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Federal Income Tax Outline

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Federal Income Tax
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Mechanics of Determining Individual Tax Liability:

1. Gross income minus Section 62 (above the line) deductions equals adjusted gross income

2. Adjusted gross income minus section 63 deductions to reach taxable income.

3. Taxable income times applicable marginal rate equals tentative tax liability

4. tentative tax liability minus credits equals tax liability OR Alternative Minimum Tax Income: Definition: Eisner v. Macomber (p. 46) (1920) Rule: "The gain derived from capital, from labor, or from both combined" Later expanded by Glenshaw Glass Commissioner v. Glenshaw Glass (p. 78) (1955) Current Law Rule: "Gains or profits and income derived from any source whatever." Expands Eisner v. Macomber to include gains acquired from sources other than capital or labor. Money found in street Prize winnings Gambling winnings Gratuitous transfers Punitive Damages Congress has general taxation power; courts will not impose restrictions on Congress unless Congress has passed a statute restricting itself. Compensatory damages: income because replaces income would have received (later overruled by SS104, excluding damages for personal physical injury). Punitive damages: is this from capital, labor? Should it be taxed? Court: yes Reasoning: if it affects your ability to pay, it's income Old Colony Trust Co. v. Commissioner (p. 50) (1929) Rule: "the discharge by a third person of an obligation to him is equivalent to receipt by the person taxed" Haig-Simons definition (p. 46) (1938) "Personal income may be defined as the algebraic sum of (1) the market value of rights exercised in consumption and (2) the change in the value of the store of property rights between the beginning and the end of the period in question." Impractical - would need receipts of everything you do For gifts as income see below Inclusions (SS61) Fringe benefits included except as enumerated in SS132 Includes but not limited to the following: (may be excepted in other statutes) (1) Compensation for services, including fees, commissions, fringe benefits, and similar items; (2) Gross income derived from business; (3) Gains derived from dealings in property; (4) Interest; (5) Rents; (6) Royalties; (7) Dividends; (8) Alimony and separate maintenance payments; (9) Annuities; (10) Income from life insurance and endowment contracts; (11) Pensions; (12) Income from discharge of indebtedness; (13) Distributive share of partnership gross income; (14) Income in respect of a decedent; and (15) Income from an interest in an estate or trust. Constructive Receipt: when a benefit (either at that time or for the future) is treated as a taxable receipt at a certain time - see later on

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Mutual Exchange of Services In a commercial context: usually taxable In a social context: usually not taxable See also SS83 (property transferred in connection with performance or services) Rev. Ruling 79-24 (p. 76) (1979) General Rule: if services are paid for other than in money, the FMV of the property or service taken in payment must be included as income. Assume stipulated price for services is FMV. Facts 1: lawyer and house painter Rule 1: FMV of value of services received by lawyer and the house painter are includible in their gross incomes Facts 2: renter of apartment gave work of art instead of cash Rule 2: FMV of the work of art and the six months fair rental value of the apartment are includible in gross income of the apartment-owner and the artist respectively Damages SS104 - (lawsuits) Business: Recovery for lost profits: income (Glenshaw Glass) Recovery for damage to property: include amount recovered over the basis (Inaja Land Co., see below) Punitive damages: include as income (Glenshaw Glass) Even though this is a deterrent, it's still taxable Personal 104(a)(2): the amount of ALL damages received, other than punitive damages, on account of personal (physical) injuries or sickness is excluded (note that this includes all damages other than punitive damages), see also the following for other exclusions: (a)(1): workers compensation for injuries or sickness (a)(2): all damages from personal physical injury or sickness other than punitive. Includes both lump sum and periodic payments, even if payments will over time exceed the amount of physical damage done. Medical expenses (but check SS213) Pain and suffering Lost wages Other non-punitive damages (a)(3): accident health insurance (a)(5): disability income as a result of terrorist or military action Note: there must be physical injury, emotional distress doesn't count Exclusion provisions of 104(a)(2) apply whether suit or settlement, and whether lump sum or periodic payments, and lump sum sale (JG Wentworth) follow same rules, but income therefrom taxable for JG Wentworth because not from personal injury Once tortfeasor has paid the money, they may deduct it Can deduct upfront if structured settlement, but need to wait for annuity payouts Settlements are judged to see if unreasonable/excessive (Dennis Rodman photographer was seen as purchase of confidentiality, not settlement of purely things related to injury) Interest accrued for structured settlements/periodic payments is also excludable Note: Exclusions offset by previous deductions arising from the same issue. E.g. medical expenses deduction taken in year of accident: 2015: $100k Salary, $18k Med Expenses Deduct in excess of 10% of salary - $8k 2016: $18k judgement (normally deductible) Exclude $10k because you have already deducted $8k/$18k Exclude to the extent that you haven't deducted See also: tax benefit rule Compensatory damages other than relate to personal physical injury: treated as income (Glenshaw Glass) Emotional distress Dignitary torts (age discrimination, gender discrimination, etc.) Punitive damages: treated as income (Glenshaw Glass) If [?](d) is a business entity, would usually get deduction for payments to the person p(P) SS162 business expense.

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Example: if judgment of $10k paid up front, interest (from voluntary investment by the recipient) therefrom taxable. If instead agree to $30k payments over ten years, then not taxable Structured Settlements: Problem: Tortfeasor cannot deduct setting the money aside Plaintiff is at risk for Tortfeasor becoming insolvent Option: Tortfeasor pays lump sum upfront and takes deduction. Tortfeasor loses out on ability to invest the money. Best for plaintiff (assuming entire settlement is deductible): can invest money immediately. If settlement is taxable plaintiff gets no tax deferral benefits. Option: Tortfeasor purchases annuity with payout in amount of settlement. Tortfeasor deducts each time annuity makes a payout. Worst for tortfeasor: loses control of money and can't deduct up front Tortfeasor can give full sum to a structured settlement company: Tortfeasor gets deduction right away, removes long term obligation from the books but can't invest Plaintiff reduces risk of non-payment while also getting tax deferral. Illegal Income: Illegal income does not avoid tax liability! But what about embezzlement where there is intention to pay back?
IRS will get its share of tax on illegal income before the embezzler is allowed to repay the victim. (first in time first in right) Victim may deduct as casualty loss (theft) Embezzler may deduct what he repays to victim. Rationale: criminal law, not tax law, is concerned with punishing the embezzlement. Can claim net operating loss if the embezzler can show that he is in the trade/business of crime: must show pattern Gilbert v. Commissioner (p. 181, 1977) - exception if it's like a loan Facts: Corporate exec embezzles company money to make a stock transaction he believes is in the company's best interests. He knows the taking is illegal but acts with every intention to repay. Rule: Loan, not income. Clear expectation of full repayment overrides illegality of taking. Policy: some courts look to the circumstances of receipt to determine whether borrower, or swindler (see note p. 185) Gifts (see SS102, generally not included) Dividends (SS1(h)) Non-qualified dividends: ordinary income Qualified dividends: capital gains Preferable tax treatment (allow ordinary income investment to be treated as taxable gain); incentivizes investment in stocks. Strategy: purchase bonds (whose interest is always ordinary income) out of pension trust (whose interest is not taxed annually) and stocks (whose dividends are capital gains if qualified) out of ordinary savings. Summary: pay capital gains now from stocks, ordinary income later from pension trust Possible Exclusions Meals and Lodging (SS119) - narrowly tailored exclusion for meals and benefits offered by employer. Extends to employee's spouse and dependants. Current Law: SS119 Lodging: income unless for convenience of employer and "required to accept as a condition of employment" E.g. oil rigs, military bases Grey area: Benaglia, live-in maids and butlers Not covered: people who live at work purely because it's convenient Policy: levels playing ground for those with little bargaining power Meals: if (1) for the convenience of employer and on the (2) premises then excludable See possible meal deduction if not excludable as SS162 business expense Self-Employed Loophole

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Incorporate, hire yourself as an employee of your corporation, and make a contract requiring that you live on the premises as a condition of employment Cite staffing shortages and need to be on call Hire spouse as a "chef," then deduct the cost of meals Note: Employer can write write them all of either as salary or as a business expense (see Business Outlays) Old Rule - Benaglia v. Commissioner (p. 52, 1937) Facts: Hotel manager and his wife lived at the hotel for free and got free meals because "he was required to be on call at all times." (although often traveling, and managing multiple hotels) Rule: anything for the convenience or benefit of the employer is not income Result: broad exclusion for employee benefits Fringe Benefits (SS132) - broader attempt than just SS119 Generally: All fringe benefits included by SS61 except those exempted by SS132. Spouses, Dependent Children, Retired/Disabled Employees, Surviving Spouses - SS132(h) Only applies to (a)(1) no additional cost services and (a)(2) qualified employee discount See details for definitions of the categories (h)(3) airplane use by parent of employees treated as use by employee Employee Discount SS132(a)(2) (details SS132(c)): qualified exclusion, must not: Exceed profit margin for products, and/or Exceed 20% for services 132(j)(1): bars highly compensated employees from using discount unless it is offered to all other employees. No Cost Additional Services SS132(a)(1) (details SS132(b)) Services ordinarily offered to the employee and at no cost to employer (including forgone revenue) E.g. airline employees flying in empty seats Working Condition Fringe SS132(a)(3) (defined by SS132(d)) Use of employer property or services E.g. trips on the company jet De Minimis Fringes SS132(a)(4) (details SS132(e)) (1) Small value compared to other fringes so that unreasonable/impractical to account (2) Can include eating facility if (A) near business and (B) revenue equals or exceeds operating costs of the eatery Parking SS132(f)(C) Not available to self-employed workers or partners Fringes in other SSs: Life Insurance (up to $50k) SS79 Deferred Compensation (SS409A) Transportation (SS132, but travel deductions in SS162) Educational Assistance (SS127) Child Care up to $5k SS129 Cafeteria Plans (SS125) Taxpayers can choose either the benefit or cash (which results in liability for value of fringe) No tax on otherwise excluded fringes simply because there was an option to take cash instead ("safe harbor"). Limited to: Everything in SS132 plus what's below - Group term life insurance (up to $50k) Dependent care assistance Adoption assistance Health saving accounts Certain deferred compensation plans (generally excluded) Everything else: considered constructive receipt (even if otherwise considered a fringe) Good deal for the taxpayer if he values the limited excluded fringes (SS132 and others) as much as he would the cash. (c) cannot discriminate in favor of highly compensated employees, see (e) (d) definition: employees choose between cash or qualified benefit

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See list of excluded benefits (f) qualified benefits defined Health and Accident Insurance (SS104, SS106) Deductible to employer and excludable to employee Government subsidizes health care through tax code to encourage employers to insure their employees. Do concurrently with SS213 describing deduction of medical expenses not compensated by insurance U.S. Treasury Bonds: SS135 exempts interest from U.S. Treasury bonds that is used to pay for higher education to the extent that it does not exceed education expenses State and Local Bond Interest (SS103) Interest collected on state and local bonds generally excluded Policy: Indirect method of support from federal government to state and local governments (subsidy) Incentivizes investment in state/local bonds over federal bonds Putative tax: allows state and local governments to pay less interest, knowing investors will pay less tax (putative tax is the difference in interest from state and local bonds and that of other investments) Exception: Arbitrage, Private Activity Bonds, and Unregistered Bonds Arbitrage Bonds: when the state or local government takes advantage of higher rate of return in the private market to turn a profit for paying back interest to bondholders as well as for themselves Also not allowed for taxpayers who take advantage of different tax treatments of bonds and deduction for loan interests to pay for the bonds in order to change other ordinary income into capital gains Private Activity Bonds - see SS141 Public: has a salutary effect on the general welfare Ex: Schools, roads, gov't buildings Private: serves the monetary interest of a private party Ex: Industrial development bonds Exception to the Exception: Qualified Private Activity Bonds E.g. airports, mortgage subsidy, and student loan bonds Unregistered Bonds: more like a promissory note than a formal government debt. Not binding in a court of law without the physical document. Valuation Turner v. Commissioner (p. 67) (1954) Facts: Taxpayer won 2 tickets to Buenos Aires on a radio show (could not afford them himself). He reported them as income at 25% of FMV. Issue: how do we value it as income?
Value to Taxpayer (Subjective Approach) Pro-taxpayer, pro-liquidity, administrative nightmare Limited to occasional receipts, not routine ones Market Value (Objective Approach) Pro-market, pro-efficiency, harsh marginal effects Cost by Employer/Provider of the Benefit Ruling: Split the baby--halfway between subjective value and FMV. See also homerun baseball case: treats as income at time of sale of the ball, not when you caught it Imputed Income: non-taxable Benefits or satisfaction to taxpayer from (1) using and enjoying property owned, (2) producing and consuming goods, (3) performing services for self All excluded: consuming food you grew yourself, stay-at-home parents saving cost of child care, paying in-state tuition., Policy: valuation, line drawing, and oversight problems Mutual Exchange of Services: Taxable Income if not between family unit See Revenue Ruling 79-24 (p. 76): lawyer exchanging services for painting personal residence Psychic income: subjective reward you get from various activities/employment/leisure (obviously not taxed in part due to valuation problems) Can't tax people for choosing not to work full time based on enjoyment of leisure See Inaja Land: recovery of capital Gifts (SS102(a))

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Definition/Exclusion: "gross income does not include the value of property acquired by gift, bequest, devise, or inheritance" (does not need to be reported to IRS) Generally does not exclude gifts from employers from income (see Duberstein) Carveout for SS61 that would otherwise include it as income Strategic Transfer: Since gift is not defined well, taxpayers can aggressively seek gift label Label as a gift makes it non-deductible for the giftor Options: Donor deducts, done includes Donor has no deduction, Donee has income Donor has no deduction; Donee has no income Law Reasoning: gift is out of donor's post-tax income. Business Gifts: Commissioner v. Duberstein (p. 83) (1960) Facts: D received Cadillac as a "business gift" from an associate he gave valuable advice to. Rule: Intent of the donor controls, although courts/IRS may make an inquiry into whether something the donor classifies as a gift is actually a gift and not compensation. ("detached and disinterested generosity"/"out of affection, respect, admiration, charity") Policy: jury generally controls outcome in case by case basis, leading to uncertainty Current Rule for Employers/Employees SS102(c): No transfer from an employer to employee is a gift.
SS74(c) Lone Exception: "employee achievement awards" are considered gifts
SS274(b): Employers may deduct gifts as business expenses, but only $25 per donee per year. Stanton v. United States (p. 84) (1960) - overruled by SS102(c) Facts: As Mr. Stanton leaves employment for managing Trinity Church's holdings, the church offers $20k gift for his fabulous services. Released from all claims to benefits not already accrued: was this bargaining?
Ruling: because it was the employer's desire to become a benefactor (not to compensate) it should be treated as a gift Overruled by SS102(c) because no transfer from employer to employee is a gift Possibly Illegal Gifts: United States v. Harris (p. 91) (7th Cir. 1991) Facts: mistresses/prostitute, benefactor now diseased. Letters regarding decedent's intent. Tax evasion case. Rule: Prostitution income taxable, but general gifts not quid pro quo for sex is not. Policy: even income from illegal jobs is taxable (wages of sin) Gifts of Appreciated Assets: Taft v. Bowers (p. 104) (1929) - see SS1015 Facts: Grandfather transferred appreciated stock to granddaughter. It further appreciated, and then she sold it. Rule: Donor's basis is recipient's basis. Recipient is taxed on everything above the donor's basis at the time she sells the asset. No tax consequences at the time of the gift. Gift tax: separate from income tax, paid by donor with secondary liability on the donee if the donor does not pay (p. 107 fn. 14) Basis for Gifts: SS1015 Donee assumed donor's basis unless the donor's basis is greater than FMV at the time of gift, in which case the basis changes to the FMV. Cannot gift a loss. o.k. boss. If no evidence to determine donor's basis then use FMV at time of gift. Exception: Upon death you always assume FMV as basis (see SS1014) Strategy: Hold appreciating assets, and leave in will (take advantage of SS1014) Sell depreciating assets to take the capital loss (avoid SS1015 problem) Transfers At Death
SS1014: Basis step-up Basis for bequeathed appreciating asset is FMV on the date of death Incentivizes people to hold onto appreciating assets and will them instead of gifting them while alive. Incentivizes people to sell depreciating assets while alive--take deduction.

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No income tax liability to recipient at time of death Recovery of Capital
SS1001 - Determining Gain or Loss Gain = amount realized (AM) - adjusted basis (AB) Inaja Land Co. v. Commissioner (p. 111) (1947) - Basis First Facts: bought land for $61k and fished on it, city started dumping in water, settled for an easement of
$50k less $1k attorney's fees Rule: Property devaluation damages reduce basis. 49K in damages subtracted from 61K basis to produce 12K adjusted basis. If damages exceed basis, basis goes to 0 and taxpayer pays taxes immediately on excess damages. Policy: valuation problems, and tax deferral because property (timing) Life insurance payouts (SS101) Payout received at death of insured is not income Taxpayer looking for mortality gain (recovery of investment), insurance looking for mortality loss Mortality loss non-deductible Definitions: Mortality Gain: amount of interest gained upon payout above the total sum of premiums. When you die earlier than expected. Gain is excluded by SS101. Mortality Loss: the gap between what was paid out and the total sum of the premiums (only when it is negative, you live longer than expected) - no loss deducted per SS101 Exclusionary treatment to insured may extend to inside buildup Endowment policy: insured makes payment(s) so that there is payout to the insured at a specified time. Payouts receive exclusionary treatment to the extent of the basis (premium(s) paid), the gain is treated as ordinary income. Gain = AR - Basis. Viatical settlement: exclusion for terminally ill person who sells life insurance policy to third party. You get an exclusion for the payment received from third party. Annuities (SS72) Annuities given as compensation: Income at time it is given (i.e. when they put it in the annuity, not delayed until you actually get the $). Basis is what you paid tax on for final payout rules below. All annuities: Income at payout is treated as follows Inside buildup (interest) excluded until payout Gain above basis is taxed; no tax on recovery of basis Payout over multiple years: Exclusion Ratio (pro rata) Each payout is taxable at the ratio of basis to interest E.g. Basis of 100, payout of 120: 20% of the payout is interest so 20% of each payment is taxable income (the rest is recovery of basis). Old rule: basis first. No taxation until amount paid out exceeds basis.
SS72(b): If you die before the annuity is paid out, you may deduct unrecovered basis. Gambling (SS165) Rule: annual "basketing" - year's total gambling activity is grouped whereby losses are deductible only to the extent of that year's gains (i.e. no deduction for net loss, and net gains taxable) Professional gamblers can deduct expenses (travel, meals, lodging, etc.) if they are considered business expenses under SS162. Gains and losses still basketed above the line. Recovery of Loss Clark v. Commissioner (p. 122) (1939) Facts: attorney filed erroneous 1932 return (improperly deducted from income the total amount of losses from sale of capital assets for period of more than two years instead of applying limitation in SS101(b)) and gave amount of overpayment to client to retain business Rule: not income if not derived from capital, labor, or both Would be income under Glenshaw but not Eisner Policy: gave up wealth, then trying to get it back Less relevant now because there is a 2 year window to amend Loans and Debt

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