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TAX I OUTLINE

Tax I | Brooks

INTRODUCTION

3 TAX POLICY

4 GROSS INCOME

5 WORK RELATED FRINGE BENEFITS
IMPUTED INCOME
GIFTS, BEQUESTS & CONCEPT OF BASIS
RECOVERY OF CAPITAL: LIFE INSURANCE, ANNUITIES, GAMBLING, ETC.
RECOVERY FOR INJURIES
LOANS, DISCHARGE OF INDEBTEDNESS
TRANSFER OF PROPERTY SUBJECT TO DEBT
ILLEGAL INCOME
TAX EXPENDITURES: TAX-EXEMPT INTEREST, SALE OF HOME, ETC.

5 7 8 9 11 12 14 15 16

TIMING

17 TRANSFER OF PROPERTY SUBJECT TO DEBT
NONRECOGNITION & LIKE-KIND EXCHANGES
CONSTRUCTIVE SALES & FINANCIAL INSTRUMENTS
ORIGINAL ISSUE DISCOUNT
OPEN TRANSACTIONS & INSTALLMENT METHOD
CONSTRUCTIVE RECEIPT
DEFERRED COMPENSATION, QUALIFIED EMPLOYEE PLANS
ALTERNATIVE SYSTEMS
STOCK OPTIONS
MARRIAGE & DIVORCE

17 19 22 24 25 27 28 31 31 34

DEDUCTIONS

36 PERSONAL DEDUCTIONS
CASUALTY LOSS
EXTRAORDINARY MEDICAL EXPENSES
CHARITABLE CONTRIBUTIONS
HOME MORTGAGE INTEREST
STATE AND LOCAL TAXES
PERSONAL EXEMPTIONS
PERSONAL CREDITS
MIXED PERSONAL & BUSINESS DEDUCTIONS
HOBBY LOSSES
HOME OFFICES
"TRADING" V. "INVESTING
TRAVEL & ENTERTAINMENT EXPENSES
CHILD CARE EXPENSES
COMMUTING EXPENSES
CLOTHING, LEGAL EXPENSES, EDUCATION
BUSINESS DEDUCTIONS
CAPITALIZATION
REPAIR & MAINTENANCE

36 37 38 40 43 44 44 45 46 48 49 50 50 51 51 53 54 54 56

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Tax I | Brooks

ORDINARY & NECESSARY EXPENSES
DEPRECIATION

57 59

TAX AVOIDANCE

63 TAX SHELTERS & ECONOMIC SUBSTANCE DOCTRINE
PASSIVE ACTIVITY LOSS, INVESTMENT INDEBTEDNESS & AT-RISK RULES

63 63

INCOME SPLITTING

66 INCOME DIVERSION
MARRIAGE PENALTY
TRANSFERS OF PROPERTY V. INCOME FROM PROPERTY

66 66 68

CAPITAL GAINS AND LOSSES

70 STATUTORY FRAMEWORK
POLICY
DEFINITION OF CAPITAL ASSET
DISTINGUISHING BUSINESS INCOME
DISTINGUISHING OTHER ORDINARY INCOME CASH FLOWS

70 71 72 74 76

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Tax I | Brooks

Introduction
Gross Receipts
- Costs & Exclusions
-------------------------
Gross Income
- Deductions (§ 62)
-------------------------
AGI (§ 62)
- Itemized Deductions OR Standard Deduction (§ 63)
- Personal Exemptions (§ 151) (no longer used)
- Section 199A deduction (bonus for some business income)
-------------------------
Taxable Income
Tax = Tax Base x Tax Rate(s)
e.g. Income Tax = Taxable Income x
Tax Rate(s)
INCOMEEconomic Income...
o Cash wages

Non-cash property or benefits (award show gift baskets)
o Non-property of value (vacation prize, tuition payment)
o Increases in the value of property

Imputed income and leisureTaxable income.
o 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)
o Non-taxation of imputed income and certain items because of the difficulty of valuation.Haig Simons: Y = C +∆WGlenshaw Glass (1955)/16A/Reg. § 1.61(a): Y is "from whatever source derived"

TERMINOLOGYMarginal rate: the rate applicable to the last dollar of income earned by the
TPAverage 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.

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Tax I | BrooksProgressive: 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.
o  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.
o  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 rateThe 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

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Tax I | Brooks

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.)
o

o

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

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Tax I | Brooks

Gross Income
INCLUSIONS
- Fringe benefits. § 61(a)(1).
o 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 if stolen items returned in same taxable year
- Interest. § 61(a)(4)
o BUT interest from state or local bonds. § 103(a).
o BUT arbitrage bond § 103(b)(2).
EXCLUSIONS:
- Employee-provided meals & lodging § 119.
- Imputed income. (e.g. child care, owner-occupied housing)
- Gifts. § 102 (limitation on employer/employee & business context).
- Recovery of capital. §§
o Life insurance

BUT annuity gains included, but exclusion ratio
- Recovery of damages to physical injury. § 104(a).
- Loan proceeds (loan repayments not deductible)
- "Misconceived" discharge of debt (like a "gift" Diedrich) (discharge of debt for insolvent debtors, student loans, mortgage forgiveness)
- Principal residence sale/exchange if w/in 5-yr period, at least 2 years live there; up to $250K/$500K. § 121(a). / No loss allowed. § 165(c).

Work Related Fringe Benefits
Employer-Provided Meals or Lodging?
Rule:
o

o o

Excluded from income IF (See § 119; Benaglia)
Furnished by or on behalf of the employer?
For the convenience of the employer?
On the business premises?
Acceptance is a condition of employment ( required for lodging, not meals)

Application:
o If requirements of § 119 ^MET, then cost will not be included in gross income.

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o o

Tax I | Brooks

Cost = Rental Value/FMV.
Extends to spouses and "dependents."
 "Dependent": to qualify, must receive more than half of her support from the TP (among other things under § 152).

Employer-Provided Health Insurance?
Rule: Excluded from income.
Application:
o Employers may deduct the cost of insurance.
o Employees exclude benefits received from insurance.
o Exclusion extends to spouses or "dependents." Reg § 1.106-1

Excluded from wages.
o Extends to value of insurance and medical services when received.
o But medical services reimbursed directly by the employer under qualifying plans are included in income.
o Self-employed TP? Can deduct health ins. as "business expense"
under § 162(1).
Benefits Common in Practice (Safe Harbor List)
STEP 1: Rule: The following fringe benefits are excluded in gross income. §

132. o § 132(b) "no additional cost services" - free seating for airline employees on flights that would otherwise have sold out  SEE STEP 2
RESTRICTION
o § 132(c) "qualified employee discounts"  SEE STEP 2
RESTRICTION
o For services: discount cannot exceed 20% of the price of service

For property: cannot exceed gross profit percentage of price of property

§ 132(d) "working condition fringes" - such as business use of a company car, or a free subscription to a magazine that relates to the employee's job (e.g. where a brokerage house buys a financial publication for its brokers)
o *If employee paid for it himself, it would be deductible as a business expense

§ 132(e)(1) "de minimis fringes" - or those of succinctly low value to make accounting for them unreasonable or administratively impractical

§ 132(e)(2) special rule to certain eating facilities w/o regard as to whether they would otherwise qualify:
o § 132(f) "qualified transportation fringes" - such as employerprovided parking or mass transit passes

§ 132(g) "qualified moving expense reimbursement"
o § 132 (m) "qualified retirement planning services"
o § 132 (j)(4) certain "on-premises gyms and other athletic facilities"

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