FEDERAL INCOME TAX

INTRO

§ 61 Gross Income = “all income from whatever source derived,” including wages, salaries, interest, dividends, and rents.

  • § 101 – 127contain explicit exclusions from income such as interest on state and local bonds (§103) and tort recoveries for personal injuries (§104(a)(2)).

§ 62 Adjusted Gross Income (AGI) = (gross income) – (deductions in §62 like costs of producing business income)

§ 63 Taxable Income = (AGI) – [(personal exemptions) + (standard deduction or itemized deductions not previously deducted)]

  • §151 personal exemptions are allowed for 1) taxpayer; 2) taxpayer’s spouse; 3) and each of the taxpayer’s dependents.

[(Taxable Income) x (§ 1 Tax Rate)] – Credits = TAX

§ 1222 Capital Gain/Loss = gain or loss from the sale or exchange of a capital asset.

  • § 1221 Capital Asset = property with some exceptions.
  • Long-term gain = gain from sale of capital asset held for more than a year
  • Short-term gain = gain from sale of capital asset held for one year or less
  • Net short-term gain is taxed as ordinary income
  • Capital loss can be used to offset ordinary income up to $3,000. Above $3,000 is used only to offset capital gain.

Cash method: income only when received in cash (or equivalent) and deductible when paid.

  • Capital costs: costs of capital investments may not be deducted when the cash outlay is made, but only as the asset is used or when it is sold, exchanged, or abandoned (ACRS).
  • Constructive receipt: a right to a payment is treated as if received when the taxpayer had an unrestricted right to receive cash.
  • Economic benefit: people are treated as if they had received cash (fair market value) when they receive valuable property or rights.

Accrual method: income when earned and deductible when the obligation to pay is incurred.

Realization: when a change in circumstances such that the gain or loss might be taken into account for tax purposes.

Recognition: when the change in circumstances is such that the gain or loss is taken into account.

Accelerated Cost Recovery System (ACRS): cost of machine is spread out over a number of years (less than the expected life) according to formulas provided in the Code, bunching the deductions in the early years of the use of the machine.

  • Applies only to tangible property.
  • For intangible property (depreciation), cost is deducted over the realistic expected life of the asset, usually using straightline method.
  • Straightline method: equal amounts of deductions each year

Basis: cost of an investment – of the amount one looks to in calculating the deduction for cost recovery or depreciation, and in determining, on disposition, the amount of any gain or loss.

  • § 1014 Inheritance – basis of property acquired from a decedent is the FMV of that property at the time of decedent’s death.
  • § 1015(a) Substituted basis – for lifetime gifts, for computing gain, the donee takes the same basis that the donor had, increased to reflect any federal gift tax paid by the donor. Same thing happens for computing loss except when the (FMV at time of transfer)<(donor’s basis). Then it is just the FMV at time of conveyance.

Adjusted Basis: cost minus the ACRS or depreciation deductions

Sole Proprietor – all income and expense are that of the proprietor

Partnership – partnership pays no tax, but the partners report on their individual tax returns their pro rata share of whatever net profit or loss was calculated by the partnership (pass-through)

Corporation – separately taxed as an entity, and dividends taxed to shareholders.

CHARACTERISTICS OF INCOME

Regs. § 1.61-1(a) - Gross income includes income realized in any form, whether in money, property, or services.

Regs. § 1.61-2(d)(1) – If services are paid for in property, the fair market value of the property taken in payment must be included in income.

“all accessions to wealth, clearly realized, and over which the taxpayer has dominion and control.” Glenshaw Glass

Noncash Benefits

“For the convenience of the employer” is exclued from gross income Benaglia

§ 119 Meals or lodging furnished for convenience of the employer are excluded only if:

  • the meals are furnished on the business premises; employee is required to accept such lodging on the business premises as a condition of employment.

§ 132 Certain fringe benefits are excludable

  • “no-additional cost services”: like free seating for airline employees
  • “qualified employee discount”: like a dept store offering discounts to employees
  • “working condition fringe”: business use of company car or free magazine relating to employee’s job
  • “de minimis fringe”: those of sufficiently low value to make accounting for them unreasonable or administratively impractical
  • certain on-premises gyms and other athletic facilities
  • “qualified transportation fringes”: like employer-provided parking or mass transit passes
  • “qualified moving expense reimbursement”
  • NO-ADDITIONAL COST SERVICES & QUALIFIED EMPLOYEE DISCOUNTS ARE SUBJECT TO TWO RESTRICTIONS:
  • One must work in a line of business of the employer in which the item at issue is ordinarily offered for sale to customers.
  • Does not apply to highly compensated employees if the employer discriminates in favor of such employees in determining to whom a given fringe benefit is available.

Frequent flyer miles – travel credits converted to cash in a personal travel account established by an employer are not excludable. Charley

§ 125 Cafeteria plans – expressly authorizes a plan under which an employee may choose among a variety of noncash nontaxable benefits or may choose to take taxable cash.

  • Permissible only for group life insurance (up to $50,000) (§79), accident and health insurance (§106), and dependent care (§129).
  • Must not discriminate b/n employees
  • “Use-it-or-lose-it” rule (Regs. §1.125-1) states you can’t be reimbursed for portion not used.

Benefits from other than employer – sample books (received by a book reviewer) would be taxable only if the taxpayer donated them to charity and claimed a deduction for that deduction (Rev. Rul. 70-498, 1970-2 C.B. 6).

Subjective Value: Although income is usually valued at FMV of property or services, that value is not reasonable to people who win a round-trip cruise b/c that is not something they needed in the ordinary course of their lives. Turner.

Imputed Income

Home ownership – With money to invest, buying a house with that money causes nontaxable imputed income in the form of rent that is avoided by owning a house. Investing the money will cause taxation on the return.

Economic Benefit – in exchange of services, the FMV of the services received are includable in gross income (Rev. Rul. 79-24, 1979-1 C.B. 60).

Windfalls and Gifts

Damage Awards – including lost profits and punitive damages (excluding torts for personal injuries), are taxable. But damages given as reimbursement for lost capital are not taxable. Glenshaw Glass Co.

Treasure troves are taxable in the year it is found. Cesarini

§ 102 Gifts and inheritances – not taxable.

  • Gifts must be from “detached and disinterested generosity.” Duberstein
  • Transfers pursuant to an antenuptial agreement are generally treated as gifts b/n the parties. Unless reasonable inquiry yields a clear answer to the taxability of such payments, the taxpayer could not have formed the necessary, willful, criminal intent. Harris

Ordinary tips – are includable in income as payment for services rendered (Regs. §1.61-2(a)(1))

Welfare – welfare payments and various other government payments, such as those for relief of disaster, and for victims of crime, are excludable as not within the contemplation of §61.

§ 117 Scholarships – “qualified scholarships” received by “degree candidates” are not taxable.

  • Degree candidates = primary, secondary, undergraduate, or graduate student.
  • Qualified scholarships = to the extent that it covers only the tuition and required fees, books, and supplies.
  • Exclusion does not apply to the extent that the scholarship is compensation for services, including teaching and research (and maybe sports). §117(c)

§ 74 Prizes & Awards – prizes and awards are taxable except when transferred directly to charities and for certain employment achievement awards.

Recovery of Capital is not taxed, as opposed to Return on Capital

When real property has been damaged, recovery which is less than the basis is not taxable. Inaja Land Co.

Regs. § 1.61-6 - Partial Sales

The basis ofthe totalthe FMV of the parcel sold

the parcel=basis of all x ------

sold of the parcelsthe total FMV of all the parcels

Annuities

  • Cost = $100,000; Annual Payments = $10,000; Expected life of annuitant = 15 yrs.
  • BASIS FIRST METHOD – treats each payment as a tax-free recovery of capital until the entire $100,00 investment is recovered.
  • INCOME FIRST METHOD – treats all payments as income to the extent of any income set aside for the policyholder in the insurance company’s reserves.
  • Most of the early payments would be income and most of the later payments would be received tax-free as basis recovery.
  • PRO RATA METHOD – adopted by the Code, it allocates a pro rata portion of the cost to each of the 15 payments.
  • § 72(b) provides that the taxpayer may exclude from each annuity payment the product of the payment multiplied by the exclusion ratio, which equals the cost of the annuity contract divided by the expected return on the annuity contract ($100,000 cost/$150,000 expected return).
  • Deferred annuities are calculated the same.
  • The longer the period of deferral, the greater the return on the taxpayer’s annuity investment.
  • Amounts borrowed on a loan secured by an annuity policy are taxable to the extent that (due to the build-up of interest) the value of the policy has risen as the payout date approaches. §72(e).
  • Unless the recipient is age 59½ or older, a 10% tax penalty applies to such amounts. §72(q).

§ 101 Life Insurance

  • TERM – provides coverage for a specific period of time.
  • Deduction for the cost of policy is not allowed if you live out the term.
  • Beneficiary receives the insurance proceeds tax-free. §101
  • WHOLE – provides coverage for the life of the policyholder. To the extent that
  • Qualifies for same exclusions as term insurance.
  • If you live to life expectancy or longer, its better than other forms of investment with the same percentage return b/c you pay tax on those.

§ 165(d) Gambling losses – all gains are taxable, but losses (both for professional and amateur gamblers) are deductible only to the extent of such gains from the same taxable year.

Reimbursement of unnecessary tax paid due to bad tax advice is not taxable. It is simply recovery of a loss. Clark

Life Estates and Remainder Interests – in situations where a bequest is split into life and remainder interests, the entire basis is allocated to the remainder interest and all of the income from the life interest is taxable.

  • Where both the remainder and life interest are sold concurrently, basis is allocated b/n the two interests in accordance with their respective FMVs.

Annual Accounting

§172 Net operating loss deduction – suffered in any year can be carried back to the previous two taxable years, and/or carried forward against income for the next 20 years.

Claim of right – “If a taxpayer receives earnings under a claim of right and without restriction as to its disposition, he has received income which is taxable, even though it may still be claimed that he is not entitled to the money, and even though he may still be adjudged liable to restore its equivalent." North American Oil Consolidated v. Burnet

  • If this taxpayer later is forced to give up this income, an adjustment in her tax liability in the form of a deduction should be made in the year in which the income is repaid. Lewis
  • § 1341 – If requirements of that section are met (for example, if the amount of the deduction exceeds $3,000), the taxpayer will reduce her tax liability (not income) in the year of repayment by the reduction in tax that would have occurred in the year in which the income was included had the taxpayer not included that amount.
  • If on the other hand, the taxpayer’s tax bracket is lower in the year of inclusion than in the year of repayment, the taxpayer may deduct the amount repaid, in the year of repayment, despite the fact that the deduction saves the taxpayer more than she paid in tax when the item was included in the earlier year.

Tax Benefit Rules – exception to annual accounting

  • INCLUSIONARY TAX BENEFIT – triggers an inclusion whenever an event occurs that is fundamentally inconsistent with a tax benefit recognized in an earlier year. Hillsboro National Bank
  • Suppose a taxpayer deducts a charity donation in year one, but is given back the contribution in year two. Taxpayer must include the contribution as income in year two.
  • § 111(a)EXCLUSIONARY TAX BENEFIT – permits a taxpayer to exclude the recovered item in the later year to the extent that it did not reduce the taxpayer’s tax liability in the earlier year.
  • So if the exclusion did not reduce the taxpayer’s liability in year one (like if he had zero taxable income), he may exclude retrieval of the donation in year two.

Loan Transactions

§ 61(a)(12) Discharge of Indebtedness – If a loan is discharged for less than the amount owed, the borrower must include in income the amount of the discount unless exceptions apply. Indebtedness must be a legal obligation to pay or subject to which the taxpayer holds property. Zarin

  • § 108 - A financially troubled taxpayer can exclude the discharge income if the taxpayer has filed a bankruptcy petition or only to the extent of taxpayer’s insolvency at the time of debt discharge.
  • § 108 – If the seller of property takes back debt on the property sold (purchase money debt) and later reduces the purchaser’s debt, the reduction in the debt is treated as a purchase price adjustment, not discharge income.
  • § 108 – Discharge of a liability is not discharge income to the extent that the liability would have been deductible had it been paid.
  • § 108 – excludes discharge of a student loan, provided the cancellation is contingent upon work for a charitable or educational institution.
  • § 102 – If a lender cancels a debt at a discount as a gift to the borrower, the borrower does not have to include the discount in income.
  • If a lender and borrower disagree about the amount owed and the borrower ultimately pays less than the amount the lender said was owed, the difference is not income. Sobel, Inc.
  • If a taxpayer is relieved of a nonrecourse liability in connection with the disposition of encumbered property, the debt relief is included in the taxpayer’s amount realized for the purpose of computing her gain or loss realized in the property transaction.
  • When nonrecourse debt is incurred to acquire or improve the property, the debt relief is included in the taxpayer’s amount realized . Crane
  • The amount realized includes the debt relief even if the encumbered property is worth less than the amount of debt at the time the taxpayer disposes of the property. Tufts
  • A donor who makes a gift of property on condition that the donee pay the resulting gift tax receives taxable income to the extent that the gift tax paid by the donee exceeds the donor’s adjusted basis in the property transferred. Diedrich

Illegal Income - Where a taxpayer withdraws funds from a corporation which he fully intends to repay and which he expects with reasonable certainty that he will be able to repay, where he believes that his withdrawals will be approved by the corporation, and where he makes a prompt assignment of assets sufficient to secure the amount owed, he does not realize income on the withdrawals. Gilbert

Gain from sale of personal residence

§ 121 – Gain from the sale of a personal residence – allows qualifying taxpayers to permanently exclude from income up to $250,000 ($500,000 for joint returns) of gain from the sale or exchange of their personal residence.

  • To qualify, the taxpayer must have owned and occupied the property as a principal residence for at least two of the last five years prior to the sale or exchange; and the exclusion can only be made once every two years.
  • For non-qualifiers, reduced exclusion available: $250,000 x (# of months occupied divided by two years) or (# of months since the taxpayer excluded gain under §121 divided by 2 yrs)

TIMING - RECOGNITION

Reg. § 1.1001-1(a)– provides that gain or loss is realized when property is exchanged for cash or other property “differing materially either in kind or in extent.”

  • Exchanged properties are materially different if they embody “legally distinct entitlements.” Cottage Savings Association

Reg. § 1.1001-3 - modification of a debt instrument is treated as a sale or other disposition triggering gain or loss (or income from cancellation of debt), if a “significant modification” has occurred in yield, timing or amounts of payments, the obligor, or the nature of the instrument.

Stock - Dividend in the form of stock is not a realization of income even though the MV of the shares of the stock appreciate. Eisner

  • § 305(a)If the stockholder had the option to take cash or other property instead of stock, then the dividend is taxable.
  • Regs. § 1.307-1(a) taxpayer’s total basis of the old shares is allocated b/n the old and the new shares in accordance with relative FMVs after stock dividend distribution.
  • § 1223(5)new shares will be deemed to have been acquired at the time when the old shares were acquired.

§ 109 & 1019 Tenant improvements are realized by the lessor as capital on the termination of the lease, provided that the improvements were not a form of rent. Helvering v. Bruun

Like-Kind Exchanges

§ 1001(c)provides that realized gains and losses are recognized unless otherwise provided in the Code.

§ 1031provides for nonrecognition of gain or loss realized on the exchange of trade or business or investment property for like-kind property that will also be used in the taxpayer’s trade or business or held for investment; there’s no choice in the matter.

  • Mostly for exchanges of real property for 2 reasons:
  • §1031 doesn’t apply to inventory, stocks, bonds, notes, other securities or evidences of indebtedness, partnership interests, beneficial interests in trusts, or contract rights.
  • Whether developed or not, commercial or residential, all real property is like-kind.
  • Reg. § 1.1031(a)-1(b) like-kind refers to “the nature and character of the property and not its grade or quality (silver is different from gold).
  • Property sold and leased back for a 30-year period from an unrelated party is not an exchange of like-kind properties. Jordan Marsh Co.
  • However, Reg. § 1.1031(a) deems a lease of over 30 years to be equivalent to a fee ownership. Therefore, the IRS holds the exchange in this case to be one of like-kind properties.
  • § 1033 provides for nonrecognition where property is compulsorily or involuntarily converted (theft, destruction, or condemnation) and is replaced with property that is “similar or related in service or use.”
  • Nonrecognition is of gain is mandatory where there is a direct conversion. Where the taxpayer receives cash and then buys the replacement property, nonrecognition of gain is optional (loss is recognized), but the replacement must occur within 2 years.
  • Substituted Basis – basis for the property received will be the same as the basis of the property relinquished.

The basis for determining gain or loss upon the sale or other disposition of property is not affected when, subsequent to the acquisition of the property, the owner receives a loan in an amount greater than his adjusted basis which is secured by a mortgage on the property upon which his is not personally liable. Woodsam Assoc.