Introduction 3

Tax Policy 4

Gross Income 5

Work Related Fringe Benefits 5

Imputed Income 7

Gifts, Bequests & Concept of Basis 8

Recovery of Capital: Life Insurance, Annuities, Gambling, Etc. 9

Recovery for Injuries 11

Loans, Discharge of Indebtedness 12

Transfer of Property Subject to Debt 14

Illegal Income 15

Tax Expenditures: Tax-Exempt Interest, Sale of Home, etc. 16

Timing 17

Transfer of Property Subject to Debt 17

Nonrecognition & Like-Kind Exchanges 19

Constructive Sales & Financial Instruments 22

Original Issue Discount 24

Open Transactions & Installment Method 25

Constructive Receipt 27

Deferred Compensation, Qualified Employee Plans 28

Alternative Systems 31

Stock Options 31

Marriage & Divorce 34

Deductions 36

Personal Deductions 36

Casualty Loss 37

Extraordinary Medical Expenses 38

Charitable Contributions 40

Home Mortgage Interest 43

State and Local Taxes 44

Personal Exemptions 44

Personal Credits 45

Mixed Personal & Business Deductions 46

Hobby Losses 48

Home Offices 49

“Trading” v. “Investing 50

Travel & Entertainment Expenses 50

Child Care Expenses 51

Commuting Expenses 51

Clothing, Legal Expenses, Education 53

Business Deductions 54

Capitalization 54

Repair & Maintenance 56

Ordinary & Necessary Expenses 57

Depreciation 59

Tax Avoidance 63

Tax Shelters & Economic Substance Doctrine 63

Passive Activity Loss, Investment Indebtedness & At-Risk Rules 63

Income Splitting 66

Income Diversion 66

Marriage Penalty 66

Transfers of Property v. Income from Property 68

Capital Gains and Losses 70

Statutory Framework 70

Policy 71

Definition of Capital Asset 72

Distinguishing Business Income 74

Distinguishing Other Ordinary Income Cash Flows 76

Introduction

Gross Receipts

• Costs & Exclusions

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Gross Income

• Deductions (§ 62)

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AGI (§ 62)

• Itemized Deductions OR Standard Deduction (§ 63)

• Personal Exemptions (§ 151) (no longer used)

• Section 199A deduction (bonus for some business income)

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Taxable Income

INCOME

• Economic Income...

  • Cash wages

  • Non-cash property or benefits (award show gift baskets)

  • Non-property of value (vacation prize, tuition payment)

  • Increases in the value of property

  • Imputed income and leisure

• Taxable income.

  • Tracks changes over an annual period

  • Taxable when realized through a sale or disposition (which then, does not account for the fluctuations in the value of certain properties held by the TP)

  • Non-taxation of imputed income and certain items because of the difficulty of valuation.

• Haig Simons: Y = C +W

• Glenshaw Glass (1955)/16A/Reg. § 1.61(a): Y is “from whatever source derived”

TERMINOLOGY

• Marginal rate: the rate applicable to the last dollar of income earned by the TP

• Average tax rate/effective rate: the tax due from the TP divided by taxable income

An individual’s average tax rates is not generally higher than his marginal rate.

• Progressive: as TP’s income increases, the rate of tax increases. High income individuals not only pay more tax b/c their incomes are higher but also pay a large portion of their incomes in taxes than lower income TPs b/c their rates are higher.

  • The average tax rate is lower than the marginal tax rates

  • Imposed to reduce the tax incidence of TPs with a lower ability to pay.

  • Encourages high-bracket TPs to shift their income to low-bracket TPs.

• Regressive: as a TP’s income increases, the rate of tax decreases

  • The average tax rate is higher than the marginal tax rate

• The average tax rate tends to be lower than the marginal tax rate because

  • (1) Exemptions and deductions

  • (2) Top marginal tax rates apply only to a portion of income

  • (3) Credits

Tax Policy

1. EQUITY, EFFICIENCY & ADMINISTRABILITY

Equity The tax burden should be distributed equitably.

• Horizontal Equity: the same rate structures should apply to all individuals

• Vertical Equity: one with more ability to pay should pay at least as much tax as one with less ability

Efficiency The tax should be neutral, and avoid creating negative incentives

• “Pigouvian” taxes: levied on any market activity that generates negative externalities (costs not internalized in the market price) corrects market failures

Administrability The tax should be easy to comply, compute and pay, and for government to check

2. TIME VALUE OF MONEY

Because a dollar today is worth more than a dollar tomorrow, a TP has an incentive to deter tax liability because it will cost less in present value terms.

Future amounts need to be discounted to reflect their present value

• Assuming a 5% after-tax discount rate, $1 today = $1.05 next year

Similarly, $1 tomorrow = $.952 today

• The longer you defer tax liability, the less it costs in present value terms

3. REALIZATION

Gains in assets are only taxed when there is a realization event.

Creates incentives to defer gains and accelerate losses, resulting in

1. Lock-in effect: people creates tax shelters to “shelter” their gains

2. Increases tax avoidance transactions (such as opening retirement accounts)

4. CAPITAL GAIN INCOME (*capital gains are usually stocks, investment properties, etc.)

• Ordinary income (“OI”): maximum tax rate is 40% (39.6%)

• Capital gain income (“CG”): maximum tax rate is 20% (actually 23.8%)

• Those in the highest income tax brackets will try to label OI as CG

Gross Income

INCLUSIONS Fringe benefits. § 61(a)(1). BUT employee-provided meals & lodging (if meets conditions of § 119.) Annuity gains, but exclusion ratio Gambling gains, but losses deductible to extent of gains. §§ 61, 165(d) Recovery to injuries: damages to property, non-physical injury, punitive damages (to phys injury). § 104(a). Discharge of indebtedness BUT insolvent debtors, student loans, mortgage forgiveness BUT discharge when given as “gift” (Diedrich) (“misconceived” discharge of debt) Transfer of property subject to debt (incl. recourse & non-recourse) Illegal income BUT offset...

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