Gross Income Outline

GROSS INCOME

1. General Rule: Inclusion

   1. Basic assumption under §61 is that income is all income from whatever source derived

   2. Other definitions:

      1. Eisner v Macomber (US 1920, p 249)—NJ company decides to issue an additional share of common stock for each share outstanding. Court has to wrestle with whether this is income, and what is income. Decides this is not income. Shareholder is not getting any anything out of the company, this is functionally just an accounting thing—twice as many shares outstanding, each worth half as much. Court here defined income as “derived from labor, capital, or from labor, or from both combined.”

      2. Commissioner v Glenshaw Glass (US 1955)—expands on Eisner definition so it includes windfalls.

         1. Taxpayer recv’d settlement in antitrust litigation settlement, which included punitive damages. Argues those are just meant to punish D and he got lucky, not income.

         2. Court says income is “all accessions to wealth, clearly realized, and over which the taxpayers have complete dominion,” unless clearly exempted.

      3. James test (cited in Collins): taxpayer receives income “when she acquires earnings, lawfully or unlawfully, w/o the consensual recognition, express or implied, or an obligation to repay and w/o restriction as to their disposition…

   3. Realization Rule (§1001): We only collect tax when there’s some kind of transaction or transfer or exchange that is a realization event.

      1. Rationale: Maybe too hard to value illiquid assets; maybe ppl don’t have cash to pay tax as stock rises in price but before they sell; just simpler. Realization rule also allows for compounding—the gains from each period stay in there and aren’t taxed until much later.

      2. What is an exchange? In Cottage Savings, Supreme Ct defined it as an exchange of something “for something materially different.”

      3. Alternatives to realization rule:

         1. Mark to market: poses valuation and administration issues. Even if only for liquid stocks, still makes gov’t income really volatile.

         2. Progressive realization: basically like mark-to-market, but only for certain taxpayers

   4. Exclusions from Income

      1. Conceptual exceptions (imputed income)

      2. Statutory Exceptions

         1. Gifts

         2. Certain fringe benefits

         3. Damages received for personal physical injuries

2. Non-Cash Income

   1. Valuation: Reg. §1.61-2(d): When income is received in the form of property or services, the value is the fair market value. If services are rendered at a stipulated price, such price will be presumed to be the FMV absent evidence to the contrary.

      1. Valuation of fringe benefits (Reg §1.61-21(b)): income includes the FMV of any fringe benefit received minus any amount paid for the benefit, minus any amount for benefits specifically excluded by the code.

   2. Property, Stocks and Stock Options (§83): Basically, you don’t pay tax until the options vest, unless you elect to pay at grant (then you don’t pay at vesting until you sell). Employer takes deduction when payee pays tax.

      1. Substantial Risk of Forfeiture (§83(c)): This is the statutory grounding for vesting. Because you don’t pay as long as there is substantial risk of forfeiture, defined as “if such person’s rights to full enjoyment of such property are conditioned upon the future performance of substantial services by any individual.” (§83(c)(1)). Similarly, transferrable only if the rights of the transferee are not subject to substantial risk of forfeiture.

         1. Regs example notes that two year work requirement is sufficient for SROF (1.83-3(c) examples)

         2. Taxes are due at the earlier point of either when the risk of forfeiture is no longer substantial or when the property becomes transferrable (where the rights in such property of any transferee are not subject to a substantial risk of forfeiture).

         3. If property is forfeited before vesting, the employee (or holder of option) pays ordinary income tax on any amount he receives upon forfeiture, minus whatever he initially paid for the property.

         4. If you sell unvested property, you pay ordinary income on whatever you receive in the sale minus the basis (§1.83-1(b)(1))

      2. Election (§83(b)): You have the choice of paying tax on the FMV of the option minus whatever you paid for it, or you otherwise would have to pay at vesting. Decision basically depends on opportunity cost of funds, projected growth in stock, and projected changes in your marginal tax bracket.

         1. Employers: Many prohibit election b/c they would rather take a larger deduction at vesting.

         2. Deductions: If taxpayer elects, and later forfeits the property, no deductions is allowed w/r/t the forfeiture. He eats the tax paid as a result of a bad bet in electing. However, you can take a loss for the amount realized upon forfeiture (usually zero) minus your basis (whatever you piad for it, which is often zero, so no deduction). Employer would then have to include as income an amount equal to the deduction it took when employee did the election (Reg 1.83-6(c), but not covered for this class).

         3. Policy: Maybe Congress wants to help out startups, maybe they want to encourage payment through equity to align managerial incentives.

         4. Capital gains: election also carries benefit of lowering basis (assuming stock rises over time), so more of the income is shifted from ordinary to capital gains (lower rates).

         5. Alves v Commissioner (9^th Cir 1984, p 224): Alves was senior employee at company, got stock and did not elect. At the time he took stock, he paid FMV for it (no discount). So he argued it wasn’t in connection w/ services, b/c he wasn’t given any deal. But the stock was basically only available to employees, public couldn’t buyit was in connection with performance. Court says it is irrelevant that there’s no discount and that employee paid FMV at time of transfer. Since he didn’t elect, he has to pay tax on difference b/w FMV at time of vesting and price he paid upon transfer.

         6. No tax on option exercise (§83(b))

         7. Valuation of stock options (83(a))-you do not reduce the FMV of stock options for tax purposes due to any vesting...

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