I. Introduction
A. Types of Audits
· Audit - FG finds people who owe more than what they paid, service focuses its attention on those who typically cheat
· Correspondence audit – done through the mail
o Letter wants tax itself, interest accrued, and penalties if any
· Field audit – agent comes to your home and moves in
o Interested in wide range to issues
o KIM: Burden of proof on TP usually
· Office audit – revenue agent’s office
o Tend to be more specific in wanting information
B. Kinds of Courts
· Tax Court: Most important of the Three
o Taxpayer commences action in court for re-determination of a deficiency w/o first paying the asserted deficiency
o Most sophisticated on tax issues, only hears tax cases
o No jury and only one judge
· Federal District Court - Can have jury trials here
o Has jurisdiction in any case against US regardless of amount
o R: Have to first pay the amount owed to file suit
· United States Court of Federal Claims
o Jurisdiction over all federal tax claims regardless of amount
o No venue requirements, no juries
o No deficiency cases, only can hear refund cases
C. Sources of Rules
· Constitution: 16thA FG ability to tax income of citizens
· Congress: creates statutory provisions – Code §§’s
· Executive: Department of Treasury
o Regulations proposed and sent out for public notice and comment, respond and then go to admin process of issuing
· Revenue Procedures: IRS puts out certain procedures to follow
o Court treatment: Sometimes given persuasive weight because it may be a long standing interpretation OR NO weight at all
o IRS puts out a line in the sand, as a litigation tactic
· Private Letter rulings – IRS gives personal specific rulings to those who request information about taking certain tax action
o Decision is binding on TP – decision locks in the tax treatment
D. Accounting Principles – what years does gross income get reported
· Cash Method – work when paid
o IF you are a cash method TP, THEN the year of actual receipt
o Corollary: Constructive receipt – counts, used for anti-abuse
· Accrual Method – rolling billing
o IF you are an accrual method, when there is a right to receive
E. Tax Formula
· Gross Income
o Determine if amounts are included or entitled to exclusion
o Presumption that if item met income definition then included
· Above the Line Deductions
o Approved Deductions listed in §62, if not listed its BTL
§ Most trade/business types are above the line
§ Most personal are below the line
§ Investments can go either way
o Deduction presumption work opposite way, unless you can find a specific deduction you cannot deduct the value
· Adjusted Gross Income
o Gross income – ATL Deductions
· Below the Line Deductions/Standard Deduction
o §63 Standard Deduction
o §151 – all TP’s entitled to personal exemption
· Taxable Income
o AGI – BTL deductions
· Tax Rate
o Applied to Ordinary Income
o Applied to Capital Gains
II. Gross income
A. Definition of Income – defined abstractly, exclusions -> specific provisions
· §61 GR: Gross income means all income from whatever source derived including (list of items, not exclusive list)
o R: Exclusions can include statutory, judicial, and administrative decisions
· Glenshaw Glass - punitive damages constituted gross income
o Three prong test to determine gross income
§ Undeniable accession to wealth
§ Clearly realized
ú I: Look for realization event
§ Dominion – TP has to have it
ú No restrictions on its use
· N: Statutory scheme: income from all sources is taxed unless the TP can point to an express exemption
B. Income realized in any form
· Forms of Gross income Reg. § 1.61-1(a) – gross income may be realized in any form, whether money, property, or services
o §1.61-2(a)(1) Compensation for services including fees, commissions, and similar items
· Barter Clubs – trade services amongst its members rather than engage in cash transactions
o H: Still gross income even if you cut out the cash element of the transaction
· Fair Market Value of Property/Services Reg. § 1.61-2(d)(1)
o IF services are paid for in property/services THEN the FMV of the property/services is the measure of compensation
o IF the services rendered at a stipulated price, such price will be presumed to be the FMV of the compensation received in the absence of evidence to the contrary
o §20.2031-1(b) FMV = price a willing buyer would pay a willing seller with neither a compulsion to buy or sell and both having knowledge of relevant facts
C. Realization, Imputed Income, Bargain Purchases
· Realization Events: Matter of Timing
o Unrealized total gain may fluctuate from time to time as the property’s value changes, but that total will be treated as income only on realization
o GR: We do not tax mere accession to wealth when it is appreciation of property value
§ §1.1001-1(a) In property cases, realization requires a conversion into cash or other property…a Disposition
· Imputed Income: Self performing services for self or family/friends
o GR: Imputed income is not taxed although the Code contains no specific exclusion to that effect
o Two categories: imputed income from services and imputed income from property
§ Performing services for one’s family => Not treated as income
§ Performing services for self => not treated as income
§ Living in self-owned property => Not treated as income
o N: Tax policy of favoring home ownership
§ 163 Interest, §164 Property tax deduction, 121 Exclusion of Gain on Sale of Principal Residence
§ BUT, §1.61-8(a) Rents and Royalties are Gross Income
· Bargain Purchase: Purchased product for less than FMV
o Policy – unworkable to have IRS look behind every deal to see if there was a taxable bargain
o BUT, IF property transferred as compensation for services in an amount less than FMV, THEN FMV – Amount Paid = gross income. Reg. § 1.61-2(d)(2)(i)
§ Usually relation to employment compensation for services rendered is a clue but fringe benefits complicates the issue
o N: DO Not confuse realization requirement with compensatory bargain purchases. Reg. § 1.61-2(d)(2)(i)
§ Its gross income not now, but when she realizes it by selling it later
o T: When value is known and purchase for less than FMV
D. Cases applying Gross Income
Roco - TP had a qui tam payment from FG; gross income
· R: no specific § for exclusion means TP cannot exclude it
· §6662 – Penalty: TP substantially understates income by 20%
o Could be excused in GF shown, there was none here
Cesarini: TP’s found money in used piano; filed seeking a refund
· §1.61-14 governs this, treasure trove is reportable
· I: Accession to wealth took place - When money was found
McCann: Employer paid for employee to go on seminar
· I: Whether the services rendered are gross income
· TP: Attended training seminars; mixed with fellow employees
· GP: Employees are not required to attend, attendance is awarded to those who meet performance goals
· R: IF it is not for the purpose of the employer then it is gross income, value to employee must be regarded as income
o T: Did employer expect to get more work out of them or any benefits from the trip
Old Colony: Company decided to pay TP income tax liability
· IF someone pays tax obligation for a TP then that becomes gross income.
o Pyramiding the gross income is required by regulations
· By doing this for employers who pay employees tax liability equals out to those who just paid the employee and make him pay the tax
III. Gains from Dealings in Property
· Gain: § 61(a)(3) gross income includes “gains derived from dealings in property.”
· N: No realization while property is being held
o Realization event is the sale or transfer of property
· §1.61-6(a): Gain = Amount Realized – Un-recovered Cost/Other Basis for the Property Sold/Exchanged
o §1001(a): Gain = Amount Realized – Adjusted Basis
o §1001(b): Amount Realized = Sum of $$$ received + FMV of the property received
o §1011 Adjusted Basis shall be §1012 Cost adjusted by §1016
o §1012 Cost Basis: Basis of property = Cost of Property
§ Cost of real property shall not include any amount w/r to real property taxes, which are imposed on TP
o §1016 Requires TP to adjust basis in property to reflect any recovery of TP investment or any additional investment made in the property
§ Ex: Increasing adjusted basis in property
ú Paying additional money for add-on to house
§ Ex: Lowering Adjusted basis in property
ú Using insurance proceeds from damage to house to not repair home but go on vacation
· Recovery of Capital Concept
o TP has right to recover tax-free investment (capital) in property before being charged with income from a disposition in property
o §1012 Cost basis and §1016 Adjusted Basis provide a measure of the capital TP is entitled to recover Tax-free
o Basis is critical to determining the gain/loss realized by TP on disposition of the property
· N: §61(a)(7) Dividends are gross income
o Just like rent and interest earned – earnings on or profit from one’s investment
o Basis not adjusted to reflect payment of dividend
A. Tax Cost Basis: When property is given over as payment
· reporting the amount of compensation income upon receipt of land, the basis of the land is the fair market value of the services rendered
· §1.61-2(d)(2)(i): IF property is transferred by an employer to an employee/IC as compensation for services, for an amount less then FMV,
o THEN compensation (gross income) = Amount Paid for the property – FMV at time of transfer.
o Gain/loss from subsequent sale of such property, Basis = Amount Paid for the property + Amount of such difference included in gross income
· Exceptions: stock options (§1.61-15) and others see §421
· Ex: A owes B $50k. A gives property (FMV of $50k) to B.
o B has $50k of income (compensation for services whether $$/property)
o B later sells land for $60K, A has realized gain of $10k
§ Having reported $50k already as income, means B has §1012 Cost Basis of $50k, thus AR – Cost = Gain
o The reporting of the $50k of compensation income on the land constitutes a Tax Cost Basis
· Ex: What if FMV of land is $60k, A owes B $50k, and A pays B $10k for the land
o Not to be confused with bargain purchase:
§ Nature of parties’ relationship and the circumstances of the land transfer means that what one might view as a bargain purchase is really paying for services
o §1.61-2(d)(2)(i): Basis = Amount paid + Amount of such difference included in gross income, Basis is $60k
§ Gross income is $50K, Amount paid - FMV
B. Impact of Liabilities
· Impact on Basis: Recourse/Non-recourse/Seller’s loan
o GR: Recourse liabilities incurred by a TP in the acquisition of property are included in the TP’s basis in that property
o Due to of the obligation to re-pay, TP is entitled to include the amount of the loan in computing basis in property; the loan under §1012 is part of the TP’s cost of the property
o N: Beneficial to TP’s acquiring depreciable assets, b/c depreciation deductions are computed w/r to basis in property
o R: TP may not increase basis when debt is paid
· Impact on Amount Realized: Cash, Assuming TP liability
o GR: Recourse liabilities of a Seller, assumed by a purchaser, are included in the Seller’s Amount realized
o §1.1001-2(a)(1): Corollary to inclusion of liabilities in basis is the inclusion in amount realized of those liabilities of the TP assumed by the purchaser
C. Basis of Property Acquired in a Taxable Exchange
· GR: Cost Basis of Property Acquired in Taxable Exchange is the fair market value of the property received in the exchange
· Ex: Property swap between K and P
o K adjusted basis of $150k and P - $50k. Property was $450k
o Was there any gain? Gain = amount realized – adjusted basis
§ K gain: $450k - $150k = $300k
§ P gain: $450k – $50k = $400k
o Was there a realization event? Yes.
o 1001: Gain = FMV + cash – adjusted basis.
o But what is her basis in the property received? What was her cost of the new property? Cost was $450k. Under 1012, her cost was the FMV of the property received
D. Caselaw
Philly Park – When property is exchange for property in a taxable exchange the TP is taxed on the difference between the adjusted basis of the property given in exchange and the FMV of the property received in exchange
· To not follow this would result in allowing the TP a stepped up basis, without paying a tax
· What if you cannot valuate the FMV of the property received
o IF you can’t measure the court will assume it the same value of the FMV of the property given
Woodson - Borrowing $$$ against property that you already own and using property as collateral
· Not a realization transaction, its a financing transaction, effect of which will be taken into account but it will not change basis
IV. Effect of Obligation to Repay
A. Loans – Not gross income, though no Code section says this
· Does not represent an accession to wealth, loan proceeds are accompanied by an equal and off-setting liability
o Borrower has an obligation to repay the loan as income
o Obligation negates treatment of a loan as income
· R: Repayment of a loan does not constitute gross income
o Repayment is not a deductible expense
o Lender has no income when a loan is repaid
· I: Not every loan is fully repaid, Failure to pay -> tax consequences
· R: Determination of whether a transfer of funds constitutes a loan is a question of fact