Gross Income

Question 1

Tax Due

Answer 1

• I - TAXABLE IMCOME
• II - APPLY TAX RATES = TAX LIABILITY
• III - SUBTRACT CREDITS

I - TAXABLE IMCOME

• A) Adjusted Gross Income =
  
  • 1 ) Compute Gross Income
  • 2) Subtract “above the line” deductions [those listed in § 62(a)]
• B) MINUS
  
  • 1) Personal Exemptions
  • 2) EITHER
    
    • a) Standard Deduction [§ 63(c)] OR
    • b) Itemized Deductions [§ 63(d)]

II - APPLY TAX RATES = TAX LIABILITY

III - SUBTRACT CREDITS

Question 2

Adjusted Gross Income

Answer 2

• Adjusted Gross Income =
  
  • 1 ) Compute Gross Income
  • 2) Subtract “above the line” deductions [those listed in § 62(a)]

_________________________

I - TAXABLE IMCOME

• A) Adjusted Gross Income =
  
  • 1 ) Compute Gross Income
  • 2) Subtract “above the line” deductions [those listed in § 62(a)]
• B) MINUS
  
  • 1) Personal Exemptions
  • 2) EITHER
    
    • a) Standard Deduction [§ 63(c)] OR
    • b) Itemized Deductions [§ 63(d)]

II - APPLY TAX RATES = TAX LIABILITY

III - SUBTRACT CREDITS

Question 3

Accession to Wealth

Answer 3

Does the item add to the taxpayer’s wealth?

_______________________

General Test for Income

The Glenshaw Glass Court held that an item is “income” if it represents an instance of

1. “undeniable accessions to wealth,
2. clearly realized, and
3. over which the taxpayer has complete dominion.”

(1) Accession to Wealth—Does the item add to the taxpayer’s wealth?

(2) Clearly Realized—Has the taxpayer realized the benefit of the addition to wealth?

Realization requires the accrual or receipt of cash, property, or services, or a change in the form or the nature of an investment.

Realization—A taxpayer “realizes” the benefit of an addition to wealth if the taxpayer has received something severable for his or her use or benefit. The realization element here primarily serves to distinguish items of income from the mere appreciation in the value of preexisting assets. So while a taxpayer’s receipt of $1,000 cash as compensation for services is a clearly realized accession to wealth, the fact that a taxpayer’s personal investment portfolio of stocks and securities grows by $1,000 is not income because there has been no “realization” of the growth in value. Note that realization does not require the receipt of cash or a sale of an asset. A taxpayer has realized an accession to wealth, for example, by accepting a vehicle as compensation for services performed by the taxpayer.

(3) Complete Dominion—Does the taxpayer have full ownership and control over the addition to wealth?

Illegal Receipts—A taxpayer is considered to have complete dominion over an item even if the taxpayer received it illegally. James v. US, 366 U.S. 213 (1961). The fact that the taxpayer does not have a claim of right to the item does not control its inclusion in gross income; it is sufficient that the taxpayer presently has the possession and control over the item.

Question 4

Gross Income Defined

Answer 4

“Gross income means

all income from whatever source derived.”

[I.R.C. § 61]

SCOTUS has stated that § 61 is an expression of congressional intent “to use the full measure of its taxing power” under the Constitution. [Helvering v. Clifford, 309 U.S. 331 (1940)]

The Glenshaw Glass Court held that an item is “income” if it represents an instance of

• “undeniable accessions to wealth,
• clearly realized, and
• over which the taxpayer has complete dominion.”

The source of the receipt of income is irrelevant; there merely must be a clearly realized accession to wealth.

Question 5

Clearly Realized

Answer 5

Has the taxpayer realized the benefit of the addition to wealth?

Realization requires the accrual or receipt of cash, property, or services, or a change in the form or the nature of an investment.

Realization—A taxpayer “realizes” the benefit of an addition to wealth if the taxpayer has received something severable for his or her use or benefit. The realization element here primarily serves to distinguish items of income from the mere appreciation in the value of preexisting assets. So while a taxpayer’s receipt of $1,000 cash as compensation for services is a clearly realized accession to wealth, the fact that a taxpayer’s personal investment portfolio of stocks and securities grows by $1,000 is not income because there has been no “realization” of the growth in value. Note that realization does not require the receipt of cash or a sale of an asset. A taxpayer has realized an accession to wealth, for example, by accepting a vehicle as compensation for services performed by the taxpayer.

_______________________

General Test for Income

The Glenshaw Glass Court held that an item is “income” if it represents an instance of

1. “undeniable accessions to wealth,
2. clearly realized, and
3. over which the taxpayer has complete dominion.”

(1) Accession to Wealth—Does the item add to the taxpayer’s wealth?

(2) Clearly Realized—Has the taxpayer realized the benefit of the addition to wealth?

Realization—A taxpayer “realizes” the benefit of an addition to wealth if the taxpayer has received something severable for his or her use or benefit. The realization element here primarily serves to distinguish items of income from the mere appreciation in the value of preexisting assets. So while a taxpayer’s receipt of $1,000 cash as compensation for services is a clearly realized accession to wealth, the fact that a taxpayer’s personal investment portfolio of stocks and securities grows by $1,000 is not income because there has been no “realization” of the growth in value. Note that realization does not require the receipt of cash or a sale of an asset. A taxpayer has realized an accession to wealth, for example, by accepting a vehicle as compensation for services performed by the taxpayer.

(3) Complete Dominion—Does the taxpayer have full ownership and control over the addition to wealth?

Illegal Receipts—A taxpayer is considered to have complete dominion over an item even if the taxpayer received it illegally. James v. US, 366 U.S. 213 (1961). The fact that the taxpayer does not have a claim of right to the item does not control its inclusion in gross income; it is sufficient that the taxpayer presently has the possession and control over the item.

Question 6

Complete Dominion

Answer 6

• Does the taxpayer have full ownership and control over the addition to wealth?
• Claim of Right — If a taxpayer asserts a claim to money and uses it as if it were her own, the amount is includible in her gross income for the year in which she asserts the claim, regardless of the fact that she must repay the amount in a later year.
  
  • Hence, a bonus erroneously paid is income in the year the bonus is received and gives rise to a deduction in the year in which the erroneous sum is repaid. [Cf. I.R.C. §1341]
• Borrowed Money — Borrowing money does not give rise to income, because both the taxpayer and the lender understand that the taxpayer will return the money and thus does not intend to keep it and use it as her own.
• Income from Illegal Source — The fact that the income may be from an illegal source, and thus the taxpayer is legally obligated to return the income, does not alter the requirement that the taxpayer report the income in the year of receipt. The criminal will be entitled to a deduction in the year in which she pays the money back.
  
  • A taxpayer is considered to have complete dominion over an item even if the taxpayer received it illegally. James v. US, 366 U.S. 213 (1961). The fact that the taxpayer does not have a claim of right to the item does not control its inclusion in gross income; it is sufficient that the taxpayer presently has the possession and control over the item.

_______________________

General Test for Income

The Glenshaw Glass Court held that an item is “income” if it represents an instance of

1. “undeniable accessions to wealth,
2. clearly realized, and
3. over which the taxpayer has complete dominion.”

(1) Accession to Wealth—Does the item add to the taxpayer’s wealth?

(2) Clearly Realized—Has the taxpayer realized the benefit of the addition to wealth?

Realization requires the accrual or receipt of cash, property, or services, or a change in the form or the nature of an investment.

Realization—A taxpayer “realizes” the benefit of an addition to wealth if the taxpayer has received something severable for his or her use or benefit. The realization element here primarily serves to distinguish items of income from the mere appreciation in the value of preexisting assets. So while a taxpayer’s receipt of $1,000 cash as compensation for services is a clearly realized accession to wealth, the fact that a taxpayer’s personal investment portfolio of stocks and securities grows by $1,000 is not income because there has been no “realization” of the growth in value. Note that realization does not require the receipt of cash or a sale of an asset. A taxpayer has realized an accession to wealth, for example, by accepting a vehicle as compensation for services performed by the taxpayer.

(3) Complete Dominion—Does the taxpayer have full ownership and control over the addition to wealth?

Illegal Receipts—A taxpayer is considered to have complete dominion over an item even if the taxpayer received it illegally. James v. US, 366 U.S. 213 (1961). The fact that the taxpayer does not have a claim of right to the item does not control its inclusion in gross income; it is sufficient that the taxpayer presently has the possession and control over the item.

Question 7

General Test for Income

Answer 7

The Glenshaw Glass Court held that an item is “income” if it represents an instance of

1. “undeniable accessions to wealth,
2. clearly realized, and
3. over which the taxpayer has complete dominion.”

______________________________

(1) Accession to Wealth—Does the item add to the taxpayer’s wealth?

(2) Clearly Realized—Has the taxpayer realized the benefit of the addition to wealth?

Realization requires the accrual or receipt of cash, property, or services, or a change in the form or the nature of an investment.

Realization—A taxpayer “realizes” the benefit of an addition to wealth if the taxpayer has received something severable for his or her use or benefit. The realization element here primarily serves to distinguish items of income from the mere appreciation in the value of preexisting assets. So while a taxpayer’s receipt of $1,000 cash as compensation for services is a clearly realized accession to wealth, the fact that a taxpayer’s personal investment portfolio of stocks and securities grows by $1,000 is not income because there has been no “realization” of the growth in value. Note that realization does not require the receipt of cash or a sale of an asset. A taxpayer has realized an accession to wealth, for example, by accepting a vehicle as compensation for services performed by the taxpayer.

(3) Complete Dominion—Does the taxpayer have full ownership and control over the addition to wealth?

Illegal Receipts—A taxpayer is considered to have complete dominion over an item even if the taxpayer received it illegally. James v. US, 366 U.S. 213 (1961). The fact that the taxpayer does not have a claim of right to the item does not control its inclusion in gross income; it is sufficient that the taxpayer presently has the possession and control over the item.

Question 8

“Haig-Simons” definition of income

Answer 8

Income =

Consumption

+ Additions to the store of property rights

Income is 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 end of the period in question.

__________________________

(1) the market value of rights exercised in consumption

• Consumption
• The phrase “rights exercised in consumption” merely reflects what a taxpayer spent (or would have spent if she received something for which she did not have to pay) to purchase something.
  
  • “Imputed income” refers to the monetary value of goods and services which someone produces and consumes within the family unit, as well as the monetary value of using property which someone owns.

An income tax imposed on imputed income would be difficult for taxpayers to comply with, and difficult for the IRS to enforce. Thus, imputed income is not included in the concept of income within the U.S. income tax system.

__________________________

(2) Additions to the store of property rights

• The phrase “additions to the storehouse of property rights” merely reflects a taxpayer’s saving money, perhaps by depositing some of her income in a savings account or in a more sophisticated investment.
• Accretion in Value — refers to accumulations of wealth during a particular period of time.
  
  • Although increases in the value of property are within an economic concept of income, they are not included in the income tax concept of income for two basic reasons. First, there would be considerable practical problems of compliance, administration and enforcement because of the need to annually determine the value of virtually all of a taxpayer’s property. Second, there is a liquidity problem. If an income tax is computed by reference to the increase in value of an individual’s property, a particular taxpayer may be required to pay income tax even though he has not received any money or other property during the year.
  • Because of the problems of enforcement, compliance and liquidity, the income tax concept of income departs from the Haig-Simons definition of income by requiring that any appreciation in the value of property must be realized before it is included in gross income.

Question 9

Treasure Trove

(as grosss income)

Answer 9

Did the taxpayer discover the item and take possession of it?

If yes, the value of the “treasure trove” is included in gross income.

In Cesarini v. US (N.D. Ohio 1969), for example, the court held that money found inside a piano purchased at an auction sale was gross income to the taxpayers in the year they discovered the money inside the piano.

Question 10

Barter Exchange

(as gross income)

Answer 10

Did the taxpayer participate in a barter exchange (i.e., swapping property or services in exchange for other property or services)?

If yes, the fair market value of the property or services received in the exchange is included in gross income.

Fair market value is generally the price at which an item would trade between a willing buyer and a willing seller, neither acting under compulsion to buy or sell, and both having knowledge of all material facts.

Question 11

Prizes and Awards

(as gross income)

Answer 11

Did the taxpayer receive the item as a prize or award? If yes, the item is included in the taxpayer’s gross income unless either of the exceptions below applies. IRC § 74(a).

1. Certain Awards Donated to Charity
2. Employee Achievement Awards
3. Qualified Scholarships

• Exception for Certain Awards Donated to Charity — Gross income does not include the value of any prize or award given primarily in recognition of religious, charitable, scientific, educational, artistic, literary, or civic achievement, provided: (i) the taxpayer was chosen without any action on the taxpayer’s part to enter the contest; (ii) the taxpayer is not required to render substantial future services as a condition to receiving the award; and (iii) the prize is transferred to a governmental or charitable organization. IRC § 74(b).
• Employee Achievement Awards — A taxpayer need not include the value of an employee achievement award in gross income to the extent the employer’s cost in providing the award does not exceed the amount the employer may deduct for furnishing the award. IRC § 74(c). An employee achievement award is any item of tangible personal property awarded to an employee by and employer in a meaningful presentation for length of service or safety achievement and not as disguised compensation. IRC § 274(j)(3)(A).
• Qualified Scholarships — A taxpayer need not include in gross income any prize or award that constitutes a “qualified scholarship” under IRC § 117.

Question 12

Tax Beneft—Inclusion Rule

Answer 12

If a taxpayer takes a deduction in a prior year that produces a tax beneft, and the property that led to the deduction is later recovered, the value of that property will be includible in gross income in the year of recovery. Any differential in the applicable tax rates in the two years is ignored; thus, a taxpayer may gain or lose under this rule.

Example: The taxpayer gave real property worth $5,000 to charity in Year 1 and took a charitable deduction from which she derived a tax beneft. In Year 2, the gift fails due to charitable restrictions on the gift and the real property is returned to the taxpayer. The taxpayer must include in her gross income for Year 2 the amount that she deducted in the prior year. The fact that the return of the land appears to be simply a recovery of her own property does not prevent its inclusion in gross income, because the taxpayer derived a “tax beneft” from the earlier deduction.

Question 13

Alimony

(as gross income)

Answer 13

If alimony meets the IRC § 71(b)(1) definition it must must be included in the taxpayer’s gross income.

A payment in cash that meets these three requirements:

1 ) the payment is received by (or on behalf of) the taxpayer under a divorce or separation instrument (specially defined in IRC § 71(b)(2)) that does not designate the payment as non-alimony;

2 ) if the taxpayer and the payor are legally separated, they are not members of the same household at the time of payment; and

3 )after the taxpayer’s death, the payor has no liability to continue making payments or any substitute for payments.

Question 14

Alimony Recapture

Answer 14

If the amount of alimony received by the taxpayer in the first two years of alimony payments substantially exceeds the payments received in later years, the taxpayer receiving the payments may have a deduction under IRC § 71(f) for the “excess front-loading” of payments in the first two years.

Question 15

Child Support

(as gross income)

Answer 15

• Payments for child support are not considered to be payments of alimony. IRC § 71(c)(1).
• Therefore, such amounts are not included in gross income.
• To the extent the amount of any cash payment to the taxpayer will be reduced upon the occurrence of a contingency related to a child, such amount will be considered child support and not alimony. IRC § 71(c)(2).
• If the taxpayer receives a payment for alimony and child support that is less than the amount required to be received under the divorce or separation instrument, the taxpayer is deemed to receive all of the required child support before receiving any portion of the alimony. IRC § 71(c)(3).

Question 16

Third Party Satisfaction of Taxpayer’s Liability

(as gross income)

Answer 16

• Did a third party pay or otherwise satisfy an obligation of the taxpayer?
• If yes, then the taxpayer has gross income unless a specific exclusion provision applies. See Chapter 3.
• To determine the amount included in gross income, pretend the third party paid the taxpayer directly and that the taxpayer then used that payment to satisfy the liability.
  
  • Thus, for example, if the taxpayer’s employer pays the taxpayer’s federal income tax liability directly to the IRS, the taxpayer has gross income equal to the amount paid to the Service by the employer. Old Colony Trust Company v. Commissioner, 279 U.S. 716 (1929).

Question 17

Discharge of Indebtedness

(as gross income)

Answer 17

Was a debt of the taxpayer discharged or canceled to any extent?

If yes, the taxpayer has gross income equal to the amount discharged unless a specific exclusion provision applies. IRC § 61(a)(12); US v. Kirby Lumber Co., 284 U.S. 1 (1931). See Chapter 3.

Question 18

Payment under an annuity, endowment, or life insurance contract.

(as gross income)

Annuity - a fixed sum of money paid to someone each year, typically for the rest of their life.

Endowment - an income or form of property given or bequeathed to someone.

Answer 18

The amount of the payment is included in gross income except for that portion of the payment equal to the exclusion ratio. IRC § 72(a).

Exclusion Ratio—The exclusion ratio is the ratio determined by dividing the “investment in the contract” by the “expected return under the contract.” IRC § 72(b)(1). The investment in the contract is generally equal to the total amount of premiums and other consideration paid for the contract less any amounts received under the contract before the annuity starting date. IRC § 72(c)(1). The expected return under the contract is generally equal to the aggregate amounts receivable under the contract in the form of an annuity. IRC § 72(c)(3). If the total amount receivable under the contract depends on the life expectancy of one or more individuals, the expected return is determined by multiplying the recipient’s life expectancy by the annual amount receivable under the contract. See Treas. Reg. § 1.72–9, Table V for a table of life expectancy figures based on the age of the recipient.

Limitation on the Exclusion Ratio—Once the taxpayer has recovered his or her entire investment in the contract through application of the exclusion ratio in prior years, all subsequent annuity payments under the same contract are fully includible in gross income. IRC § 72(b)(2). If the taxpayer dies before all of the investment in the contract has been recovered, the taxpayer’s final return may claim a deduction for that portion of the investment in the contract which was not recovered. IRC § 72(b)(3)(A).

Question 19

Compensation for Services

(as gross income)

Answer 19

Did the taxpayer receive the item as compensation for services?

If yes, then the item must be included in gross income. IRC § 61(a)(1). Note that any form of compensation is subject to this rule, including fees, wages, commissions, fringe benefits, and tips. Treas. Reg. § 1.61–2(a)(1).

I - Property Transferred in Connection with Performance of Services—Under IRC § 83(a), a taxpayer has gross income if property is transferred to the taxpayer or to a third party in connection with services performed by the taxpayer if either of the following conditions is met:

• (a) No Substantial Future Services Required—The recipient’s rights to the property are not conditioned upon the performance of substantial future services by anyone. IRC § 83(c)(1).
• (b) Property is Transferable—The rights of any transferee are not conditioned on the future performance of substantial services by anyone. IRC § 83(c)(2).
• If neither of these conditions exist, IRC § 83(a) does not apply. Nonetheless, the taxpayer may elect to include the value of the property received (less any amount paid for the property) in the year of receipt by making an election under IRC § 83(b). Such an election is advisable if the taxpayer anticipates that the value of the property will surge between the year of receipt and the year in which one of the two conditions above is met.
• If a taxpayer has gross income under IRC § 83(a), the amount included is equal to the fair market value of the property received less any amount paid for the property. Importantly, when IRC § 83(a) applies, the taxpayer has gross income in the year of receipt.
• Payments to Third Party as Compensation—Remember that payments by a third party on behalf of the taxpayer for services performed by the taxpayer are treated as compensation paid to the taxpayer. Old Colony Trust Company v. Commissioner, 279 U.S. 716 (1929).

Question 20

Advance Payments

(as gross income)

Answer 20

Has the taxpayer received the item as an advance payment for goods or services to be rendered in the future?

If yes, the taxpayer must include the amount of the advance payment in gross income, generally in the year of receipt. Commissioner v. Indianapolis Power & Light Company, 493 U.S. 203 (1990). See Chapter 10 for more on this issue.

Question 21

Imputed Income

(as gross income)

Answer 21

Item not income

Does the accession to wealth stem from the taxpayer’s own efforts or from the use of the taxpayer’s own property?

If yes, the accession to wealth represents “imputed income” and will not be included in gross income. While economic theory would conclude that imputed income is like any other form of gross income (in that it is either consumed or enhances the taxpayer’s net worth), Congress and the Internal Revenue Service recognize the insurmountable practical obstacles inherent in enforcing the taxation of imputed income. As a result, benefits from growing one’s own garden vegetables, occupying one’s own home on a rent-free basis, or (in the case of a lawyer, at least) writing one’s own will are not subject to taxation.

Question 22

Bargain Purchase

(as gross income)

Answer 22

Item not income

Did the taxpayer benefit from purchasing an interest in property at a price below its fair market value?

If yes, the taxpayer will not be required to include the amount of the discount in gross income. It is well accepted that a taxpayer need not include the benefit of a bargain purchase in gross income. If the bargain purchase was income, there would be less of an incentive for taxpayers to seek bargains and this would make market transactions less efficient. Thus, for example, a taxpayer does not have gross income from purchasing a painting worth $1,000 at a garage sale for $20. Instead, the taxpayer will have a basis in the painting of $20; when the taxpayer later sells the painting, the gain may be subject to tax. See Chapter 6.

Question 23

Unrealized Appreciation

(as gross income)

Answer 23

Item not income

Does the accession to wealth represent an increase in the value of a property interest that the taxpayer did not sell or otherwise dispose of during the taxable year?

If yes, there is no gross income yet. Taxpayers do not have income from the mere increase in the value of property owned during the year. The appreciation will not be taxed until there is a “realization event” with respect to the property (i.e., a sale or other disposition of part or all of the property). Thus, for example, a taxpayer does not have gross income if stocks purchased at the beginning of the year for $1,000 have a value of $1,800 at the end of the year.

Question 24

Free Samples

(as gross income)

Answer 24

Item not income

Did the taxpayer receive the item as a free sample or through some promotional activity by the provider?

If yes, then the taxpayer does not have gross income. Although there is no firm authority, it is well accepted that a taxpayer does not have gross income from “free samples” provided by a manufacturer, distributor, or retailer because the primary benefit of the sample inures to the provider. When a company provides a free sample of its product to a taxpayer, it hopes that the taxpayer will like the product enough to purchase additional quantities of the product in the future. The incremental accession to the taxpayer’s wealth is far outweighed by the promotional benefit to the provider.

Question 25

Loans

(as gross income)

Answer 25

Item not income

Did the taxpayer borrow the amount received under a consensual arrangement under which the taxpayer has an obligation to repay the lender?

If yes, the transaction is a loan and the taxpayer does not have gross income from the transaction. A borrower does not have an “accession to wealth” from the receipt of loan proceeds because there is an offsetting liability to repay the amount borrowed.

Question 26

Deposits

(as gross income)

Answer 26

Item not income

Is the taxpayer under an obligation to repay the amount received upon the occurrence of a contingency that is outside the taxpayer’s control?

If yes, the taxpayer has received a deposit and there is no inclusion in gross income until such time as the contingency lapses and the taxpayer is entitled to keep the amount received. Commissioner v. Indianapolis Power & Light Company, 493 U.S. 203 (1990). Thus, for example, a damage deposit received by a landlord from a new tenant is not gross income to the landlord at the time of receipt because the tenant retains the power to reclaim the deposit upon surrendering an undamaged and clean premises to the landlord upon termination of the lease. If the premises is damaged to the point that the lease agreement permits the landlord to retain the damage deposit, the landlord then has gross income.

Question 27

Attributing Income to the Proper Taxpayer

Income from Property​

It is often important to consider to whom the income should be taxed. Most of the time, this will be obvious. But where it appears that the person whose efforts or assets created the income attempts to assign that income to another person (often a related person in a lower tax bracket)

Answer 27

Does the income represent compensation for services, or is the income item attributable to services performed by a person?

If yes, then the income is generally taxed to the person who performed the services, not necessarily the person who receives the income. Lucas v. Earl, 281 U.S. 111 (1929).

• Earner Has No Rights to Income — If the person performing the services has no right to receive the income, the income cannot be taxed to that person even though he or she performed the services that generated the income. For example, in Teschner v. Commissioner, 38 T.C. 1003 (1962), a father entered a contest that would award an education annuity to an individual who was under a stipulated age. The father named his daughter as the beneficiary on the contest entry form. The taxpayer’s entry form was selected as the winner, and the prize was awarded to the daughter. The Tax Court held that the daughter should be taxed on the value of the prize and not the father, for although he performed the services necessary to generate the income, he was never entitled to have the income and had no claim to it under the contest rules.
• Direction and Control — If the service provider has the final say as to who receives the income, the service provider will be the one who is taxed. If the service provider disclaims all rights to the income and such income passes to person related to the service provider, the service provider likely would not be taxed on the income because the service provider had no control over the recipient of the income. See Commissioner v. Giannini, 129 F.2d 638 (9th Cir. 1942). If, however, the service provider knows that a disclaimer will cause the income to be paid to the related person, the Internal Revenue Service might succeed in claiming that the service provider indirectly controlled the payment of the income and therefore should still be taxed on it.

Question 28

Attributing Income to the Proper Taxpayer

Income from Services

It is often important to consider to whom the income should be taxed. Most of the time, this will be obvious. But where it appears that the person whose efforts or assets created the income attempts to assign that income to another person (often a related person in a lower tax bracket)

Answer 28

Is the income attributable to property? Examples include rents from an apartment complex, royalties on a copyright, interest on a promissory note, damages on a cause of action, and dividends on stock.

If yes, the income will generally be taxed to the person who owns the property. Helvering v. Horst, 311 U.S. 112 (1940). The income is said to be the “fruit” of the property “tree,” and the fruit must be taxed to the person who owns the tree when the fruit is realized.

• Transfer the Property to Assign the Income— Accordingly, if a taxpayer wants to assign income from property to another person, the taxpayer must generally assign the entire property to the desired person. In Horst, a father attempted to assign interest income from a coupon bond to his son by giving the interest coupons to the son. Because the father retained the bond, however, the Court held that the father was the person to be taxed on the interest income and not the son. A different result may have occurred if the father had transferred the entire bond to the son.
• Exception for Transfers of Property with Vested Income — If the taxpayer assigns property that already has vested income associated with it (a tree with ripe fruit?), the taxpayer may still be the person taxed on such vested income. In Salvatore v. Commissioner, T.C. Memo. 1970–30, for example, the taxpayer conveyed a one-half interest in a gas station to her children after accepting an offer from Texaco to sell the entire property. The court held that the entire gain from the sale to Texaco should be taxed to the taxpayer because her conveyance to the children was merely a single step in an overall plan to sell the entire property to Texaco. It was no different, said the court, than if the taxpayer sold the entire property to Texaco herself and then gave half of the cash to her children.
• Exception to Exception — Even if property has vested income associated with it, a taxpayer can effectively shift such income by selling the property to the transferee instead of gifting it. In Estate of Stranahan v. Commissioner, 472 F.2d 867 (6th Cir. 1973), for instance, the taxpayer wanted to recognize some income to offset a substantial interest expense deduction for the year at issue. So the taxpayer sold his rights to $123,000 in future dividends on stock to his son for $115,000 (the present value of the $123,000 that would be paid over time). The Tax Court held that the dividends ultimately paid to the son should be taxed to the son because the prior sale of the property interest (the right to dividends) was not a gratuitous transfer to any extent.

Question 29

Life Insurance

Answer 29

Item Not Income

IRC § 101(a)(1) excludes amounts received under a life insurance contract if such amounts are paid because of the death of the insured. There are two general exceptions to this exclusion. The first is the “transfer-for value rule” set forth in IRC § 101(a)(2). If the owner-beneficiary of a policy acquired it for “valuable consideration,” the exclusion is limited to the sum of the consideration paid and any amounts (including premiums) paid after the transfer by the owner-beneficiary. The other exception applies to installment payments of death benefits. Under IRC § 101(d), to the extent any such installment payment represents interest, such portion must be included in gross income.

Question 30

Gifts and Bequests

Answer 30

Item Not Income

The exclusion in IRC § 102(a) for gifts and bequests is one of the centerpieces of the Internal Revenue Code. The exclusion has been justified on the grounds of administrative convenience, that it softens the burden imposed on transferors by federal estate and gift taxes, and that it encourages generosity and wealth transfers. None of these justifications has been universally embraced, however. In any case, IRC § 102(a) ensures that donees do not have to include the value of gifted or inherited property in gross income. Gifts of income, however, are not eligible for the exclusion, as IRC § 102(b) makes clear. In addition, IRC § 102(c) declares that an employee can never receive a “gift” from an employer. As a result, any property transferred to an employee will likely be treated as compensation income unless a different exclusion provision applies.

Question 31

Interest on State and Local Bonds

Answer 31

Item Not Income

The exclusion in IRC § 103 for interest received on state and local bonds effectively represents a federal subsidy to state and local governments. Because the interest is tax-free, state and local governments can sell their bonds at a lower interest rate, making the bonds less expensive for the governmental units to issue. There are several limitations to the exclusion, most attributable to perceived abuses by local governments. For example, a city might issue bonds to finance the development of private businesses, an activity that may be of marginal public benefit. The interest on these “private activity bonds” generally is ineligible for the exclusion.

Question 32

Damages Received on Account of Physical Injury or Physical Sickness

Answer 32

Item Not Income

IRC § 104(a)(2) excludes from gross income most damages received “on account of personal physical injuries or physical sickness.” Punitive damages are not excludable under this rule. The exclusion used to apply to damages received for “personal injury or sickness,” but Congress added the word “physical” (twice, no less) in 1996 after courts interpreted the term “personal injury” to authorize exclusion for any tort recovery. Now it is clear that the taxpayer must receive damages on account of a physical injury or physical sickness to qualify for the exclusion. Congress also added language to IRC § 104(a) to make it clear that emotional distress, by itself, was not a physical injury or physical sickness. Accordingly, taxpayers suing only for emotional distress will recover taxable damages, while taxpayers suing for physical injuries will recover tax-free damages, even if some of those damages compensate for emotional distress.

Question 33

Certain Income from Discharge of Indebtedness

Answer 33

Item Not Income

The Supreme Court held that when a corporation was able to repurchase its own bonds for an amount less than it borrowed from investors, the corporation had gross income equal to the difference. Congress codified that result in IRC § 61(a)(12), which provides that gross income includes income from the discharge of indebtedness. The premise is simple: if a taxpayer borrows money from a lender, there is no gross income because the taxpayer’s additional wealth is offset by the contemporaneous obligation to repay that amount to the lender in the future. If the lender cancels, forgives, or discharges the repayment obligation, then, the rationale for excluding the amount received by the taxpayer has likewise disappeared. Consequently, the amount of the discharged debt is included in gross income. Where the taxpayer is insolvent or bankrupt, however, there is little sense in requiring the taxpayer to include the amount of canceled debt in gross income because there is hardly an accession to the taxpayer’s wealth in these instances. IRC § 108(a) lists five events (bankruptcy, insolvency, and three others) where the canceled debt is excluded from gross income. This exclusion comes at a cost, however; generally, the amount excluded must be applied to reduce the taxpayer’s “tax attributes,” features like loss and credit carryovers and the basis in property that would normally be of benefit to the taxpayer in later years. Thus, one should view IRC § 108(a) not as a permanent exclusion of income but instead as a deferral of income until a later date.

Question 34

Lessee Improvements

Answer 34

Item Not Income

IRC § 109 was expressly enacted to overrule the Supreme Court’s holding that a landlord had gross income upon reclaiming possession of real property from a tenant where the tenant had made permanent improvements to the property. IRC § 109 provides that the value of the improvements is excluded from gross income, but IRC § 1019 then provides that the taxpayer’s basis in the property cannot be adjusted to reflect the value of such improvements. This means that while the landlord will not have gross income upon repossession of the property, the landlord very likely will have gross income in the form of additional gain when the taxpayer later sells the property.

Question 35

Qualified Scholarships

Answer 35

Item Not Income

IRC § 117 contains a limited exclusion for certain scholarship and fellowship grants. Recall that prizes and awards are generally included in gross income under IRC § 74(a) (see Chapter 2), so this exclusion provision ensures that two types of scholarships are not subject to tax. The first is a “qualified scholarship,” generally defined as a payment used for tuition and related expenses (but not room and board) by a degree candidate at a nonprofit educational institution. The second is a “qualified tuition reduction” extended to employees of certain education organizations generally for the undergraduate education of the employee, the employee’s spouse, or the employee’s children.

Question 36

Meals and Lodging on Employer’s Premises

Answer 36

Item Not Income

Compensation can come in many forms, and free meals and lodging provided by an employer to an employee (or the employee’s spouse or dependents) would normally qualify as compensation to the employee. But IRC § 119 generally provides that if the meals and lodging are furnished for the convenience of the employer and on the employer’s business premises, the employee can exclude the value of these benefits from gross income. The thinking here is that the primary benefit of the meal or lodging inures to the employer and not the employee.

Question 37

Certain Fringe Benefits

Answer 37

Item Not Income

There are other forms of compensation that arguably benefit the employer more than the employee or which come at little or no cost to the employer. Congress has identified a number of other “fringe benefits” that can be excluded from an employee’s gross income and crammed all of them into IRC § 132. IRC § 132 is a veritable cornucopia of exclusions, including no-additional-cost services, qualified employee discounts, working condition fringes, de minimis fringes, qualified moving expense reimbursements, and much more. It is important to note that all of these excludable benefits apply only to employees and not to self-employed individuals or independent contractors.

Question 38

Gain or loss on sale or exchange of property

Computation Formula

Answer 38

Adjusted basis =

unadjusted basis

+ additions

– reductions

_____________________________

Gain =

amount realized

– adjusted basis

_____________________________

Loss =

adjusted basis

– amount realized

Question 39

Unadjusted Basis

Answer 39

• Adjusted basis = unadjusted basis + additions – reductions
• Gain = amount realized – adjusted basis
• Loss = adjusted basis – amount realized

Unadjusted Basis

This is usually cost. However, there are special rules for gifts, inheritances, and tax-free exchanges.

• (1) Cost Basis — Generally, the basis of property is the cost thereof. It includes cash, mortgages, or other property paid to obtain the asset. Income charged to the taxpayer in acquiring the property also is added to the basis.
• (2) Inter Vivos Gifts —​ For the purpose of computing gain, the donee takes the donor’s basis; But for loss purposes, the donee’s basis is the fair market value at the time of the gift or the donor’s basis, whichever is less.
  
  • (a) Increase by Gift Tax Paid — The basis is increased by the gift tax the donor paid, which is attributable to an appreciation in property, but not in excess of the fair market value at the time of the gift.
• (3) Tax-Free Exchanges — The basis of property in a tax-free exchange is that of the property transferred—adjusted upward for gain recognized and downward for money received on the exchange.
• (4) Inherited Property — The basis of inherited property in the hands of decedent’s estate or the person inheriting it is the property’s value at the date of death of decedent (or six months later if the alternate valuation date is elected).
  
  • (a) Form in Which Property is Held
    
    • 1) Community Property — If decedent and her surviving spouse owned the property as community property, both halves receive a new basis.
    • 2) Tenants in Common — On the death of one tenant in common, the person inheriting the decedent’s interest receives a new basis, but the surviving tenants in common do not.
    • 3) Joint Tenancy — Property owned as joint tenants receives a new basis if includible in the estate for estate tax purposes, and maintains its former basis if excluded from the estate.
  • (b) Term Interests — “Term interests” include life estates, term for years, or an income interest in a trust. Special rules apply to determining the recipient’s basis in the term interest.
  • (c) Income in Respect of a Decedent — This refers to situations wherein income is not taxed to the decedent even though events leading to its realization occurred prior to his death. In these cases income is taxed to the recipient, but a deduction is available if the item was subject to estate tax.

Question 40

Adjusted Basis

Answer 40

• Adjusted basis = unadjusted basis + additions – reductions
• Gain = amount realized – adjusted basis
• Loss = adjusted basis – amount realized

Adjusted Basis is determined by adding to the unadjusted basis all subsequent expenditures chargeable to the asset that were not deductible as current expenses.

From the sum is subtracted

(i) receipts, losses, or other items properly chargeable to a capital account; and
(ii) depreciation, depletion, amortization, or obsolescence allowed.