#14140 - Federal Income Tax - Federal Income Tax

Federal Income Tax

• 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 §104, 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 (§61)

    • Fringe benefits included except as enumerated in §132

    • 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

    • Mutual Exchange of Services

      • In a commercial context: usually taxable

      • In a social context: usually not taxable

      • See also §83 (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 §104 - (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 §213)

            • 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 π(P) §162 business expense.

        • 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 §102, generally not included)

    • Dividends (§1(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 (§119) - narrowly tailored exclusion for meals and benefits offered by employer. Extends to employee’s spouse and dependants.

      • Current Law: §119

        • 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 §162 business expense

        • Self-Employed Loophole

          • 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...