Tax Law V. Tax Policy

INTRODUCTION

TAX LAW V. TAX POLICY

Tax policy[2-4]

Tax policy topics

Size and structure of government
Who/what levies and collects taxes?
How much to tax?
What to tax?
Tax base: what is being taxed(mostly income for our purposes)
Behavioral responses to taxes
Deficits/surpluses

Tax gap

Amount of taxes that should be collected under the current law versus the amount of taxes actually collected
The tax gap has a negative effect on taxpayer morale

Tax expenditures

Congress uses the IRC to disguise spending as taxes
Expenditures operate like subsidies

Efficiency

What does efficiency actually mean?

Incidences

Disguising a tax on one person as a tax on another

Tax law[4-8]

Most of tax law is civil rather than criminal because the mens rea in tax cases is even hard to prove than in regular criminal cases

Sources of tax law

The Code
Treasury Regulations
Not law, but very, very persuasive authority
Revenue Ruling
Similar to a judicial opinion with hypothetical facts
Essentially advisory opinions
Helpful and persuasive, but not as much as the Regs.
Private Letter Rulings
Involves real facts
Helpful and persuasive, but not as much as the Regs.
Common law

Tax litigation

Tax payer has three forums to chose from in bringing his case:
Tax Court (national)
Appeal as of right is in Court of Appeal for Taxpayer’s residence
If IRS is reversed in say the 4th Circuit, the only consequence is that it cannot no longer employ that argument which they were trying to advance in the 4th Circuit. The argument is still valid in other Circuits where it has not been shot down.
Precedent is only set for people coming from that specific Circuit.
District Courts
Appeal as of right is in Court of Appeal for Taxpayer’s residence
Same as Tax Court
Court of Claims
Appeal as of right is in the Federal Circuit
…everything goes to the US Supreme Court

LEGAL ETHICS AND TAX ETHICS[8]

Tax evasion v. tax avoidance
Evasion…you are on the illegal side of aggressiveness
Avoidance…you are on the legal side of aggressiveness

AVERAGE AND MARGINAL TAX RATES[9-11]

Terminology

Average tax rate =total tax/total income
Marginal tax rate =percent of next dollar of income that is taxed
Progressive tax =tax rate rises as income rises
Regressive tax =tax rate falls as income rises
Proportional tax = tax rate is constant as income rises
Zero bracket = amount of money which the federal government does not tax

Ways to get progressivity

Zero bracket/single rate income tax
Tax brackets
1: brackets
1(f): Brackets are updated for inflation
In determining tax liability, refer to Rev. Proc. (p.636-638 (Bank))

Calculation

Gross income =
Taxable income = Gross income – (Deductions + Exemptions)
Deductions
Above-the-line
Below-the-line
63(c)(2):standard deduction (p.638 (Bank))OR
married individuals filing jointly and surviving spouses: 11,600
heads of households: 8,500
unmarried individuals (other than surviving spouses and heads of households): 5,800
married individuals filing separate returns: 5,800
63(d):itemized deductions
Exemptions
151(d): personal exemption (p.636 (Bank))
$3,700

Tax = (.1 x 17,000) + (.15 x [69,000 – 17,000]) + (.25 x [139,350 – 69,000]) + (.28 x [212,300 – 139,350]) + (.33 x [379,150 – 212,300]) + (.35 x [? – 379,150])
1,700 + 7,800 + 17,587.50 + 20,426 + 55,060.50 + ?
Example of someone with a TI beyond the last bracket

MTR = 35%
percent of next dollar of income that is taxed
ATR =
Total tax/total income
More hypos (p.9-10 (Notes))

IMPLICIT TAXES[11]

Taxable bonds v. municipal bonds

WHAT IS INCOME?

DEFINING INCOME[12-13]

Important terminology

Stock variable: value is defined meaningfully without the passage of time
Full variable: value is defined meaningfully only with respect to the passage of time
There has to be a unit of time attached
Income is a full variable
High wealth individuals often have high incomes
When we are talking about income, we are not talking about wealth
Income refers to the flow of money into someone’s account over a period of time, usually a year

Haig Simons (HS) income

Y (income) = FMVc (fair market value of consumption) – ∆NW (change in net worth [wealth])
Consumption is a full variable
Net worth is a stock variable
Y = C (consumption) + S (saving)
In order to measure income in all of its forms, we have to measure everything spent plus change in your net worth
Real world problems with HS…they don’t create exceptions, but “holes in the cheese”
(1) Realization v. Accrual
Accrual…you have gotten wealthier
Realization…you have turned that wealth into cash
If we focus on the realization of income, we are not really taxing the person’s change in net worth, but rather how much they cashed out
(2) Imputed income
Things that have fair market values that you have received or consumed, but do not consider taxable
(3) Below-market sales
Paying a different price for the same product
This skews the FMVc variable
(4) Leisure
Leisure is often described as a consumption choice
Its never in actually included though
(5) Valuation
Often difficult to determine fair market value
How do you determine the FMV?
1.61-2(d)(1): if the services are rendered at a stipulated price, such price will be presumed to be the fair market value of the compensation received in the absence of evidence to the contrary

Defining income

61: gross income is all income from whatever source derived
The broadest measure of income that we can impose
Assume it is income unless the Code says otherwise
Important considerations
Substance dominates form
Under policy concerns
Vertical equity
Consider whether the thing we are looking at enhances the person’s ability to pay taxes?
If yes, then it is probably income
Taxes paid should increase with the amount of income earned
Horizontal equity
Two people who are substantially equal should pay the same taxes
Whether something is earned by windfall or labor, it should be taxed the same
Many things are excluded from TI as matters of custom
Imputed income
Almost never taxed
Some, but not all, below market sales
You have know the common law to know which below market sales are taxed
Leisure

OLD COLONY AND GROSSING UP[13-14]

Old Colony

Held that an employer’s payment of federal income taxes on behalf of its employee constituted income to the employee

Grossing up

Due to withholding, it is now routine for an employer to make federal (along with state and local) tax payments on the employee’s behalf, and yet for these payments to be included in the employee’s gross income
Calculation(p., 117-118 (Notes))
G = Gross Pay (employer controlled); N = Net Pay (target); t = marginal tax rate
Here, G = ? ; N = 80k; t = 0.2
N = G – t(G)
N = (1-t)G
G= N/(1-t) = 80,000/(.8) = 100,000
Checking your answer
G – (G x t) = N
Caveat in calculation
If the gross up will send you into the next tax bracket, using the higher tax rate for it will provide you with maximum amount necessary for grossing up

NONCASH BENEFITS

Introduction[14-15]

Includes fringe benefits
Why should we tax fringe benefits?
(1) Horizontal equity
However, in practice, some noncash benefits get taxed and other don’t
It really quite arbitrary
(2) It would be unfair for those whose bosses don’t play along
(3) Behavior would change in perverse ways if we didn’t
Employers and employees would both have an incentive to reduce the cash portion of their salaries for the sole reason of reducing tax liability
You would not want to run a system in that way that taxes changed peoples’ behaviors
Concerns about a slippery slope with regards to fringe benefits
Everyone is going to want their benefit to be and remain tax free

Meals and lodging provided to employee[14-19]

Beneglia(BTA 1937)

Room and board provided to an employee is excluded from their income, and therefore not taxable, if its provide for the convenience of his employer
Here, room and board were provided for the convenience of the employer
NB finds the rule and holding wrong
But, NB suggests that the majority correctly limited the opportunity for collusion between the employer and the employee under the COE test by shifting the burden of proof away from the Service and onto them
Valuation
If dissent prevailed and room and board was TI, valuation is done by calculating the FMV of what the employee received

119: codification of a variation of the “convenience of employer” test

Meals and lodging furnished to employee, his spouse, and his dependants, pursuant to employment
(a)(1):Meals shall be excluded from income only if furnished on business premises (not the fanciest restaurant in town)
(b)(4): Meals must be furnished to at least half of the employeesfor the meals to meet the convenience of the employer standard
egalitarian provision
geared at preventing special treatment
“furnished”
Kowalski (US SC 1977)
Meal allowance payments to state highway patrol troopers were not excludable under 119 due to failure to satisfy the “furnished” requirement. Thus, in effect, to meet the terms of the statute, the state would need to open its own version of McDonald’s and Pizza Hut at various convenient points along the highway, rather than relying on the private sector to supply its troopers with fast food.
9th Circuit essentially disregarded this holding
This discord is not unusual in tax law. Furthermore, it highlights how tax law is aberrant in that
(a)(2):Lodging shall be excluded from income only if it is a condition of employment that you must live on the premises
(b)(1): A trier of fact may consider evidence of a contract saying that lodging is for the convenience of the employee; however, such contract will not be determinative
this is to prevent collusion between he employer and employee
RR 71-411: Employer’s convenience is most often established by proof that the employee is ‘on call’ outside of business hours
“employee”
Exclusion is only available to employees so not to self employed but would be available to the sole employee of a corporation even if that employee owned all shares and therefore was self employed in the practical if not legal sense (and the corp could also deduct the cost as a business expense)
Lodging furnished to certain education institution employees
(d)(1): in the case of an employee of an educational institution, gross income shall not include the value of qualified campus lodging
(d)(2):Exception – cases of inadequate rent (cases when the employer charges below “reality rent” (regardless of whether it is charging FMV to others) to its employees
Paragraph (1) shall not apply to the extent of the excess of
(A): the lesser of:
(i) 5% x appraised value of the qualified campus lodging, or
(ii) the average yearly rent paid by those not favored by the university (non-employees)
non-favored yearly rent (per/month x 12)
(B): Lesser of (i) and (ii) – employee’s yearly rent (per/month x 12)
If this number is positive, this is TI
Qualified campus lodging
119(d) applies when it is a university, and the university is providing rental apartments. However, if you are living somewhere for the convenience of the university (the employer) – such as a RA – then 119(a) applies instead.
Policy behind 119(d)
The policy behind 119(d) is that when a university wants to provide its employees with discounted housing, then the university has to provide that benefit to all people. If it does not provide discounts to everyone, then the employee will have to pay taxes on some level of income.
Horizontal equity
Also, remember the employee is not living at the convenience of the employer here
Calculation (p.18 (Notes))
Facts
Reality rent = 7,200
Analysis (119)
(d)(2):
reality rent = 7,200 per year
rent charged = 200 per month (2,400 per year)
below reality rent
(d)(2)(A): lesser of:
(i): 5% x appraised value of qualified campus lodging
200k is the FMV if the unit went condo
.05 x 200k = 10k
(ii): for comparable units, what the university is charging to not favored people (non-employees)
Monthly rent = 800
Annual rent = 9,600 (800 x 12)
(d)(2)(B): employee’s rent
monthly rent = 200
annual rent = 2,400
9,600 (lesser of (i) and (ii)) – 2,400 (employee’s annual rent) = 7,200
$7,200 would be included in TI

Other fringe benefits statutes[19-20]

American approach to fringe benefits
Fringes started to be provided, and the if IRS doesn’t notice or doesn’t care, then the fringes get more popular
This is a huge morale issue
Loss aversion
People are more bummed out when they thought they had something then lost it, rather than knowing they never had it at all

132: fringe benefits

Drew a line at the fringe benefits people have gotten used to received as non-taxable
There is no commonality amongst the fringes treated as non-taxable
fringe benefits apply to families – i.e., spouses and dependants
however, the definition of family is relevant to the traditional definition of a family as required by DOMA
thus, same-sex couples are excluded

(b) no-additional-cost service
e.g., empty seats on airplanes
letting an employee fill an empty seat is of no additional cost service to the employer
the employee receives something of value, but 132 allows the employee to exclude that from the value of their income
(1) “in the ordinary course of the line of business”
intended for corporations with multifaceted businesses
if you are a programmer for a corporation that happened to have an airline, you CANNOT get the free airfare deal
(j) “boys in the boardroom” provision applies
(c) qualified employee discount
as long as the employer sells something to an employee at cost
in the case of services, the Code simply institutes 20%
employee does not have to include the difference between cost and retail, even though they are receiving a benefit
(4) “in the ordinary course of the line of business”
Same as 132(b)(1)
(j) “boys in the boardroom” provision applies
(j)special rules
(1) exclusions under no-additional-cost service and qualified employee discount fringes apply to highly compensated employees only if there is no discrimination
goes against the boys in the boardroom problem
for our purposes, highly compensated means highly compensated
(d) working condition fringe
It can be excluded when it is provided by the employer as fringe benefit if an employee could have deducted it as a business expense itself
(e) de minimis fringe
most important fringe of all
does not mean it is a small fringe, it means that it is an annoying fringe
accounting for them would be unreasonable or impracticable
not about “lines of business,” about annoyance
(f) qualified transportation fringe
(1) you can exclude from your income, the costs of a
commuter highway vehicle
essentially employee vans taking employees from satellite parking lots to their offices
a transit pass
qualified parking,
bicycle commuting -- from your income
(2) limitations on exclusion – an exclusion shall not exceed
$230 per month for commuter highway vehicles and transit passes
$230 per month in the case of qualified parking
the applicable annual limitation in the case of any qualified bicycle commuting reimbursement
this fringe is here to allow people to exclude commuting costs from their taxable income
1.61-21(b)…taxation of fringe benefits
Valuation
FMV if you can determine it
If you can’t determine FMV, then there may be a safe harbor rule to turn to
Sometimes its difficult to determine FMV. So if you follow a safe harbor rule, you can avoid an IRS challenge.
(b)(5) chauffeur services: use what the limo company paid the chauffeur

Cafeteria plans[20-21]

125: cafeteria plans

Another kind of fringe benefit
(a): the fact that you have a choice among benefits does not turn them into cash and make them taxable
132 (a bunch of isolated benefits that you may receive) v. 125 (an employer has to specify a cafeteria plan)
(d): you can choose some fringe benefits from the cafeteria plan and you will not have to include in your taxable income, but if you opt out of everything and take the cash you have to pay taxes on that income
(f): inclusion by reference(anti-abused provision)
other Sections of the Code tell you what can be included in a cafeteria plan
Key examples of what can be included in a cafeteria plan
Group-term life insurance
Dependant care assistance
Adoption assistance
Excludable accident and health benefits
Elective contributions under a qualified cash or deferred arrangements under 401(k)
The idea of a cafeteria plan is to allow employees to pick and choose all, some, or none of the benefits provided by the employer
If you take all of the benefits, you will have a lower taxable income
So, there is no horizontal equity
But, there are psychological aspects to this
You can personalize the fringes to your own situation
Employee envy
The fact that you can opt-out should allegedly reduce the element of employee envy
Use-it-or-lose-it rule
If you don’t use the whole benefit up, you just lose it
This stems from an incorrect estimation of what you may need in a flexible spending account
People go in for all kinds of unnecessary medical procedures on March 30 or 31
To cure these problems, NB suggests that Congress simply set limits rather than attempting to prevent people from overspending on the preferred items by raising the risk associated with overestimating
If you don’t use it, the funds go back to the employer
The employer may pocket the excess funds
Or, the employer may redistribute the excess funds across all the employees

Another Approach to Valuation[21-23]

Turner(TCM 1954)

Suggests a subjective approach to valuation…incorrect

Rooney

Any previous hints at taking into account subjective valuation should not be taken seriously

Rule

You want to look for objective manifestations of value
Important distinction
Opinions and the like can affect fair market value if people put their money where there mouth is
What we don’t want to do is take into account people’s unique situations

Windfalls and perks[23]

Treasure trove

1.61-4: treasure trove, to the extent of its value in US currency, constitutes gross income for the taxable year in which it is reduced to undisputed possession
If you gave back such a windfall immediately, as in the case of the record-breaking home-run balls, you are treated as if you never possessed it at all.
There is a realization requirement for found treasure.
Only when you sell it and turn it into cash are you taxed on it.
HS income but not taxable income.

IMPUTED INCOME