- 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.
• 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
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:
(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.
• 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
• so if you want to give Duberstein a 50,000 vehicle as a gift – you cannot deduct it, and onthis you spend 50,000
• but if you give it to him and deduct it, it will cost you only 30,000
• so you decide to give him a buick, and don’t deduct it – the transferor is indifferent
• if he gets a 30,000 Buick, he has to pay no taxes on it – it was a gift
• if he gets a 50,000 dollar Cadillac – he has to pay taxes on it, b/c the transferor deducted cost and it was therefore not a gift
So, the transferor is out only 30,000 after tax cost if it gives the cadillac
and Duberstein has a net gain, after taxes of 40,000
but if Duberstein were at a higher tax bracket – say 50%
then he would only have 25,000 net gain after taxes
and in the end he has less than the transferor – this is a transaction he would not want to enter into.
• §274(b) – denies the transferor a business expense deduction for any business gift over §25.
- thus - if the Cadillac to Duberstein was a gift, the provision would limit Mohawks deduction to $25.
- this deduction disallowance means that the value of the fit will be taxable to the transferor
- as long as the car was not a gift, Mohawk’s deduction would not be limited by §274(b), and Mohawk could deduct the entire cost of the car
Olk v. U.S. (1976) – tips given to crap dealers by players were not gifts, since the giving of the gifts since the intent of the donors was hopefully to please the gods of chance.
Tips to restaurant employees – not a gift
Keychains with a donor’s business name on it – not a gift
Cordless phone given to an individual in exchange for hearing a real estate pitch – not a gift
Employee achievement awards given by employer – not a gift if the award is an item of tangible property. §274(j).
E & E
• Gifts of appreciated or depreciated property
• if at the time of the transfer the fair market value of the property is equal to or greater than the basis of the property in the hands of the donor: the donee takes the donor’s basis. The gain is deferred until the donee sells the property.
• If property has declines in value in the hands of the donor so that the fair maker value at the time of the transfer is less than the donor’s basis:
1) for purpose of determining gain on a subsequent disposition, the donee takes donors basis
2) for purpose of determining loss on a subsequent disposition, donee takes basis equal to the fair market value of the property at the time of the transfer
explanation: If a taxpayer sells property that she received as an inter vivos gift:
1) if at the time she received the gift, the fair market value of the property transferred was greater to or equal to the donor’s basis, the donee takes the donor’s basis. On a subsequent sale of the property, she has a gain to the extent that her amount realized on the sale exceeds her basis
2) if property declined in value in the donor’s hands, so that bsis is greater than fair market value at the time donee received the gift
a) on a subsequent sale of the property first apply the gain rule and give the donee the same basis as the donor. If that produces a gain to the donee, calculations are done
b) if the calculation does not produce a gain, apply the loss rule and give the donee a basis in the property equal to its fair market value at the time of the transfer. The donee realizes the amount of loss that comes from that transaction.
- if the gain rule does not produce a gain and the loss rule does not produce a loss, the donee does not realize a loss or gain on the transaction
Property acquired by bequest:
• §102 – beneficiary excludes gift by bequest from gross income
• §1014 – defines basis for gifts by bequest – property acquired by death takes a basis in the hands of the beneficiary equal to the property’s fair market value on the date of decedent’s death
- this means that appreciation of property during decedents life will never be taxed
b. Damages on account of Personal Physical Injuries §104 • §104(a)(2) – excludes from gross income “any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness.”
• exclusion applies to nonpecuniary damages (for pain and suffering or loss of enjoyment), damages for medical expenses (past and future), and damages for lost wages (past and future)
• if you are being reimbursed for these, you are being reimbursed for a loss – so you can say that there is no economic benefit for these, and therefore they should not be taxed
• Glenshaw glass says that outside of personal injuries, punitive damages are taxable
ex: Paul loses arm, sues and recovers 1 million.
• 1 million award is intended to make paul as well off as if the accident never occurred. I.e., having 1 million and no right arm is supposed to be equal to having a right are and no damage award
• most people therefore have a right arm with a basis of zero and a value of 1 million, but they never pay tax on the unrealized appreciation of this b/c they never sell their arm
• the exclusion of pecuniary damages is based on solicitude for victims of forced sales
• thus, if one voluntarily sells a zero basis body part of one’s body (such as hair, blood, or a kidney) the amount realized is not received as damages and §104(a)(2) does not apply – you should have to pay taxes on this sale
• Note that emotional distress shall not be treated as a physical injury, even if it causes physical symptoms
• §104(a)(2) interest earned on damages received is taxable under §61(a)(4), but if payments are received over a period of years, the entire recover is excluded from income – even if the payments to be made in the future include implicit interest as compensation for the delay in payment.
Medical expenses • if §104(a)(2) did not apply to damages on account of medical expenses, then a taxpayer would include the damages in gross income but offset the inclusion with a medical expense deduction
• in practice the exclusion under 104(a)(2) produces better results than produced by the inclusion and then the deduction
•• the medical expense deductions allows only for medical expenses in excess of 7.5% of AGI, and the this excess is deductible only if the taxpayer does not claim the standard deduction
• exclusion for lost wages is often justified as a tax subsidy for the tort plaintiffs lawyers fee, as the wages would not be excluded if the taxpayer had been working
c. Life Insurance
§101(a) provides, in general, that gross income does not include amounts received under a life insurance contract, if such amounts are paid by reason of the death of the insured.
• Two categories:
1) Term – provides protection for a specific term, almost always 1 year
- you win if you die in that year – the pay out is not taxed – under §101 the beneficiary receives the proceeds tax free
- but if you live out the policy you cannot deduct the cost of the policy
ex: insurers operate under the law of large numbers
1000 people and they have an age cohort (people of the same age)
- you get a year older or a year younger, for insurance purposes. you have a ½ birthday – that is when you advance a year older for insurance company
• the insurance table shows that 5 of these people will die in the next year
- if the insurance company agrees to pay 1000 dollars to each person that dies – then the insurance company knows it needs 5,000 dollars to pay death benefits
• so it charges each insured 5 dollars just to pay death benefits
• in addition, the insurance company has to make a profit, and have to pay salaries – so the premium will include the death benefit and sales load (salaries for the people that sell the policy) and home office (which is the expenses of the actuaries and whatever else)
• this is called TERM INSURANCE – the premium has no investment aspect, but only the gambling aspect. Whether or not you die, and if so, the loss from that is spread through everyone else through the payments. It is the spreading the risk through the group
• speaking of only the death benefit:
- at the end of the year there are 995 people left
- the insurer looks at the table and says next year six will die – so each person now owes 6 dollars – but there are 995 left to pay, so the premium becomes 6.05
- the next year there are 989 left – and the tables say that this year 7 will die
- so even if the same number of people died every year, the premium still has to go up b/c there are less people in the pool. So by the time you are 99, you will be charged 1,000 b/c the pool is so small
at some point the insurance company does not want to write insurance, and the insured does not want to buy.
- the actuaries thus invented the level payment premium WHOLE LIFE POLICY
- generally whole life policy requires annual premiums – but amount of the premium does not increase with the age of the insured
- if insured lives to the life expectancy, the insurance company will be able to invest the premiums paid in early years and earn interest on the investment
- proceeds for whole life policy are also excluded under §101
ex: premium for the first year is 25 dollars, the death benefit is 5 – so the insurance company has 20 dollars
- the insurance company will invest the 20 dollars – this is typically called a reserve
- in most states, the reserve is attributed to a particular policy – there is no ownership of it – but on the books of the insurance company it shows that Davenport has a reserve of 20 dollars – b/c he payed 20 dollars more than the death benefit
- so the insurance company earns 5 percent on the 20 dollars – which is 1 dollar
- the reserve then becomes 21 dollars
-the next year – the premium is still 25 dollars (b/c it is a level payment) and the death benefit is 6
- this time you have 19 dollars, on which again 5 percent is made, which is 2 dollars. Adding 19 and 20, as well as the 1 dollar from the first year and the 2 dollars from the second, you now get 42 dollars in the reserve
• if everything works out – at the time of your death, the amount will be the policy price
- the amount earned on the reserve – those amounts are not taxed. And if they are paid out – they are exempted by §101 – so there is never any tax paid on those earnings
• what difference does this make?
- this is a way of reducing the tax base
- or compare this: suppose Davenport bought term insurance for 5 dollars and put the other 20 in a savings account. If he earned the dollar in the savings account – it would be subject to tax.
- what’s wrong with this? – it says to people that this aspect of life insurance is more favorably taxed than buying a term policy and putting what you pay into the reserve into a bank
- this means the insurance company decides where those funds will be invested, instead of my deciding where those funds will be invested – this is an economic distortion, b/c it makes insurance more attractive
- the consequence – there is more insurance sold than if it weren’t more attractive – and this is a bias toward getting people to put their money into insurance policies
- these earnings are called INSIDE BUILD-UP or INTERNAL EARNINGS
• thus, whole life policy is a tax favored investment: an individual who places §2,000 per year in a saving account and gives that sum, together with interest, to her children upon her death will pay tax on the annual interest income. The same individual who purchases a whole life policy and lives to live expectancy earns, in effect, the same interest but is not taxed.
• note §101(g) permits a terminally ill or chronically ill taxpayer to exclude amounts paid to her, during her life, pursuant to a life insurance contract.
d. Other source based Exclusions for cash receipts
• Two of the most important
1) §103 exclusion for interest on municipal bonds
2) §121 exclusion on the gain of a sale of a personal residence
B. IS IT TAXABLE IF IT ISN’T CASE? 1. Generally Yes, As Far as §61 is concerned Rooney v. Comissioner (1987).
• Ronney, Plotkin and Willey partners in certified accounting firm. They patonize business of clients. Reduced clients debt to partnership by amount equal to price normally charged for goods, then recognized the amounts as gross receipts. They later determined that some goods received were overpriced, and therefore discounted the retail prices of the goods and services and reduced their gross receipts by the amount of the discount.
• Issue: whether accounting partnership, in computing its income, may discount the retail prices of goods and services received in exchange for accounting services by considering the partner’s subjective determination of their values.
• Held: §61 requires an objective measure of fair market value – Petitioners may not adjust the acknowledged retail price of the goods
• tax code wants taxpayers similarly situated to be treated the same
Rev. Ruling 57-374 “Where an individual refuses to accept an all expense paid vacation trip he won as a price in a contest, the fair market value of the trip is not includable in his gross income.”
• This ruling is in conflict of the doctrine of constructive receipt – which says that a taxpayer who has the right to receive a taxable item cannot avoid the tax by “deliberately turning his back upon income”
• IRS wanted to give taxpayers (game show contestants) who valued the trip, worth 10,000, at only 2000. a 30% marginal rate taxpayer would have to pay $3,000 in taxes – one more than the contestant valued the trip at. IRS gave these taxpayers a break by the ruling by not applying constructive receipt doctrine here.
2. The two great non-statutory exclusions of non-cash economic benefits a. imputed income
• Rev Reg. §1.62-2(d)(1) – “if services are paid for in exchange for other services, the fair market value of such other service taken in payment must be included in income as compensation”
• Imputed Income is the gross annual fair rental value of consumer assets such as residences, cars or the value of self-provided services.
Imputed Income is not usually gross income and hence NOT includable. This includes unitary transactions, where the individuals produces goods & services that they themselves consume (i.e. a lawyer who drafts her own will).
• the biggest source of imputed services income is homemakers.
Imputed Income from Property
• like imputed income from services, imputed income from owner-used property is implicitly excluded from the scope of §61.
• In both cases the key to the exclusions is THE ABSENCE OF ANY TRANSACTION OR EXCHANGE.
• ex: 3 people each have 10,000
1) one buys a corporate bond – and pays 10,000 for it
- this bond pays 6% interest – this means at the end of every year, this tax payer gets a check for 600 dollars: This is taxable
2) 2nd taxpayer buys a house for 10,000 and lives in it
- the rental value is equal to 6%, so the rental value of the house is 600 a month. But this is not paid b/c the taxpayer lives in the house.
• this is not taxable. And this person gets a further benefit – b/c this person can deduct property taxes, and can deduct the interest on any mortgage
3) 3rd taxpayer is addled, and has a tin can. He puts the 10,000 in the can and buries it in the backyard. The taxpayer believes that we are about to enter a period of deflation, and that prices will fall to 10% what they were, making his money worth 100,000 in today’s market (though there are people that believe this – Davenport seems to think this is odd). This is not taxable.
• does it make any sense that the house owner is not taxed, and gets to deduct expenses?
• should there be tax income from the use of property?
• it is argued that there should be no tax on this – b/c there is no exchange. However, there is 600 dollars worth of income. But, b/c there is no exchange, it is argued that it is imputed income.
b. Unrealized Appreciation
• unrealized appreciation is the second of the two great implicit exclusions from gross income. It resembles the other – imputed income – in that it is available only in the absence of an exchange.
• upon sale, the §1001 formula for gain realized (amount realized minus adjusted basis) will cause you to be taxed on what had been unrealized appreciation until the sale – the sale is a trigger for taxation of the appreciation that accrued
- the exclusion of unrealized appreciation results in a deferral of taxation, rather than a permanent exclusion
- note that if the taxpayer holds the property until death, the property’s basis will be stepped up to the fair market value under §1014 – and the deferral will become a permanent exclusion
• policy: valuation and liquidity – unrealized appreciation would generate no cash to pay the tax
3. Statutory Exclusions Based on the non-cash nature of the Benefit, or on the required use of cash.
• non-cash economic benefits (other than imputed income and unrealized appreciation) are generally includable in gross income in the absence of an explicit exclusion provision
• In many cases, exclusions for employer provided benefits – a taxpayer who purchases the same items are either no deductible or are subject to sever restrictions
• ex: an employee who received employer provided health insurance will be able to exclude the entire value of te insurance under §106, but a taxpayer who purchases health insurance on her own will be allowed a deduction (under §213) only to the extent that her total medical expense exceeds 7.5% of her AGI
a. employer provided health insurance
• §105(b) excludes from gross income amounts employees receive from their employers as reimbursement for medical expenses and the value of services employees receive under an employer provided health plan
• 106(a) excludes from gross income the value of health and accident insurance premiums
• Many people receive health insurance through their employer, but pay for some or all of the cost of the coverage by payroll deductions. This amount of the payroll deduction is excluded from income, but only b/c §125 provides that health insurance coverage may be offered under a cafeteria plan
• under §125 – taxpayer offered a choice b/t cash and health insurance coverage, and who chooses insurance, will not be taxed under doctrine of constructive receipt
• §105 heath insurance subject to non-discrimination rules
• Those who do not get health insurance from employers: can deduct expenses under §213 – as itemized deductions – but only to extent they exceed 7.5% of AGI (i.e. the deduction is below the line and thus not available to taxpayers claiming the standard deduction).
b. group term life insurance
• §79 allows employees to exclude the value of group term life insurance provided by their employers for up to §50,000 of insurance
• larger policies can be provided, but to extent policy exceeds $50,000, §79 says that the employee has additional wage income in the amount of the premium property allocable to the excess coverage
• §79 operates as an exclusion from gross income – without it life insurance premiums paid by an employer would be includible in the employee’s income of §61
• Tres. Reg. 1.61-(2)(d)(ii)(a) if an employer buys life insurance for an individual employee and the employee designates a policy beneficiary, value of the insurance is income to the employee
c. Scholarships and other tax benefits for higher education expenses
• §117(a) – qualified scholarships excluded from gross income – student must be primary, secondary, undergraduate or graduate student
• 117(2)(b) exclusion is limited to amount of tuition and fees, and the cost of course-related books, supplies and equipment.
• thus – room and board scholarship not eligible for exclusion
• §117(c) – exclusion DOES NOT apply to any amount received which is payment for teaching, research or other services by the student required as a condition for receiving the qualified scholarship
• also applies to employee who receives a “scholarship” from his employer, if employee rcvd scholarship as part of his compensation
• but if employer provides a grant for a disinterested purpose of simply assisting the person to purse an education, it may qualify as a scholarship under §117. The IRS will treat employer grants as scholarships if
1) availability of grants falls outside pattern of employment and
2) grant do not represent compensation for past, present or future services by employees r their children and
3) grants are not for studies or research undertaken for the benefit of foundation or employer
• programs cannot be used by employer as an inducement for employees to continue employment or as a recruitment tool
• §127 – provides exclusions for employee whose tuition is paid by the employer under an educational assistance program – but this is subject to two limitations
1) maximum annual exclusion is $5,250
2) nondiscrimination requirement
• §117(d) – college or university can provide its employees with tax free qualified tuition reductions.
• also has a nondiscrimination requirement – where universities only offer this to children of faculty members – they must pay tax on their children’s tuition reductions
Hope credit and lifetime learning credit
• Hope Credit - §25(A)(b) – as much as $1,500 for first 2 years of college – equal to 100% of first 1000 dollars of qualified tuition expense and 50% of second 1000.
• Lifetime learning credit -§25A(c) – may be as much as $2000 per taxpayer per year
- credit equal to 20% of first 10,000 of qualified tuition expenses
- for years before 2006, taxpayer may elect to deduct tuition expenses
under §222 instead of claiming credit under §25A. Maximum deduction is $4000.
- you cannot get the hope and lifetime credit at the same time
- but there is a deduction on interest on student loans
- there is a limited deduction for tuition and fees
- And there is a covered al savings account – when the money is taken out and spent on qualified expenses, this is not subject to tax (limit of 500 a year)
- qualified tuition program §529s – it is a plan where one can put money in for a beneficiary, and when the beneficiary takes it out and spends it on qualified educational expenses, there are no income tax consequences. So the earnings accumulate tax free. These plans are not nearly so limited as the §530 Coverdel education savings plan. Basically, if you get above 11,000, it may become a taxable gift – which is certainly not the same as income tax
- there is another version of the 529 – where the state says that if you put this much in, we assure you this amount to be credited against tuition
C. INCOME INCLUSIONS AS MISTAKE CORRECTING DEVICES
• These categories of gross income based on the tax systems use of annual accounting
• Taxpayer rcvs favorable tax treatment (such as an exclusion or deduction) in one year, based in certain factual assumptions, in some later year it becomes clear – based on benefit of hindsight – that assumption was wrong.
• usual way of correcting this is not to amend the prior return, but to include an appropriate amount in gross income in later year
1. The Annual Tax Accounting Period
• §441 – income tax is based on annual accounting
• nearly all individuals use calendar year as taxable year
• an individual must pay tax if he has a positive net income w/in calendar year, regardless of losses he may foresee in future
• income tax cannot leave tax consequences open pending later developments, but the closure requirement no violated by tax rules that look back to determine tax consequences of this year’s receipts
• § 172 - Net Operating Loss (NOL) (applies only to business losses)- a loss carryover provision which allows the taxpayer to offset positive income of other years. A net operating loss is an accounting loss, in which you take business income, and subtract business deductions. If the deductions are greater than the income, you get a loss. This is §172.
• 172(a)(1) and (b) – a net operating loss suffered in any year can be carried back to the previous two taxable years
• An NOL is carried first to the earliest permissible year – to the extent it exceeds the income in the earliest year, the excess is carried to the following year, and so on until the NOL is fully used or the loss carryover period expires – 20 years
• the amended return produces a tax refund for the taxpayer
• if the company prefers-it can forgo the loss carryback and simply carry the loss forward
• i.e. a loss carryback is applied first against income from the earliest eligible prior year; any loss left after reducing operating income to zero in that year is applied against income from the next earliest year.
• Loss carryforwards are applied first against income recognized during the first year following the loss; any loss left over is applied against income recognized during the following year and so on
• 172(d) disallows personal exemptions in calculating NOLs, and it allows other non-business deductions (such as the standard deduction) only to the extent of the taxpayer’s non-business income (see p. 141).
2. The uses of hindsight
a. Loans and cancellation of indebtedness income United States v. Kirby Lumber (1931)
§61(a)(12) gross income includes income from discharge of indebtedness
Plaintiff, Kirby Lumber, issued its own bonds for 12,126,800, for which it received their face value. It later purchase on the open market some of the same bonds at less than face value, the difference in price being 137,521.
• Issue: whether this difference is taxable gain or income for Kirby
• Yes- §61(a)(12) states that gross income includes income from discharge of indebtedness.
• An individual is not taxed on borrowed money on the theory that the obligation to repay the loan offsets the amount received.
• If a loan is discharged for less than the amount owed, the borrower must include in income the amount of the discount (the amount owed less the amount paid to discharge the debt). This is so b/c the taxpayer must include into income the amount borrowed that will never be repaid.
• gross income inclusion is in the year in which it becomes apparent that the loan will not be fully repaid.
• the correction in the later year approach applies if the earlier year’s return appears mistaken only with hindsight – i,e. if an event occurs in a later year that is fundamentally inconsistent with an assumption on which the original return was based
• If original return was wrong from the beginning, based on information known or knowable, then the mistake must be corrected in the earlier year – or not at all if the SOL has expired.
• Lenders may discharge the debt for less than the amount owed for two reasons
1) taxpayer is financially troubled – lender may discharge debt for amount taxpayer can pay
2) if interest rate on the debt is lower than the current market interest rate, the lender may make money by letting the borrower pay back less than the full amount owed, then relending the money at a higher interest rate
§108(a) – Exclusion from gross income
(a)(1) (A) – a financially troubled taxpayer can exclude discharge from indebtedness income if the taxpayer has filed a bankruptcy petition.
• if the taxpayer has not filed a bankruptcy petition, the taxpayer can exclude the discharge of indebtedness income only to the extent of the taxpayer’s insolvency (taxpayer’s liabilities less the values of the taxpayer’s assets. ex: discharged to 10,000. Liabilities exceed value of assets by 6,000. Taxpayer can exclude 6,000 of the 10,000 debt discharge, leaving 4,000 to include under 61(a)(12).
• §108(e)(5) – if seller of property takes back debt on the property sold, and later reduces purchasers debt, the reduction in debt is treated as a purchase price adjustment – it does not create discharge of indebtedness.
• 108(e)(2) – discharge of a liability does not result in a discharge of indebtedness to the extent that the liability would have been deductible had it been paid.
• §108(f) – discharge of certain student loans may be excluded
• if lender and borrower disagree about amount owed and borrower ultimately pays lender less than amount lender said was owed, borrower does not have to include the difference between the two amounts in income.
§108(b)(2)(E) reduction in the basis of the property of the tax payer
ex: assume property of tax payer has 100,000 of cancellation of indebtedness income (COI) – there is also discharge of indebtedness
- taxpayer has a building with a basis of 1,000,000
- it is depreciating this basis over 20 years (typically this will be 50,000 a year)
- section E says that you must reduce this basis by the 100,000
- What E is saying that you are giving the taxpayer a break. The taxpayer is being discharged of a debt of 100,000 – so the taxpayer is ahead of 100,000
§108 says that Kirby lumber does not apply if you can meet the circumstances of §108
• it says that you don’t get away from it forever – it forces you to reduce your basis by 100,000
- so that your depreciation is 45,000 instead of 50,000
i.e. your building is worth 1,000,000
depreciation over 20 years is 50,000 a year
but when you reduce the building by the 100,000 the home basis is worth 900,000
so the depreciation over 20 years becomes 45,000 depreciation deduction a year
b. Proceeds of Embezzlement and other illegal income Collins v. Commissioner (1993)
• Collins places wagers using OTB tickets that he did not purchase, while working for OTB. He placed bets on horses, he gambled approximately 80,000 dollars, and paid back about 42,000 of that from horses that won, leaving him about 38,000 in debts owed.
• what did Collins get out of all of this – the court says that thrill of the race. He got the same thrill that people that legally purchased the tickets got.
• Glenshaw glass defined income as all “accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.” All unlawful gains are taxable.
• only a loan, with its attendant consensual recognition (between the borrower and borowee) of the obligation to repay is not taxable.
• Distinguished Gilbert – Gilbert expected to repay the loans, and Gilbert reasonably believed his employer would ratify his transactions
• Held: Collins received gross income from his theft. When he repays stolen funds, he is entitled to a deduction form income in the year the funds are repaid.
Zarin v. Commissioner (1990)
Zarin High roller in NJ, casino gave him $200,000 line of credit. He incurred over 2.5 mill in debt. Resorts ignored commissioner’s order and kept lending Zarin money. Resorts sued Zarin for money, and he asserted debt was unenforceable b/c Casino ignored commissioner’s order. Zarin settled for $500,000.
• Held: court said Zarin wasn’t taxable b/c he had no indebtedness as defined by the internal revenue code. The resorts issued the money in violation of the gaming commissions order, and therefore was not enforceable under New Jersey law
• Sobel – disputed liability doctrine – When taxpayer incurs a debt in order to acquire property, a dispute arise concerning the value, and dispute is settled by reducing amount of acquisition of indebtedness. Kirby does not apply, b/c original assumption was that taxpayer was going to pay 10,000 for something of 10,000 value. Taxpayer actually received 7,000 value, which she pays 7,000 cash. Taxpayer has not received any value for which she will not pay.
c. Debt relief associated with the disposition of property • recourse loan – loan on which you are personally liable
• nonrecourse loan – loan on which you are not personally liable
Crane v. Commissioner (1947)
• taxpayer who sells property encumbered by a nonrecourse mortgage must include the unpaid balance of the mortgage in the computation of the amount the taxpayer realized on the sale.
• the debt relief is included in the taxpayer’s amount realized because the debt will have been included in the taxpayer’s basis for the property when the taxpayer bought the property.
• the amount realized includes the debt relief even if the encumbered property is worth less than the amount of the debt at the time the taxpayer disposes of the property.
Tufts v. Commissioner (1983)
• Value of encumbered property is irrelevant. When the unpaid amount of nonrecourse mortgage exceeds the fair market value of the property sold, the unpaid balance of the mortgage must be included in the computation of amount realized on the sale.
ex: Taxpayer buys property with 50,00 of own money and 150,000 of debt secured by property. Basis in property is therefore 200,000. §1012. Taxpayer takes 70,000 in depreciation deductions. Sells property for 10,000 cash and take over of the mortgage. Taxpayers adjusted basis is 130,000 (b/c of 70,000 depreciation deductions). Taxpayer’s amount realized is $160,000 – the 10,000 in cash plus 150,000 of debt relief. Taxpayer’s gain realized is 30,000 – 160,000 minus adjusted basis of 130,000.
• debt relief is included in amount realized b/c the 150,000 of debt was included in basis – permitting taxpayer to take depreciation deductions on property in excess of taxpayer’s cash investment.
• note – there is a limitation on rule of including debt in basis – if taxpayers inflate their basis in order to claim large depreciation deductions, by claiming nonrecourse debt far in excess of value of property (ex: 2.5 mill for a home worth 1 million) taxpayer’s basis may not include all or portion of the debt.
• §1016 – basis is adjusted for depreciation allowed or allowable – so even if you don’t take depreciation deductions, for tax purposes the basis in property is adjusted for depreciation deductions that would have been allowable.
• §1001(b) – amount realized is “the sum of the money received plus the fair market value of the property (other than money received)”
• At the time of acquisition, basis can never exceed fair market value of the property
d. The inclusionary Tax Benefit Rule
• inclusionary tax benefit rule triggers an inclusion whenever an event occurs that is fundamentally inconsistent with a tax benefit recognized in an earlier year.
• it is an exception to the annual accounting rule
ex: tax payer gives 10,000 to college in year 1 and takes a charitable deduction. Colleges ceases operations and returns money in year 2. Taxpayer’s receipt of 10,000 in year 2 is inconsistent with charitable deduction taken, so taxpayer must include 10,000 in income in year 2.
Hillsboro Bank v. Commissioner (1983)
Held: tax benefit rule ordinarily applies to require the inclusion of income when events occur that are fundamentally inconsistent with an earlier deduction
• recovery no always necessary to invoke the tax benefit rule.
• purpose of tax benefit rule is to achieve transactional parity in tax
• for inclusionary tax benefit rule to apply, later even must be fundamentally inconsistent with prior deduction
- ex: paid rent for one month, and then apartment burned by fire. Resulting inability of taxpayer to occupy building not fundamentally inconsistent with prior deduction of rent as business expense under 163(a). In this case, only if landlord refunded the money would taxpayer have to recognize income on the deduction.
- but if taxpayer decides to use space for personal use, it is fundamentally inconsistent with the business use on which the deduction was based
• must be applied on a case by case basis
• note – that tax benefit rules requires that the mistaken assumption deduction only be mistaken with the benefit of hindsight
• if the mistaken deduction was known or knowable – then you have to file an amended return
exclusionary tax benefit rule
• § 111(a) permits a taxpayer to exclude the recovered item in the later year to the extent that it did not reduce the taxpayer’s tax liability in the earlier year
claim of right and § 1341
• Taxpayer rcvs money in 2003 under claim of right, but is later required to repay money.
• amounts received under claim of right are taxable in year of receipt
• the mistaken assumption is corrected not by amending the return, but by allowing the taxpayer a deduction in the repayment year.
• §1341 gives taxpayer favorable treatment if amount of deduction exceeds $3,000. If taxpayers marginal rate was higher in year funds were received (2003) than year they were paid back (2004), in lieu of a deduction the taxpayer’s 2004 tax liability is reduced by the amount by which his 2003 tax liability would have been reduced if the money had not been included in income in 2003.
Rosen v. Commissioner
• Rosen owned property, made charitable gift to town, and claimed charitable deduction for value of property, 51,250. Next year city returned property b/c it could not use it. Same year Rosens gifted property to Hospital, and took deduction of $48,000 – value of property. Hospital also transferred property back.
• Held: b/c Rosens took charitable deductions when they transferred property, they were required to treat the value of the property, upon its return, as income in the year in which it was returned, up to the amount of the charitable deduction previously taken.
• note that when property was returned to Rosens it was worth less than when given to charity – IRS conceded that amount included in income should be the “value of the property upon its return.”