
4) Next step, after computing taxpayer’s taxable income, is to compute the amount of tax due on taxpayer’s taxable income
• §1(a)-(d) – taxable income is tax at specified rates
• §1 rates are progressive
• marginal rate - the rate applicable to the last dollar of income earned by the taxpayer
• effective rate – taxpayer’s tax liability for the year divided by his taxable income for the year – it is the same as the taxpayers average rate
• Capital gain – the gain on a capital asset
• individuals, estates and trusts pay lower tax rates on capital gain other than short term capital gain
• short term – asset sold that was held by the taxpayer for a year or less
• §§1(h), 1222 – the rate that applies to a capital gain other than short term depends on the type of asset sold
• Capital asset = generally – an investment asset as opposed to an asset used in operating a business
• C Corporations – are treated as separate taxpaying entities and are taxed at progressive rates specified in §11
• a C corporation is any corporation that is not an S corporation
• §§ 1261, 1362 - a corporation is an S corporation only if it meets certain eligibility requirement s and elects to be an S corporation
• the special §1(h) capital gain rates do not apply to corporations
5) Step 5 - after applying appropriate tax rates to taxpayer’s taxable income – next reduce the tax due by the credits for which the taxpayer is eligible.
• Credit - a direct reduction in tax
• Deduction or exclusion – reduces the taxpayer’s taxable income – they reduce the tax due from the taxpayer by an amount equal to the produce of multiplying the deduction or exclusion by the taxpayer’s tax rate.
• ex: $1000 deduction save a taxpayer in the 30% bracket $300 of tax
• a $1000 credit saves the taxpayer $1000 of tax
• if the taxpayer’s credits exceed the taxpayer’s tax due – the taxpayer receives a tax refund
• to compute tax liability taxpayers use either cash method or accrual method of accounting
• cash method – taxpayer includes an item of income in the year in which the item is actually or constructively received
- cash method deducts an expense in the year in which it is paid
• Accrual – taxpayer using this method includes an item of income in the year in which (i) all of the events have occurred that fix the right to receive income and (ii) the amount of the income can be determined with reasonable accuracy
- accrual method deducts an expense when (i) all of the events have occurred that establish the fact of liability and (ii) the economic performance requirement of §461(h) (which often requires payment before a deduction is allowed) is met
• the cahs method permits some manipulation of the timing of inclusions and deductions
• business that keep inventories, including wholesalers, retailers and manufacturers must use the accrual method
B. The Time Value of Money and the Value of Deferring Tax
• a dollar received today is worth more than a dollar received in the future and a dollar paid today costs more than a dollar paid in the future
• deferral of tax is advantageous to a taxpayer because he can invest the deferred tax and earn income on it until it is paid to the government
• you can quantify the savings from deferral by determining the amount that would have to be set aside in year one so that the sum of the amount set aside and the earnings on the amount that would have to be set aside in year one so that the sum of the amount set aside and the earning s on that amount would fund future tax liability
Future Value
Present Value = ------
(1+ r )nth
(r is the interest rate and n is the number of period of deferral)
Ex: taxpayer defers a 10,000 tax payment for 5 years and the interest rate is 8 percent
the amount that needs to be set aside is:
10,0000
------
(1.08) (1.08) (1.08) (1.08) (1.08) = 10,000 over 1.46933 = 6, 806
Future value = Present Value (1 + r) nth
C. Tax Administration and Litigation
• Main source of Tax law is internal revenue code and case law
• tax law administered by Treasury – which delegates responsibility to IRS
• guidance is generally provided through treasury regulations, revenue rulings and revenue procedures
• treasury regulations – are interpretive regulations – under §7805 secretary of treasury has authority to enforce the provision of the code
- regulations are not the law, but are accorded great deference.
• revenue ruling – is service’s view on a particular issue
• private letter rulings – not officially published and letter applies only to the taxpayer who requested the ruling
- private letter rulings may not generally be cited as authority
• Tax decisions are appealable to the court of appeals for the circuit where the taxpayer resides
• instead of litigating in tax court, a taxpayer can pay the asserted deficiency and sue for a refund f tax in either federal district court where the taxpayer resides or the US court of federal claims, which sits in D.C.
- typically taxpayers litigate in tax court so they do not have to pay the asserted deficiency while litigation is pending
- taxpayers may choose to litigate in district court b/c jury trials are available only in that forum
- taxpayers may choose to litigate in the court of claims b/c that court follows the precedent of the court of appeals for the federal circuit, which may be more favorable to the taxpayer than the precedent of the court of appeals for the circuit where the taxpayer resides – which the tax court or district court would follow
• SOL – is 3 years from the date the return for the year was filed, or iflater, the due date of the return
D. Tax Legislation
• Under Article I of U.S. constitution – tax legislation begins in the house. Legislation begins in the Ways and Means committee
• committee has hearings, and then has mark up sessions – where the tax bill is drafted
• when completed- sent to floor of house with the house report – its debated and then the house votes on the bill – if approved – senate considers the bill
• in senate, bill begins in Senate Finance committee
• then holds hearings and prepares its version of the bill and the senate report
• then voted on – procedural rules of senate permit amendments to the bill during floor debate
• if Senate approves bill – house and senate bills goes to Conference committee – made up of people from ways and Means and Senate Finance – the committee reaches compromises on the provisions that vary b/t the house and senate – it prepares the conference bill, and both chambers, senate and house, then vote on the conference bill. If passed, it goes to the president.
II. THE SCOPE OF GROSS INCOME
A. Cash Receipts: Does Source Matter?
1. Generally No.
§61 – Gross income – is income from whatever source derived
• §61 provides that income includes wages, interest, dividends, rents and gains from dealings in property
• Haig Simons definition of income: Income equals the sum of (i)
the taxpayers persona expenditures plus (or minus) (ii) the increase (or decrease) in the taxpayer’s wealth, i.e. personal consumption plus any change in year end wealth
Commissioner v. Glenshaw Glass Co. (1955)
• Issue: whether money received as exemplary damages for fraud or as the punitive two-third portion of a treble damage antitrust recovery must be reported by a taxpayer as gross income of §61.
• Held: yes – they must be reported as gross income: income includes all accessions to wealth, clearly realized, and over which the taxpayer has dominion and control
• anti trust damages – jury deliberates and finds that the plaintiff has been damaged by 1,000 dollars, in violation of Sherman Clayton anti-trust act
• the damages, treble damages, are then tripled – so the plaintiff gets 3,000 dollars
• punitive damages – say you get compensatory damages of 100,000 and punitive damages of 400,000
• the punitives do not in any way reimburse me for anything I have lost, just as treble damages do not reimburse me for anything I lost. Rather, trebles are an incentive for people to sue under the anti trust laws, and punitives are said that a defendant should take this to heart and realize that there are some things that they do that are beyond the pale of negligence
• these are viewed as a windfall
• b/c the people got a windfall and did nothing to earn it – it is argued that they are the best person to get taxed – the person with the windfall should be taxed, not the worker. If the windfall person doesn’t get taxed, then someone else has to pay it.
• the authors argue that the windfall is a better candidate for taxation b/c it will not affect human behavior – they believe that if the tax gets too high for the worker, the worker will stop working
• §104- damages for injuries are specifically provided for in this section - amount of any damages (except punitives) received, whether by suit or agreement, on account of PERSONAL INJURIES OR PHYSICAL SICKNESS are not included in gross income
• Glenshaw glass says that §61 and is broad language “income from whatever source derived” was used by congress to exert the full measure of its taxing power under the 16th Amendment.
• confusion in Glenshaw came from Eisner v. Macomber, which defined income as being derived from labor or from capital (or from both combined)
• under this definition a pure windfall would not be taxable b/c it was derived neither from labor nor capital
Dominion and control
Cessarini v. United States (1970)
man who found money in a piano he bought many years ago wanted to take the deduction in the year that he purchased the piano which was after the SOL had passed; Ct ruled at the moment the taxpayer has dominion & control over the income, is when he must report as income; thus, when Cessarini found the money.
• §61(a) – says that a treasure trove becomes gross income in the year that it is reduced to possession
• so to pay the tax – you might have to put some of your trove on the market to get the money to pay the tax
• and when you do this, it might dive the price in the market down
• Reg. 1.61-14 – treasure trove, to the extent of its value in United States currency, constitutes gross income for the taxable year in which it is reduced to undisputed possession.
• therefore – SOL cannot run out until 3 years after treasure trove is reduced to possession
• If taxpayer discovers piano was a Steinway – treasure trove would not apply – this is simply a discovery that property already owned was more value than they ad though
• and 4000 is not a gain – b/c capital gain only applies to the sale or exchange of a capital asset
2. But tax-free recovery of “capital” is allowed
• §61(a)(3) – gross income includes “gains derived from dealings in property”
• ex: Jane buys raw land for $50,000, sells it for $80,000.
• under 61(a)(3) Jane has 30,000 of gain. Her amount realized is 80,000, her adjusted basis is 50,000 and her gain 30,000 – the excess of amount realized over adjusted basis.
• Jane does not have to include $80,000 in gross income b/c she bought the land with $50,000 of after tax dollars – she had already paid tax on this money.
3. Source Matters When Congress Says Source Matters: Statutory Exclusions
a. Gifts and Bequests
§102 – gifts not part of gross income. §102 applies to amounts received by bequest, devise or inheritance.
§1015 – basis of a gift determined under §1015
Commissioner v. Duberstein (1960) – property acquired by gift
• Duberstein provided tips/customers to Berman. Berman found tips to be so helpful he wanted to give Duberstein a gift – and gave him a Cadillac.
• Duberstein, the taxpayer, wanted to Cadillac to be a gift
• the government argued that this was a business expense by Mohawk, not a gift
§102 says that a gift is not part of gross income and cannot be taxed
• held not to be a gift and includable in the gross income of the donee, Duberstein. This was not a gift since the purpose of the gift was either to compensate for services rendered or to induce future business.
Test: Look at the intention of the donor. The intent must be detached and disinterested generosity. If the purpose of the gift is for future benefit or to compensate for past services rendered, it is not a gift, and must be included in the gross income of the recipient.
Stanton v. United States – (the minister exception)
• Stanton, taxpayer, was en employee of Trinity Church for 10 years
• company directors gave him $22,500 in appreciation of the services rendered upon his retirement – called it a gratuity
• court: if payment proceeds from the incentive of anticipated benefit of a force of any moral or legal duty, or from the incentive of anticipated benefit, it is not a gift. Or if payment is in return for services rendered, it is not a gift.
• A gift proceeds from a “detached and disinterested generosity”
• Held: must be done on a case by case basis – if it is given from a detached and disinterested generosity – it is a gift
• • but note that the person with the pertinent details before the factfinder is the donor – that is the one that has to testify why the gift was given
Deduction by the transferor:
• if you say it is a gift, the transferor cannot deduct the gift – a gift of more than 25 dollars is not deductible