Federal Income Taxation 12/5/12 10:50 PM Introduction: Setting the Table Sources of Tax Law: Internal Revenue Code/ Title 26 of the US Code o Positive law Treasury Regulations o Not positive law, but explanations of the Code provisions o Highly regarded Revenue Procedures o Does not interpret or explain the code, but is there to do the mechanical calculations required by the IRS (e.g. inflation adjustments) Revenue Rulings o Advisory opinions o Designed to look and read like judicial opinions but without the names of any taxpayers o Released by Treasury lawyers o Usually given a great deal of deference Private Letter Rulings o A taxpayer writes to the IRS laying out the facts of their case and a question; the IRS answers that question o IRS says these deserve no deference because each decision only applies to that taxpayer; in practice, a PLR in your favor is very persuasive. Common Law o Intent of Congress is especially important for tax Committee Reports are often used to determine congressional intent
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Federal Income Taxation 12/5/12 10:50 PM
Introduction: Setting the Table
Sources of Tax Law:
Internal Revenue Code/ Title 26 of the US Code
o Positive law
Treasury Regulations
o Not positive law, but explanations of the Code provisions
o Highly regarded
Revenue Procedures
o Does not interpret or explain the code, but is there to do the mechanical
calculations required by the IRS (e.g. inflation adjustments)
Revenue Rulings
o Advisory opinions
o Designed to look and read like judicial opinions but without the names of any
taxpayers
o Released by Treasury lawyers
o Usually given a great deal of deference
Private Letter Rulings
o A taxpayer writes to the IRS laying out the facts of their case and a question; the IRS
answers that question
o IRS says these deserve no deference because each decision only applies to that
taxpayer; in practice, a PLR in your favor is very persuasive.
Common Law
o Intent of Congress is especially important for tax
Committee Reports are often used to determine congressional intent
o Because the issues are statutory rather than constitutional, Congress rather than
SCOTUS has the last rule.
o Substance dominates form
Without this people would start to believe that if they had good lawyers
they could basically get away with tax evasion; this doctrine says the courts
are going to call BS where they see it, technicality or not.
Definitions:
Tax base: the “thing” that is taxed (e.g. income, property, sales, consumption, estates,
wealth)
Tax incidence: who really pays any given tax?
Tax gap: the difference between taxes legally owed and taxes actually paid
o Can only have estimates, but approx. $500B more could be collected if people paid
all the taxes they owe.
Cross reporting: two parties with opposing interests reporting tax-relevant data to the IRS
o The average worker is a classic example: employer and employee are at opposing
sides and are both reporting the income to the IRS
Income effects: changes in behavior induced by the fact that the tax reduces the money
available to the tax payer
Substitution effects: changes in the behavior that arise from a change in the relative
attractiveness of different commodities or activities
Head tax: a tax of an equal dollar amount on everyone, or at least each person above a
certain age
Ability to pay: the attribute that might justify requiring some people to pay more tax than
others.
o The broader view looks at people’s material well-being without regard to liquidity
Marginal utility of income: the wealthier you are, the less each dollar lost to the tax
collected diminishes your well-being.
Endowment or wage rate (the rate at which one can earn money): the opportunity to earn
wealth whether or not exercised.
o This is so as to avoid possibly discouraging the exercise of wage-earning ability to
avoid paying taxes.
Cash-flow consumption tax: simply an income tax with a deduction for savings and with the
inclusion in the tax base of amounts drawn down from savings and used for consumption, as
well as amounts borrowed for current consumption.
o Seen in IRAs (individual retirement accounts) – amounts set aside in an IRA for
retirement are currently deductible in computing the amount subject to taxation
and amounts withdrawn from the IRA account are included in the income in the
year of withdrawal.
Imputed income: the value of goods and services provided to oneself.
“To the extent”: by the amount
Stock variable: variable whose value is not determined with reference to the passage of time
Flow variable: variable whose value is determined with reference to the passage of time
Tax evasion is illegal
Tax avoidance is legal
Tax Facts:
Allowed by the 16th Amendment, adopted in 1913: “The Congress shall have the power o lay
and collect taxes on incomes, from whatever source derived, without apportionment among
the several States and without regard to any census or enumeration.”
Income taxes (corporate and individual) are expected to produce 56% of total federal
revenues
Income taxes are also an important source of revenue for state government
The most common filing statuses are consistently “unmarried individual” and “married
individuals filing a joint return”
In theory, income taxes should produce both income and substitution effects
Using the tax system to deliver a subsidy allows its advocates to label it a “tax cut” rather
than a “spending increase”
Major Areas of Cheating:
o Cash businesses: small businesses are a huge part of the tax gap (big businesses
have incentives to be careful with accounting; the largest corporations are under
permanent audit)
o Underreporting of gains on securities – there is no cross reporting on the difference
between bought and sold
Tax Expenditures (refer to chart on Table 1-2 on p.17)
o Tax expenditure budget: certain tax benefits are equated with direct subsidies
o General approach is to identify various exclusions, deductions, deferrals, and credits
that are seen as departures from a neutral concept on income taxation; then to
figure out the cost of these special provisions; then to attribute these costs t various
budget functions.
o This budget wholly ignores features of the current income tax that are arguably less
favorable to taxpayers than pure income tax.
o The net effect is the same if you have a subsidy or if you collect more, then spend
Tax Law:
What happens when people violate the tax law?
99% of actions and punishments are civil
It is very rare for people to actually go to prison for tax evasion, the mens rea is very high.
The punishment often boils down to how long it took you to correct the mistake and how
big the mistake was
o Interest ≠ punishment, it is just putting you in the position you would have been in
had you paid.
Litigation is called “tax controversy”
o Always US v. Taxpayer
o Standard: preponderance of the evidence
o OIC – offer in compromise = a settlement
Jurisdictional Framework:
o Courts of original tax jurisdiction: US District Court, US Tax Court (created by
Congress under Art. I power), US Court of Claims
o If you want to appeal a Tax Court ruling, you go to the US Court of Appeals for your
circuit
o If you want to appeal a Claims Court ruling, you go to the Federal Circuit and then
SCOTUS
What is Income?
Y = C + S (Y is income, C is consumption, S is saving)
Haig-Simons: Y = C + ∆W (∆W is change in net worth) (each defined in terms of market value during
some specified accounting period)
Some characteristics of income
Noncash benefits
Why tax?
o Horizontal equity (treat likes alike)
o Our economy would move toward a barter system if noncash/ fringe benefits
weren’t taxed
Old Colony
o An employer’s payment of federal income tax on an employee’s behalf is income
o It’s the reason we have withholding – the employer Is paying on your behalf
o Grossing up: negotiating with your employer to pay income taxes – you have a
target after tax net income
N = G(1-t) where N = net pay; G = gross pay; t = tax rate
G = N/(1-t)
If you cross an upper limit of a bracket with the gross income, it becomes
more complex
Bengalia (p. 52)
o Tax years in question are the worst years of the Great Depression
o Bengalia was the manager for 2 hotels – he and his wife lived and took all their
meals at one of the hotels
o He was supposedly on constant duty and that is why he needed to live at the hotel
For the convenience of the employer
o Legal distinction: if you receive compensation that is valuable, there is a distinction
if it is for the convenience of the employer, it is not taxable
Comes from Reg. §77.
o Dissent: claims that the employee cared enough about living in the hotel that he
negotiated about it; Majority says the employer said he had to live at the hotel and
that’s good enough.
o Dissent looks at the fact that he’s managing multiple properties and can’t be at all
places at once, therefore convenience of the employer argument fails
o Both sides read “convenience” to mean requirement
o BTA creates common law by following the Reg – “convenience of the employer” test
is now law
Dissent holds that the question is really whether or not he benefitted from
the room and board. It doesn’t matter whether or not it was for the
convenience of the employer – the Bengalias received something with
market value.
Valuation under Bengalia
o If the dissent had won, the Bengalias would litigate the value of the benefit
conferred
Try for wholesale and not retail prices
Objective valuation of the horizontally equitable transaction – how much
would a 3P in an arm’s length transaction have had to pay for all the
Bengalias received?
Statutory aftermath
o §119: modifies the Bengalia ruling a little: the meals must be eaten on the business
premises; the lodging on business premises must be a requirement of employment.
More specific requirements are enumerated.
Illustration of §119(d)(2) in notes 17/9
o §132: Congress says the tax treatment of noncash benefits needs to be regularized
because it’s chaos – the give a list of fringe benefits that are not going to be taxed
Loss aversion
De minimis fringe is the default hail Mary to try to exclude
All have a non-discrimination rule
If you have a non-excludable fringe benefit, you use market value for
valuation
Look to Regs §1.61-21
Safe harbor rules: rough justice situation – you may not get FMV right, but if
you follow the rules, at least you won’t crash into the rocks
o §125: Cafeteria plans
Has a lot in common with §132, but must be properly organized into a plan
to be labeled as such
Doctrine of constructive receipt: substance over form rule
You don’t have to be taxed on the substance of the cafeteria plan because
you can always opt for cash instead
List is at the bottom of CB p. 62
“Use it or lose it” rule is a limitation on fringe benefits
o Turner
Family of four who won a radio contest for steamship tickets from New York
to Buenos Aires. Switched his two first class tickets for four couch tickets to
Rio for a small change fee
They wouldn’t have been able to take a trip like this but for the contest
The question is the value of the tickets to the Turners – neither IRS nor
Turners call it income.
Modern rule: objective valuation – not subjective because tax
administration should not “be based on anything so whimsical”
There is no Turner Rule
o Some unusual forms of income:
Realization:
Professors get free text books – no taxes unless they are turned into
cash
Catching historic home run balls – if you catch and keep or give
away, no tax; if you sell it, tax.
Specific employees can get freebies but turn them down – it is
income if you use the tickets
To solve the taxation problem for gifts/ promotions, you just need to gross
up
The other sure way to avoid taxation is not taking the prize
Imputed Income
Windfalls and Gifts
Glenshaw Glass (p. 78)
o Both companies received punitive damages and compensatory damages
o Compensatory damages are definitely taxable because they would have received
that income had they not been wronged
o In the lower courts, the taxpayer won against the IRS
o SCOTUS believed Congress was very broad in its definition of income and counted
the punitive damages as taxable income
Explicit exclusions: Gifts - §102 o Duberstein (p.83) (two consolidated cases trying to define gift)
Duberstein and Berman: professional relationship; D buys from B but often
offers advice on who might be a good customer when they don’t buy. B
gives D a Cadillac as a gift in recognition for all his help with extra clients. B
writes it off as a business expense even though he told D it was a gift.
Stanton: executive overseeing Trinity Church’s financial and real estate
holdings. He quits/ is forced out and the Church gives him a year’s salary
called a “gratuity” but says it’s for services rendered. Church says it’s giving
him the money because it likes him.
SCOTUS says in defining gift for tax purposes, they are going to use the
colloquial meaning.
It is the donor’s intent that controls
Gifts are when you don’t get something in return – can’t be a deal,
not services rendered or an anticipated benefit
It is from “detached and disinterested generosity” (p. 86)
IRS wants to make a per se rule that businesses can’t give gifts; SCOTUS
rejects this, and they won’t go so far as to say that the deduction by
businesses of the purported gifts is dispositive in making them non-gifts.
SCOTUS believes the donee should not have its tax consequences
based on what the donor did – instead it’s dependent on donor’s
intent
Duberstein: definitively not a gift.
Stanton: more complex because of the lower court’s ruling of “just a gift” –
SCOTUS willing to give a lot of deference but the trial court need to at least
explain. Stanton wins on remand.
Makes trial court’s decisions essentially non-reviewable
§102(c) would make Stanton lose automatically
§274(b) would make Duberstein less likely to get the gift because Berman
would have only been able to deduct $25
o Harris (p. 91)
Question of whether the money he gives the twins is income or gifts
Harris was convicted of criminal tax evasion by the lower court
If Kritzik wasn’t paying them income then he should have paid a gift tax
Threshold issue for Conley is if she was required to file income tax returns if
this was her only money – then, because it’s criminal, did she have the mens
rea? The court finds it was a gift and not income, therefore she didn’t need
to file the forms
Court finds the USG didn’t meet its burden
Harris: again, mens rea is lacking – the correct question is the donor’s
intent, so if Harris believed K loved her and that’s why he gave her the
money, it’s a gift. Court dismissed criminal charges.
General takeaway: for longer term relationships with a mistress where
money is exchanged but not on a transactional basis, those tend to be gifts.
If money is the exchanged each time sex is exchanged, it’s income
(prostitution)
It doesn’t matter how Harris or Conley felt, it only matters how they
believe/ have reason to believe K felt about them (Duberstein: donor’s
intent)
o Tips and unusual gifts:
Ordinary tips: IRS issued Regs – tips are income in the ordinary course of
business, but they created a safe harbor (10% of gross receipts), but the
employer has to provide gross receipts for when the employee worked, so
they can get their safe harbor income
Gambling tips to dealers, etc at casinos are income, not gifts, because the
intent is not generosity, it’s hope for luck
Welfare payments are not income
§117: Scholarships: in almost every case there is a zero bracket question/
issue
o Taft (p. 104)
Taft maintains she only owes $3000, the difference between the price of the
stocks when she received them and when she sold them. IRS says it’s
$4000, the difference between the price when bought and when sold –
doesn’t matter who bought them or that they changed hands
The 16th Amendment does not prevent “surrogate taxation” – collecting
taxes from one person on another’s behalf
Whoever has the asset, if they sell it, they face the tax
consequences
Carryover (substituted) basis/ transfer basis
Gain = proceeds - adjusted basis
Basis is usually the purchase price
§1015:
You take the basis from whoever gave you the gift
Except if the basis is greater than FMV at the time of the gift
(so that people won’t give loss properties in tax strategic
ways)
Example:
o Donor paid $1500; FMV at date of gift: $1000
o If recipient sells later for $800
800 – 1000 = -200 (discourages the gifting
of loss properties)
o If recipient sells later for $1600
1600 – 1500 = 100 (even though there was
originally a loss, the exception is only used
to calculate if selling for a loss
o If recipient sells later for $1200
Answer is 0 gain because §1015 math
doesn’t work – paradox
If high tax bracket guy has a gain – lower tax bracket gift
If high tax bracket guy has a loss, he can realize it and absorb it
better than lower tax bracket guy.
o Transfers at Death
Vertical equity question: you need to collect the same amount of taxes but
you might be collection them from a different set of people
Current state of the law:
§1014
Inheritance tax ≠ estate tax
Base is the recipient – amount of money received from
dead people – US does not have that
Estate: base is measured by money left after creditors have
been paid – measured/ taxed at giver rather than recipient
level
§1014(a)(1) treats you as if you’d paid FMV that day – death is not a
realization event; “step up in basis at death”
Means the decedent wants to keep shares that have gone
up in value and sell shares that have gone down
Decedent can borrow against unrealized gains
All kinds of generous estate planning opportunities built
into the tax rules
Currently:
$5M per spouse exception
35% bracket above that (positive taxable estate)
Default:
$1M per spouse exception
45% and 55% brackets
Policy rationales:
Why have an estate tax?
The most progressive of US tax laws
Allows for lower rates on other things
Acts as a back up capital gains tax
Encourages high wealth people to give to charity
Helps reduce the transmission of dynastic wealth
Why collect the tax upon death?
It is not a tax upon death because 99.7% of people die
without paying it
We don’t tax this during life because there can be reversals
of fortune in life – can assess once and for all ability to pay
Unreasonable attacks:
Double taxation: taxing the same basis twice – it is not
about a dollar being taxed, it is about an activity being taxed
Breaks up family firms and businesses – no evidence
Death tax and therefore immoral
Plausible attacks:
Administratively burdensome
Wrong to tax wealth that has accumulated from saved
income (moral argument)
Taxing wealth creates bad incentives
o Sometimes when you tax things, you encourage
them – “the income effect”
o Compared to what? Vertical equity question –
income v. wealth
Alternatives:
Get rid of estate tax, but also eliminate §1014 and declare
death a realization event – this would collect about 50%
more revenue than the estate tax
Get rid of estate tax, elimitae §1014, but don’t make death
a realization (you only have to pay if you sell the stocks) –
this would be a revenue loser
Loans and Discharge of Indebtedness
Discharge of indebtedness is the same as cancellation of debt
Loans are not income
o Selling bonds is borrowing money
o Buying bonds is lending money
DoI income = the reduction in the amount to be paid by borrower to lender §61(a)(12)
When a business borrows and issues bonds and must pay interest on those bonds – the
interest is deductible as a normal cost of doing business
o Not deductible for individuals
Kirby Lumber (p. 147)
o Issued $12M in bonds in July 1923; later than year, they extinguished $1M of
principle by paying $826k
o IRS claims the $138k is DoI income
o Court says “accession to income in the year” – income is income, this is not a tough
question
o Kerbaugh Empire muddies the waters because it seems Kriby’s refenence brings in
the overall story/ fate of the enterprise matter
In order to answer the DoI question, you need to know what happens to the
business
Courts have not treated this as true. They make Kriby as simple as it seems.
Fate of of enterprise is irrelevant.
Was a profitable exchange on the currency exchange market, there was no
DoI (Kerbaugh)
§108o This section is explicitly excluded from §61(a)(12)
o Insolvency (defined in §108(d)(3): if you have a negative net worth), you may not
even know if you’re insolvent, as opposed to bankrupt.
o Qualified farm indebtedness §108(g) – Congress loves farms
o Qualified principal residence indebtedness – added in response to the housing
collapse because so many people were foreclosed upon. Really almost all of these
people were insolvent anyway, but this now takes precedence over the insolvency
solution
o (e)(5): purchase money debt reduction for solvent debtor treated as a price
reduction
I lend you money to buy something from me
You come back and tell me you can’t pay the full price, if I allow a lower
price, the agreed upon payment is treated as the original purchase price
o (f) student loans: as long as you follow certain rules, you can pay less than you owe
without DoI income tax.
Zarin (p. 150)
o Basic tax treatment of gambling:
You can never deduct net losses
You do get taxed on net winnings
Winnings/ losses on either side of the calendar year cannot be offset (if you
won $1M at 11:58 on Dec 31 and you lose $1.2M on Jan 1 – you get taxed
one the $1M and can’t offset with the loss.
o Z was $3.435M in debt which he settled for $500k; the IRS says the difference of
$2.935M is DoI income.
o Majority finds this does not represent DoI income in two ways:
Claim that this was not indebtedness at all (even though their definition of
indebtedness is taken from §108(d) and that plainly states it does not apply
to §61)
The fact that Z paid them $500k undermines the idea that he didn’t
owe them money
Property analysis: Casino chips are not property
Only USG can create money
Claim this was like the negotiated price of a product (negotiation fixes value)
$3.4M was never what was owed because the parties agreed and
accepted $500k, therefore that’s what was always owed and there
is no DoI income.
Liquidated damages – the amount was known; unliquidated
damages – the amount was not known
The majority acts like this distinction doesn’t matter theat
whatever the settlement is is the correct amount and
always was – this is not true.
Gain on sale of a home
Old rule, repealed in 1997: §1034 – could exclude all gain if you buy a house with a higher
price within 2 years; at age 55, there was a one time exclusion up to $125k