This is an article in the Federal Income Tax on Individuals Series. How does the U.S. federal income taxation system work? What are the rules for calculating your federal income tax? What is the rational behind the rules? Given the existing rules, what can you to legally minimize your federal income tax? Knowledge of the tax law can save you some real money.
This is CHAPTER 3 of the series.
3.1. Codes in Internal Revenue Title
“Except as otherwise provided in this title, Gross income means all income from whatever source derived, including (but not limited to) the following items:
(1) Compensation for services, including fees, commissions, fringe benefits, and similar items;
(2) Gross income derived from business;
(3) Gains derived from dealings in property;
(8) Alimony and separate maintenance payments;
(10) Income from life insurance and endowment contracts;
(12) Income from discharge of indebtedness;
(13) Distributive share of partnership gross income;
(14) Income in respect of a decedent; and
(15) Income from an interest in an estate or trust.”
3.2. Judicial definition of gross income
Gross income means all income from whatever source derived. But what qualifies as income? In economics, Robert M. Haig offered a definition of “income” as the sum of his/her consumption and his/her change in wealth as early as 1921. Unfortunately, this definition does not work very well when one tries to apply it to taxation. Here is why. Many times, the wealth of an individual includes not only liquid assets, but also non-liquid assets such a real estate property. Taxing appreciation on the value of one’s property would work hardship by forcing the owner to generate some liquid asset at the end of a tax year, sometimes forcing a sale of the property that would be taxed on. Also, the tax system is not capable of handling negative quantities, especially in combination with progressive tax rates. First, the tax system does not reimburse a taxpayer for a net loss (although traces of efforts to alleviate the hardship for loss are found in the tax code). Tracking the gains and losses (while differentiating long-term gains and losses from short-term gains and losses) every year would trigger a lot of work even in this electronic age. Thus, practical considerations force us into adopting a more expedient and manageable system for the society.
While Internal Revenue Title provides many examples of income, Internal Revenue Title does not provide any more detailed definition of income. Apparently, Internal Revenue Service managed to run the U.S. federal tax system for almost a century without providing a precise definition of income. As one would expect, the courts were forced into defining “income.” The U.S. Supreme Court faced one of the first challenges to the interpretation of the meaning of income in Eisner v. Macomber (1920), within a few years after federal income taxation on individuals began. The Income Tax Act of 1916 passed by the Congress expressly identified stock dividends as income. Myrtle MaComber owned 2,200 shares of the stock of The Standard Oil Company of California, a publicly traded corporation. The company declared a 50 % stock dividend (2:3 split) and she received 1,100 shares of Standard’s stocks. Forced between the literal interpretation of the Income Tax Act (thereby forcing her to pay taxes on the stock split) and an interpretation contrary to the literal interpretation to avoid apparently illogical results, the Supreme Court chose the latter by a 5:4 decision and held that a stock dividend was not within the meaning of “income” as used in the Sixteenth Amendment that enabled direct taxation on an individual’s income. See Chapter I. What is “federal income tax” on “individuals”? Since the Constitution and the Amendments supersede all other laws of the United States, the dividends could not be taxed on. Citing Doyle v. Mitchell Bros. Co. (1918), the Supreme Court reiterated that “Income may be defined as the gain derived from capital, from labor, or from both combined.” Then the Court proceeded to state that “a gain, a profit, something of exchangeable value proceeding from the property, severed from the capital however invested or employed, and coming in, being “derived,” that is, received and drawn by the recipient (the taxpayer) for his separate use, benefit and disposal;– that is income derived from property.” Then the Court employed a term that would be memorialized in federal income taxation:
Far from being a realization of profits of the stockholder, [a stock dividend] tends rather to postpone such realization, in that the fund represented by the new stock has been transferred from surplus to capital, and no longer is available for distribution.
The term “realization” has now been established to mean receipt of a gain by the recipient for his separate use, benefit and disposal. If an item cannot be used by a recipient, it is not an income. If an item does not benefit a recipient, it is not an income. If an item cannot be disposed of (as he wishes at least in theory) by a recipient, it is not an income. Theoretically speaking, Eisner v. Macomber ruled that Congress cannot tax any unrealized appreciations under the Sixteenth Amendment because unrealized appreciation is not income. Thus, appreciation in value can be income only when the asset is sold, exchanged, or otherwise disposed. This solves two problems. In practical terms, taxation is postponed until the taxpayers have the fund to pay their income tax with. Also, the tax calculation becomes much more accurate because benchmark numbers (for example, the sale price of an asset) are easily established and estimation of value by assessment can be avoided very often. Today, this seems to be an obvious concept but the court of Eisner v. Macomber in 1920 had to struggle to get to a 5:4 decision to that effect.
The U.S. Supreme Court provided another useful definition of income in Comissioner v. Glenshaw Glass Company (1955). Glenshaw Glass Company received a settlement (agreed-upon monetary compensation) from an equipment manufacturer for a lawsuit alleging violation of federal antitrust laws. The settlement included punitive damages (additional money beyond actual monetary loss) for fraud and antitrust violations. The IRS Commissioner asserted that the punitive damages are subjected to income taxation. Glenshaw asserted that § 22 (a) (the equivalent of today’s § 61 (a))of Internal Revenue Title at that time excludes “windfalls” such as punitive damages are not explicitly listed in § 22 (a). The Court held that lack of explicit enumeration is not a bar to the Commissioner’s claim because the language of § 22 (a) included “Gross income includes … or gains or profits and income from any source whatsoever …” Glenshaw also asserted that the Supreme Court’s prior characterization of income as “the gain derived from capital, from labor, or from both combined” in Eisner v. Macomber should be binding to exclude punitive damages from income because punitive damages derive from a reprehensible violation of a party, but not from capital or labor. In response, the Supreme Court held that there were “instances of undeniable accession to wealth, clearly realized, and over which the taxpayers have complete dominion,” and as such, there was income to Glenshaw. Thus, another definition of income was born in 1955: instances of undeniable accession to wealth, clearly realized, and over which the taxpayers have complete dominion.
From the Comissioner v. Glenshaw Glass Company case, it naturally follows that found money or treasure trove is also income. (As we will see below, gifts are not income. However, one cannot claim that found money is a “gift” from nobody or a “gift” from God.) In Cesarini v. United States (1969), money was found in a piano that was purchased years earlier. The District Court of Ohio held that found money is taxable in the year the money is actually found (not in the year of purchase of the piano), and that it was taxable as an ordinary income, not as a capital income (the piano did not “generate” the found money!). See “Chapter VI. Ordinary Tax Rates v. Capital Gains Tax Rates” for tax advantages (lower rate) of capital income over ordinary income.
If any goods or services are purchased, payment is made typically with money (cash, credit card, check, etc.) for the purchase. The party that receives the money has income tax liability if the cost of goods or services is less than the payment. The payee’s income is equal to the excess of the payment received over the cost of goods or services. The cost of goods is the purchase price for the goods and any applicable expenses (e.g., proportionate share of bus fare if the goods were picked up in a bus trip). The cost of one’s own services is always zero. Therefore, if a chef spends $5.00 for the ingredients of a pizza and puts in his own labor worth $6.00 (in his estimate), adds $4.00 for a proportionate share of operating expenses (rent, electricity, taxes apportioned to each pizza), adds $2.00 for profit, then charges a customer $17.00 for a baked pizza, the chef’s income is not the $2.00 profit, but $8.00 because only the cost for the ingredients and the proportionate share of operating expenses count as his cost.
Likewise, the monetary value of one’s own labor is always zero. Thus, an employee is not taxed on the excess of his salary over the fair market value of his labor (the excess would be presumably zero), but on the entirety of his salary.
If a payee’s income is equal to the excess of the payment received over the cost of goods or services, what happens if there is no payment? For example, Jack the accountant exchanges his accounting services with Jill the attorney for her legal work in a barter transaction? IRS revenue rulings, typically available in semi-annually published Cumulative Bulletin, states that barter exchanges are valued at their fair market value. Thus, payment was constructively made from Jack to Jill and from Jill to Jack in the above case, and the amount of payments is equal to the value of their services, which should be equal because the parties freely entered into the bargain (theoretically speaking). IRS revenue rulings held that the result is the same if goods and services are exchanged and if goods are exchanged with other goods. The fair market value of the received goods or services the income to the recipient. The IRS revenue rulings are valid unless challenged in court and overruled. Most likely, the IRS revenue rulings on barter will be upheld in court. There is a difference between bartering one’s services and bartering goods. The cost of one’s own labor is always zero. When one renders services for another, there is no capital loss or capital gain to the provider of the service. Only the value of what she receives counts as income. When one gives goods in a barter exchange, the goods are monetized the moment they are given to the recipient. Thus, one can have a capital gain or a capital loss on bartered-away goods depending on the difference between the fair market value of the goods and the adjusted basis (cost of acquisition less depreciation claimed in prior tax returns).
What happens one offers services to oneself, or manufactures goods for oneself? For example, one can fix his own house. The so-called “imputed income” is not “income” for tax purposes. An artist can paint the most beautiful work of art and hang it in his living room without having to worry about IRS possibly taxing him on the monetary value of that painting over the cost of the canvass, paint, and frames. A home gardener can have a hearty meal of vegetables from her home garden without fearing income tax consequences of the home-grown vegetables. Benefits to a taxpayer resulting from his own personal efforts are NEVER considered income at least for federal income tax. Inheritance is another matter.
Illegal income is also subject to federal taxation if it is undeniable accession to wealth, clearly realized, and over which the taxpayers have complete dominion under Comissioner v. Glenshaw Glass Company (1955). Thus, illegal drug dealers and thieves are in principle subject to federal income taxation. IRS will not promise that it won’t tell the police of the underlying illegality, but IRS cannot take a complying taxpayer to court, civil or criminal, when the taxpayer complied with the tax law.
Obtaining money for which one has an obligation to pay back is not considered income. Thus, a loan is not income. (One does not pay income tax to the federal government for a home mortgage.) The Supreme Court initially held that embezzled money is not income because there is an obligation to pay the money back (even if the embezzled party may not know about that). Commissioner v. Wilcox (1946). Subsequently overruling Commissioner v. Wilcox in the later case of James v. United States (1961), however, the Supreme Court held that embezzled money is income to the embezzler.
3.3. Compensation for services is included in gross income unless excluded by statute.
Internal Revenue Title, § 61 (1) explicitly includes “compensation for services” in income. This passage is interpreted to mean every conceivable type of compensation, irrespective of the form, and irrespective of the recipient, unless explicit exclusion of a form of compensation is provided specifically in Internal Revenue Title or otherwise by a federal statute. See Internal Revenue Title (which is Title 26 of United States Code), Subtitle A. “Income Taxes,” Chapter 1 – Normal Taxes and Surtaxes, Subchapter A – Determination of Tax Liability, Part III – Items specifically excluded from gross income.
In Old Colony Trust Co. v. Commissioner (1929), the Supreme Court held that the payment by an employer of the income taxes assessed by the employee constitute additional taxable income against the employee. In 1916, American Woolen Company adopted a resolution that the company would pay all income taxes, state and federal, for all the officers of the company. (Sweet deal for the officers, indeed!) The president of the company received his annual pay, P, and assessed federal income tax at the federal income tax rate R, i.e., the amount of P x R. The company paid the amount (P x R) directly to the IRS in lieu of the president. Here, the court said that the president’s obligation (P x R) was discharged by the company, and this discharge is equivalent to receipt of the amount (P x R) by the taxed person, i.e., the president. Thus, the president’s total income has now been increased by (P x R) for a total of P + (P x R). In short, if one pays someone else’s obligation, that someone else receives income!
(Note: If the company tried to make good on the resolution, the company would pay more income tax of (P x R) x R = (P x R2) on the additional income of (P x R). This process would then continue indefinitely. Fortunately, there is a way of calculating this infinite series. The president’s total income would be: P + P x R + P x R2 + P x R3 + ….. = P / ( 1 – R). The president’s total income tax would be (P x R) / ( 1 – R). There may be some complications because of progressive tax rates, but president was making over half a million dollar for has pay in 1920, and would have been subjected to the highest income tax rate at that time.)
Value of an employee’s trip paid by the company may, or may not, be income depending on the nature of the trip. In general, if the trip is practically for the benefit of the employee, the value of that trip is income. If the trip is practically for the benefit of the employer, the value of that trip is not income.
An example of a trip being income: In McCann v. United States (1981), the Supreme Court held that rewards to an employee and her spouse are compensation for services, and therefore income. Applying this rule to their situation, the Court held that the all-expense trip to Las Vegas for Mrs. and Mr. McCann provided by Mrs. McCann’s employer for her outstanding performance was income for the fair market value of their trip.
An example of a trip not being income: In United States v. Gotcher (1968), Mr. and Mrs. Gotcher had taken a twelve-day expense-paid trip to Germany to decide on whether Mr. Gotcher would take a bigger stake in his employer, Economy Motors, a Volkswagen dealership in Texas. The Court concluded that the expense-paid trip primarily benefits the party paying for the trip, that in the reality of the business world he had no real choice but to go, his schedule was filled up with business activities that he did not control, and that he was serving legitimate purpose of the party paying for the trip. Therefore, the trip was primarily for business, and was not income to Mr. Gotcher. Then, the Court focused on the lack of any business activity on the part of Mrs. Gotcher and concluded that the value of the trip for Mrs. Gotcher was income. A minority opinion protested the apparently harsh result on Mrs. Gotcher, who did not have much control on this trip in practical terms.
Accepting housing accommodations offered by an employer is subjected to similar analysis. If a housing accommodation provides primarily personal benefit, any additional value of the housing accommodation over the amount the employee pays is income. If the housing accommodation is provided for business purposes, the value of the housing accommodations over the amount that the employee would have spent anyway but for employment is excluded from income.
Adams v. United States (1978) illustrates this point. Mr. Adams accepted housing accommodation in a grandiose residence in Japan as a condition of his employment as president of his company (because the company needed prestige and reputation in Japan). The Supreme Court held that acceptance of a residence as condition of one’s employment was for the convenience of the employer, and that there was a direct nexus between the housing and the business interest. In the end, the Court concluded that all conditions for exclusion from income as specified in Internal Revenue Title § 119 Meals or lodging furnished for the convenience of the employer were met in this case.
To be able to claim an exclusion from gross income based on sections of Internal Revenue Title or a federal statute, all conditions within the applicable section or federal statute must be met. The thought here is that exclusions are not inherent right of taxpayers, but discretionary grace by the Congress. Thus, an apparently minor deviation from the conditions of the applicable section or federal statute can be fatal to a taxpayer’s claim for exemption.
Commissioner v. Kowalski (1977) illustrates this point. Internal Revenue Title, Subtitle A. “Income Taxes,” Chapter 1 – Normal Taxes and Surtaxes, Subchapter A – Determination of Tax Liability, Part III – Items specifically excluded from gross income, § 119 Meals or lodging furnished for the convenience of the employer requires that for meals to be excludable from income, the meal must be furnished by the employer, for the convenience of the employer, and on the business premises. Kowalski, a state police trooper, received cash reimbursements for meals so that he may purchase his meal during a mid-shift break within any restaurant in his patrol area. Despite a lower court’s finding that the cash reimbursement is a modification of a prior meal-station system in which the state maintained state-operated official meal stations and that meal allowance was never intended to be additional compensation, the Supreme Court held that only meals, not cash reimbursements, can be excluded from income because of the specific language of § 119.
Sometimes, employees receive contingent compensation such as stocks or stock options. When does this type of compensation become income? Internal Revenue Title § 83 Property transferred in connection with performance of services provides:
If, in connection with the performance of services, property is transferred to any person other than the person for whom such services are performed, the excess of the fair market value of such property over the amount (if any) paid for such property is the gross income of the person who performed such services in the first taxable year in which the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture.
Stock awards contingent upon a condition, such as continuation of employment for any additional years of continued employment, are subject to forfeiture because the employee may decide to quit the company before the end of the required employment period. Thus, such contingent stock awards would become income only after the required number of years.
Stock option awards would have to become tradable or “not subject to a substantial risk of forfeiture” before they can become income.
If the award or compensation goes to a third party, the employee or a service provider receives income, not the third party. In other words, the person who provides service cannot deflect his/her income to someone else merely by assigning the compensation to a third party.
For example, if Ann and Ben form a partnership in which Ann provides services (legal, accounting, executive, etc.) and Ben provides all the capital, and if Ben agree to transfer 30% interest to Carla, who might be Ann’s friend or daughter, on condition that Carla forfeits the interest if Ann terminates the partnership within two years, the interest Carla holds becomes “not subject to a substantial risk of forfeiture” in the third year. Thus, the fair market value of the 30% interest in their partnership becomes gross income to Ann (not to Carla) in the third year. Carla would have the benefit, but Ann pays the income tax in this case.
3.4. Gain from dealings in property is included in gross income.
(But only the gain, not the amount realized)
Internal Revenue Title, Subtitle A, Chapter 1, Subchapter O – Gains of loss on disposition of property governs the determination of gain or loss from property. § 1001. Determination of amount of and recognition of gain or loss (a) computation of gain or loss, provides formulae for determining gain or loss from property.
The gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis provided in section § 1011 for determining gain, and the loss shall be the excess of the adjusted basis provided in such section for determining loss over the amount realized.
In other words,
(gain) = (amount realized) – (adjusted basis), if amount realized > adjusted basis, or
(loss) = (adjusted basis) – (amount realized), if amount realized < adjusted basis.
The definition for the “amount realized” is provided in subsection (b) Amount realized:
The amount realized from the sale or other disposition of property shall be the sum of any money received plus the fair market value of the property (other than money) received.
If the money is the only form of payment received from the purchaser, the amount realized is the money received. If the purchaser pays with a combination of money and property (e.g., another building, a car, a boat, a collectable, a lifetime pass at one of his clubs, or anything valuable), the money and the fair market value of the received property are added to determine amount realized.
The adjusted basis is basis adjusted as provided in § 1016. Adjustment to basis, which reflects changes in value through depreciation, amortization, etc.
§ 1012. Basis of property – cost states that:
The basis of property shall be the cost of such property, except as otherwise provided in this subchapter and subchapters C (relating to corporate distributions and adjustments), K (relating to partners and partnerships), and P (relating to capital gains and losses). The cost of real property shall not include any amount in respect of real property taxes which are treated under section 164 (d) as imposed on the taxpayer.
“Except as provided” in the above paragraph covers the entirety of Internal Revenue Title, Subtitle A, Chapter 1, Subchapter O – Gain or loss on disposition of property, i.e., these exceptions are scattered all over the subchapter. Real property taxes (e.g., school taxes) are NOT added to the cost. (But real property taxes are deductible as expenses every tax year if the property is held for business or investment.)
The basis to a property increases if capital investment is made to improve the property. The basis to a property decreases when deductions are claimed in tax returns (according to rules for claiming deductions) for depreciation (for tangible assets) and/or amortization (for intangible assets).
Philadelphia Park Amusement Co. v. United States illustrates that fair market value may be inferred from an exchange transaction based on the value of the property received in return to determine the basis of an acquired property. In return for purchase of a private bridge from Philadelphia Park Amusement Company, the City of Philadelphia gave a 10-year extension to the Company’s railway franchise (including the bridge itself). In other words, the City fixes the bridge and allows the Company to use it for 10 more years, and the bridge belongs to the city thereafter. The Company asserted that the franchise was valueless and tried to claim tax refund on the unused depreciation of the bridge at the date of the sale. The Court held that if the value of a property given in exchange is not determinable, the value of the property received in exchange should be equal to the value of the property given. The court also held that even if the value of the bridge and the value of the franchise were to be indeterminable, the undepreciated cost of the bridge should be usable as the fair market value in such a case. Essentially, the Court held that fair market value for just about anything can be quantified.
Property from a decedent:
(The receipt is not itself income! But there can be gain or loss when you dispose of it.)
When a property is acquired from a decedent (by inheritance, bequest, devise, or from an estate), the fair market value at the time of the decedent’s death becomes a new basis for the property (which might be able to reduce the recipient’s gain when she decides to sell if the property had appreciated during the decedent’s lifetime). § 1014. Basis of property acquired from a decedent, (a) In general, states:
Except as otherwise provided in this section, the basis of property in the hands of a person acquiring the property from a decedent or to whom the property passed from a decedent shall, if not sold, exchanged, or otherwise disposed of before the decedent’s death by such person, be—
(1) the fair market value of the property at the date of the decedent’s death …
Unless the fair market value happens to be exactly the same as adjusted basis as tracked by the dying person, the basis changes to a new amount (typically an increased amount). The changed basis (at fair market value) is typically referred to as “stepped-up basis” because typically the value of the property (e.g., a building) increases with inflation and the basis would go up, i.e., “stepped up.” The basis would be stepped down only in some extraordinary circumstances.
Could one use a dying person to trigger a stepped-up basis. What happens if a son gives his a building he bought 30 years ago at $30,000 (now valued at $1,000,000) to his dying dad, and the nice dad goes along with his son’s plan and gives it back to him as he dies. (Some humanity!) Can the son have the stepped up basis of $1,000,000 so that his gain would be only $100,000 instead of $1,070,000 when he sells the building for $1,100,000 the following year? Congress passed § 1014. Basis of property acquired from a decedent, (e) Appreciated property acquired by decedent by gift within 1 year of death, to stop such people. If such transaction occurs within 1 year before the decedent’s death, there is no change in adjusted basis (no stepped-up base)! But then, if one plans more than 1 year before the decedent’s death, such a plan would work.
Property from a donor (a living donor):
(The receipt is not itself income! But there can be gain or loss when you dispose of it.)
Internal Revenue Title, § 1015. Basis of property acquired by gifts and tranfers in trust controls tax treatment of inter vivos gifts, i.e., from a living person to another living person. When a donor gives a property to a donee, the adjusted basis of a donor is preserved in general. This is referred to as transferred basis or carryover basis. When the donee disposes the received property, the basis of for computing gain or loss for that property is the transferred basis. As discussed above, the donee is not taxed for the gift itself. When the donee disposes the property (e.g., sale), the donee is responsible for the capital gain or capital loss.
A special rule applies if the fair market value of the property is less than the transferred basis at the time of the transfer and the donee sells the property later on at a price lower than the fair market value at the time of the transfer? In this case only, “for the purpose of determining loss the basis shall be such fair market value” according to § 1015. Basis of property acquired by gifts and tranfers in trust.
An example should illustrate this point:
Dick gives a two year old computer purchased at $2,000 two years ago to Ed. The adjusted basis for this computer was $1,200 at the time of the transfer. Ed receives this gift and immediately sells it to Fred for a sum of money.
(a) If the fair market value of the computer at the time of transfer was $1,500, i.e., greater than the transferred basis, the basis is always $1,200 for any sale price.
If the sale price of the computer was $1,400, Ed has a gain of (amount realized) – (transferred basis) = $1,400 – $1,200 = $200.
If the sale price of the computer was $900 (fire sale!), Ed has a loss of (transferred basis) – (amount realized) = $1,200 – $900 = $300.
(b) If the fair market value of the computer at the time of transfer was $1,000, i.e., less than the transferred basis, there are two possibilities for the basis.
If the sale price is $1,300, Ed has a gain over the transferred basis. The amount of gain is (amount realized) – (transferred basis) = $1,300 – $1,200 = $100.
If the sale price is $800, there is an apparent loss from the transferred basis. However, the rule in § 1015. Basis of property acquired by gifts and tranfers in trust states that the loss must be computed from the fair market value when the fair market value is less than the transferred basis. Therefore, Ed’s loss is (fair market value) – (amount realized) = $1,000 – $800 = $200. Ed incurred the loss of only $200, not $400.
If the sale price is $1,100, there is an apparent loss from the transferred basis. Applying the rule in § 1015. Basis of property acquired by gifts and tranfers in trust, however, one finds that there is no loss because (fair market value) – (amount realized) = $1,000 – $1,100 = -$100. Negative quantities are treated as zero in Internal Revenue Title! Thus, if the sale price is between the fair market value ($1,000) and the transferred basis ($1,200), there is neither gain nor loss.
In Kenan v. Commissioner (1940), the Court held that transfer of property by a trustee of a trust to a beneficiary is a realization event in the category of “sale or exchange.” Because there was a realization event, the trustee had to recognize gain associated with the change in the stock prices. Realizing that this rule sometimes adds a tax burden to divorcing couples already under mental stress (See United States v. Davis), the Congress decided to pass § 1041. Transfers of property between spouses or incident to divorce.
No gain or loss shall be recognized on a transfer of property from an individual to (or in trust for the benefit of) —
(1) a spouse, or
(2) a former spouse, but only if the transfer is incident to the divorce.
The requirement of being related to divorce is to prevent funny schemes between an ex-husband and an ex-wife.
3.5. Cancellation of debt is included in gross income.
(But there are some exceptions for bankruptcy, insolvency, etc.)
Forgiveness of a loan or other indebtedness is income to the borrower except under some specific circumstances. Internal Revenue Title, § 108. Income from discharge of indebtedness prescribes such specific circumstances:
Gross income does not include any amount which (but for this subsection) would be includible in gross income by reason of the discharge (in whole or in part) of indebtedness of the taxpayer if—
(A) the discharge occurs in a title 11 case,
(B) the discharge occurs when the taxpayer is insolvent,
(C) the indebtedness discharged is qualified farm indebtedness, or
(D) in the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness.
(A) refers to bankruptcy case (whether the taxpayer is insolvent or not). (B) refers to a state of insolvency (whether the taxpayer is bankrupt or not). (C) is elaborated in subsection (g). (D) is to help the owner of a real property that loses fair market value after purchase once the bank decides to write off some loss.
If a corporation buys its bonds back at a price lower than the face value, the corporation’s indebtedness for the amount of the face value is discharged for the payment of the purchase-back price. The difference between the two prices is “forgiven” in that transaction, and is income to the corporation. United States v. Kirby Lumber Co. (1931).
If the existence or enforceability of a debt can be disputed and a settlement for a lesser amount is possible, the value of the debt may not be the face value but the value of the seettlement. In Zarin v. Commissioner, Zarin settled the claim by a New Jersey casino that demanded payment of about $3.4 million of gambling debt (that the casino caused upon Zarin through illegal activities that violated federal regulations). Zarin and the casino settled the claim for half a million dollars. The IRS commissioner asserted that some $2.9 million was forgiven debt for Zarin. Zarin successfully argued that the $3.4 million was the amount of contested liability, of which the value was fixed at $500,000 at settlement, and that there was not any forgiveness of the debt in the process of settlement. The Third Circuit held that “[w]hen a debt is unenforceable, it follows that the amount of debt, and not just the liability thereon, is in dispute” and therefore, there was no forgiveness of debt or tax liability in this case. (Take home lesson: Never admit to forgiveness of a debt in a settlement when you pay a settlement if the amount of debt can be challenged. Admitting to a debt that you don’t have can lead to terrible consequences.)
3.6. Gifts and bequests are excluded from gross income
(But then, what qualifies as a gift?)
Internal Revenue Title, § 102. Gifts and inheritances, (a) General rule, states:
Gross income does not include the value of property acquired by gift, bequest, devise, or inheritance.
Gift is from a living person to another living person, bequest is a transfer of a personal property by will, devise is transfer of a real property by will, and inheritance is the transfer to an heir upon death. Except for donations to charity, gift is considered to be personal consumption of wealth and is not eligible for deduction. Worse, there is gift tax imposed on the donor, although the exemptions are on the order of a few million dollars and most people (except for the very rich) do not need to worry about the gift tax. IRS provides a useful website on gift tax. Also, Internal Revenue Title, Subtitle B, Chapter 12 – Gift Tax provides relevant codes for gift tax. Internal Revenue Title, Subtitle B, Chapter 11, Subchapter A – Estates of Citizens and Residents provides relevant codes for estate tax levied on an estate of a deceased. These taxes apply to the donor or the estate of the deceased (who gives the property to someone). The donee is never taxed on the gift because the gift is specifically excluded from income as far as the donee is concerned under § 102. Gifts and inheritances.
The courts have provided guidelines to determine whether any transfer is a gift.
“[T]he most critical consideration … is the transferor’s ‘intention.’” Bogardus v. Commissioner (1937).
“A gift in the statutory sense … proceeds from a ‘detached and disinterested generosity.’” Commissioner v. LoBue (1956).
A gift is given “out of affection, respect, admiration, charity or like impulses.” Robertson v. United States (1952).
It is not a gift if the payment proceeds primarily from “the constraining force of any moral or legal duty,” or from “the incentive of anticipated benefit” of an economic nature. Bogardus v. Commissioner (1937).
As long as the payment is in return for services, lack of benefit to the donor does not make a transfer a gift. “Where the payment is in return for services rendered, it is irrelevant that the donor derives no economic benefit from it.” Robertson v. United States (1952).
For example, flowers that Romeo gives to Juliet are not income to Juliet because Romeo gives the flowers to Juliet “out of affection, respect, and admiration.” (This is so even if this act may not qualify as a “detached and disinterested generosity.) If a salesperson gives a ticket for a National Football League game from “the incentive of anticipated benefit” of the possibility of the recipient purchasing her product, the ticket is not a gift. Thus, the value of the ticket is income to the potential client who receives it. The motive of the donor, not the motive of the donee, controls the verdict in such cases.
Commissioner v. Duberstein (1960) illustrates this point. Duberstein, president of Duberstein Iron and Metal Company, was asked by Berman, president of Mohawk Metal Corporation, whether Duberstein knew of potential customers for Mohawk’s products. Duberstein’s advice brought in significant additional revenue for Mohawk. Berman sent a Cadillac to Duberstein as a gift. The Supreme Court held that “the mere absence of a legal or moral obligation to make … a payment does not establish that it is a gift.” The Court held that the Cadillac was a “a recompense for Duberstein’s past services.”
Tips constitute income. In Olk v. United States (1974), the Second Circuit (one of the 11 circuit courts directly below the Supreme Court of the United States) held that “tokes” at Las Vegas casinos are income. The Court reasoned that gamblers’ motive for giving tokes to a dealer is to offer tribute to the gods of fortune in expectation of a bounteous return (note: motive counts!), and therefore, the gamblers do not act with “detached and disinterested generosity.” Further, the Court provided a second rational in that a dealer “would come to regard such receipts as a form of compensation for his services.”
Courts may detect compensation disguised in the form of a gift and impose income on a taxpayer. In Wolder v. Commissioner, a client and an attorney signed a contract according to which the attorney performed lifetime legal services and the client was to “bequeath” stock and cash in her will in lieu of payments. Rejecting the attorney’s argument that the “bequest” was exempt from income under Internal Revenue Title, § 102. Gifts and inheritances, the Court held that the fair market value of the stock and cash that the attorney received is income to him under § 61. Gross income defined because the bequest was not from “detached and disinterested generosity.”
3.7. Loans are excluded from gross income
(But interests are different!)
Actually, this point was apparently so obvious that the Congress has not passed laws to state this. IRS has not asserted anything to the contrary, either. This rule has been accepted without question.
To elaborate, a loan is not gross income to the borrower, and repayment of loan is not gross income to the lender. The lender cannot claim deduction on the amount of the loan, and the borrower cannot claim deduction on the payment of the principal of the loan. Interest payment that the lender receives is income to the lender and is taxable, and the interest payment that the borrower makes may, or may not, be deductible by the borrower. Specifically, interest payment related to the borrower’s business or related to home (primary residence) mortgage of the borrower is deductible, but interest payment on a personal loan is not deductible.
3.8. Timing of gross income
The time of income is when a taxpayer receives property under a claim of right and without restriction as to its disposition.
In North American Oil Consolidated v. Burnet (1932), the net profit of 1916 from the operation of a property disputed between North American Oil and the U.S. government was held by a court-appointed receiver while litigation was pending. In 1917, the District Court entered a final decree vacating the receivership, and the company became entitled to, and actually received, the net profit of 1916. The legal battle went on, however, until the U.S. Supreme Court dismissed an appeal in 1922. The company wanted to have the net profit of 1916 treated as income for 1916 or 1922 to get favorable tax rates. The U.S. Supreme Court held that the net profit of 1916 became income to the company when the company became entitled to the net profit, i.e., in 1917, and the company achieved access to and control of the gains then. The Supreme Court held, “If a taxpayer receives earnings under a claim of right and without restriction as to its disposition, he has received income which he is required to return, even though it may still be claimed that he is not entitled to retain the money, and even though he may still be adjudged liable to restore its equivalent.”
Following this logic, advance payments for services yet to be rendered are income at the time of receipt because the recipient has a claim of right without restriction as to its disposition. The recipient of an advanced payment is not under an obligation to repay the money. (She has the right to keep the advance payment for now although that right might be lost in the future by her failure to render the service, should that happen. Of course, the client cannot tell her where to spend her money once it is in her possession.)
Deposits are not income because the holder of the deposit is required to return the money unless the other party incurs any financial obligations (such as damaging an apartment or non-payment of electrical bills). The holder of a deposit is under an obligation of repayment barring extraordinary events. But deposits can sometimes look similar to advance payments, forcing the courts to tell the difference as in the next example.
3.9. Assignment of gross income
(Income is taxed at the source, to one who generates it.)
As discussed in section 3.3., income derived from services is taxed to the party that performs the services (irrespective of whether the same party receives the income or a third party receives the income).
An illustrative example for this principle is Lucas v. Earl (1930). In 1901, Earl and his wife entered into a contract, in which they agreed “that any property either of us now has or may hereafter acquire … in any way, either by earnings (including salaries, fees, etc.), or any rights by contract or otherwise … shall be treated and considered, and hereby is declared to be received, held, taken, and owned by us as joint tenants, and not otherwise, with the right of survivorship.” The validity of the contract was not questioned. Hover, the Supreme Court held that Mr. Earl “was the only party to the contracts by which the salary and fees were earned” and that “the statute could tax salaries to those who earned them.” In this case, the couple’s attempt to lower effective tax rates did not work!
Income derived from property is taxed to the party that held the property that generated the income (irrespective of whether the same party receives the income or a third party receives the income).
An illustrative example for this principle is Helvering v. Horst (1940). Helvering is the IRS commissioner. Horst, the owner of negotiable bonds, detached from them negotiable interest coupons shortly before their due date and delivered them as a gift to his son, who, in the same year, collected them at maturity. The U.S. Supreme Court held that “income is ‘realized’ by the assignor because he, who owns or controls the source of the income, also controls the disposition of that which he could have received himself and diverts the payment from himself to others as the means of procuring the satisfaction of his wants.” In short, since Horst held underlying bonds, Horst was the one who controls the payment for the detached coupons as well, although the payment was assigned to his son in advance. Therefore, Horst was liable for the income from the coupons.
Assignment of the entire interest before “sale or exchange” should work in general, except when such an assignment is obviously tied to the very event of the “sale or exchange.” In Salvatore v. Commissioner (1970), Salvatore accepted a purchase offer for a gas station from Texaco, then executed a deed to divide the interest in the gas station among her family members, and then the family executed a deed transferring the combined interests to Texaco. The Court held that Salvatore’s “tax liabilities cannot be altered by a rearrangement of a legal title after she had already contracted to sell the property to Texaco.” (Take-home lesson: Such interests should be divided before accepting an offer from a purchaser. The court may give no effect to last minute legal maneuvers and just focus on the substance once the deal is shaped.)
Good financial maneuvers can actually work. In Estate of Stranahan v. Commissioner (1973), Mr. Stranahan, in order to realize some gains so that he may fully take advantage of his large interest deductions for a tax year, assigned $122,820 in anticipated stock dividends (to be received the following year) to his son in exchange for his son’s immediate payment of $115,000. Mr. Stranahan then directed the transfer agent to issue all future dividend checks to his son until aggregate payment of $122,820 is satisfied. The Court held that Mr. Stranahan “completely divested himself of any interest in the dividends and vested the interest on the day of execution of the agreement with his son.” In plain words, Mr. Stranahan sold his future interest for $115,000 in that year and realized a gain (to offset his interest deduction).
All of the recovery (payment from a losing party to the winning party) from a lawsuit is income to the litigant only even if the litigant enters into a contingent fee agreement with her attorney. While some litigants pay their attorney per-hour charges or a fixed sum, many litigants, and especially the plaintiff in personal injury lawsuits, have so-called “contingent fee” arrangement in which the litigant pays a percentage (usually 20 % – 33 %) of the recovery to the attorney only if the litigant recovers monetary compensation from the lawsuit. In Commissioner v. Banks (2005), the Supreme Court ruled that “[i]n the case of a litigation recovery the income-generating asset is the cause of action that derives from the plaintiff’s legal injury.” Citing judge Posner, the Supreme Court ruled that “[t]he contingent-fee lawyer [is not] a joint owner of his client’s claim in the legal sense any more than the commission salesman is a joint owner of his employer’s accounts receivable.” Therefore, the portion paid to the agent (the attorney) may be deductible as a deduction (in calculating taxable income once gross income is given), but was not excludable from gross income.
Internal Revenue Title, § 62. Adjusted gross income defined, (a) General rule, (20) Costs involving discrimination suits, etc. and (21) Attorneys fees relating to awards to whistleblowers, allows exclusion of recovery from some types of lawsuits from income. However, the attorney’s share of the recovery from many other types of lawsuits is not eligible for such exclusion under Commissioner v. Banks, i.e., the winning litigant pays income tax for the attorney’s share of the recovery.