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       Chapter 1

       INTRODUCTION TO FEDERAL INCOME TAXATION




       I.    PROBLEM
          Tom and Caroline Taxpayer, a married couple, use the cash method of
       accounting and report their income on a calendar year basis. Tom is a business
       consultant who owns and operates his own unincorporated business. Caroline is a
       university professor. They have provided you with the following information
       concerning their financial affairs during the calendar year and ask you to compute
       their tax liability:
            1.   Caroline’s university paid her $125,000 in salary during the year.
            2.   With regard to his consulting business, Tom provided you the following
                 information:
                  (a)    He received $150,000 in fees through a combination of cash and
                         checks from clients;
                  (b)    He provided $10,000 in consulting services to one client, a
                         landscaping company, in exchange for $10,000 in landscaping
                         services the client provided, at Tom’s request, for Tom’s mother;
                  (c)   Clients still owed him $30,000 for services he provided during the
                        year;
                  (d)    He paid an employee $60,000 in wages during the year;
                  (e)    He paid $20,000 for building maintenance, utilities, and office
                         supplies during the year; and
                  (f)   He purchased an office building for $500,000. He expects to use the
                        building in his business for the next 30 years.
            3.   The Taxpayers incurred a total of $5,000 in commuting costs in traveling
                 from their home to their respective places of work during the year.
            4.   The Taxpayers received $19,000 in interest income this year from an
                 investment account managed by their bank. They paid the bank $1,000 for
                 its management services.
            5.   The Taxpayers own their home where they live with their two children,
                 ages 5 and 7. They made mortgage payments on the home in the amount of
                 $24,000 during the year. Included in the $24,000 were $18,000 in interest
                 payments and $6,000 in principal payments.

                                                           1
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       2                            TAXATION OF INDIVIDUAL INCOME                                           CH. 1

             6.   Two years ago, the Taxpayers purchased 100 shares of stock in ABC
                  corporation for $15,000. At the end of last year, the stock had a fair market
                  value of $25,000. This year they received $1,000 in dividends on the stock.
                  They sold the stock at year-end for $30,000.
             7.   The Taxpayers made cash contributions of $9,000 during the year to the
                  church they attend.
             8.   The Taxpayers paid state and local general sales taxes of $3,000 on the
                  purchase of various items for personal use or consumption. They also paid
                  real property taxes of $4,400 on their family home. The university withheld
                  $6,000 for state income tax and $15,000 for federal income tax from
                  Caroline’s salary during the year and the Taxpayers also paid $8,000 in
                  estimated state income taxes and $16,000 in estimated federal income taxes
                  with respect to Tom’s business.

       Assignment for Chapter 1:
                 Read the “Analysis of Tax Liability of Tom and Caroline Taxpayer”
              included in the materials. In conjunction with your reading of the analysis,
              skim the sections of the Internal Revenue Code and the Regulations cited
              in the “Analysis.” The “Analysis” assumes that the Taxpayers file a joint
              return for the current year. The purpose of the “Analysis” is to provide you
              with an overview of the computation of individual income tax liability under
              the Internal Revenue Code.
       Materials:       Overview of the Federal Tax Law
                        Analysis of Computation of Tax Liability of Tom and Caroline Taxpayer


       II.        VOCABULARY
           By the end of this chapter, you should be able to explain the following terms:
              gross income
              adjusted gross income
              above-the-line deductions
              below-the-line deductions
              standard deduction
              personal exemption
              taxable income
              tax credit
              rate schedule
              joint return
              tax bracket
              marginal rate
              timing
              withholding tax
              tax base
              imputed income
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       III.               INTRODUCTION TO FEDERAL INCOME TAXATION                                                3


       III.        OBJECTIVES
              1.   To list and explain fundamental questions our income tax system must
                   address.
              2.   To identify receipts and expenditures likely to have tax significance.
              3.   To recall the formula for determining an individual’s tax liability.
              4.   To explain the significance of adjusted gross income.
              5.   To explain the significance of the standard deduction.
              6.   To recognize there are some deductions taken into account in determining
                   adjusted gross income (“above-the-line deductions”) and some deductions
                   which taxpayers may only claim if they elect to itemize their deductions.
                   (These latter deductions are referred to as “below-the-line deductions.”)
              7.   To distinguish a tax credit from a deduction.
              8.   To explain the differing tax savings produced by tax credits and deductions
                   depending on a person’s tax bracket.
              9.   To describe the general organization of the Internal Revenue Code with
                   respect to income, exclusions, deductions and credits.
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       4                            TAXATION OF INDIVIDUAL INCOME                                           CH. 1


       IV.      OVERVIEW

           A.       A Brief History of Federal Income Tax
         The federal income tax had its beginning with the ratification of the 16th
       Amendment to the U.S. Constitution in 1913. The amendment provides:
             The Congress shall have the power to lay and collect taxes on incomes, from
             whatever source derived, without apportionment among the several states
             and without regard to any census or enumeration.
          This amendment set the stage for the 1913 Income Tax Act, an act imposing a
       very low rate of taxes. Given the high exemption levels established in that act, only
       a small fraction of the American public paid income taxes. In 1920, for example,
       there were only about five and one-half million taxable individual income tax returns
       filed, although 62,667,000 Americans were 20 years of age or older! In 1920, a family
       earning $10,000 a year (quite a sum for that time) would have paid only $558 in
       income tax. By 1928, the family earning $10,000 would pay only $40 in federal
       income tax.
          While initially only the well-to-do were subject to income taxes, the pool of
       taxpayers radically increased in the 1940s primarily as a result of the government’s
       need for additional revenues to fund the American war effort in World War II. Thus,
       while only 14.7 million individual income tax returns were filed in 1940, 49.8 million
       individual income tax returns were filed in 1945. Today, the great majority of adult
       Americans are required to file individual income tax returns, with more than 140
       million individual income tax returns being filed each year.
          Needless to say, the almost overnight movement from a system which taxed
       relatively few people to a mass tax system created serious administrative problems.
       To alleviate some of the collection difficulties and to assure taxpayer compliance, the
       modern tax withholding system was created. Under that system, employers are
       required to withhold from their employees’ compensation a sum, determined by
       reference to a specially formulated schedule, which approximates the federal
       income taxes an employee will owe. Amounts withheld by employers are periodically
       remitted to the Treasury. The success of our federal income tax system is largely
       attributable to the withholding system.
          Our federal income tax system serves a number of functions apart from raising
       revenues to operate the government. The tax system also allocates the cost of public
       goods and services among Americans on an ability-to-pay basis. It accomplishes this
       through a progressive rate structure whereby high income taxpayers generally pay
       a larger percentage of their income in taxes than low income taxpayers. Exactly how
       progressive our system is and ought to be are topics of ongoing debate. Changes in
       deductions, exclusions and credits, as well as changes in tax rates and tax brackets,
       all affect the progressivity of the system.
          In addition, Congress uses the federal income tax as a tool of social policy.
       Throughout the course, you will examine various Internal Revenue Code provisions
       reflecting social concerns of the Congress. For example, § 163 of the Code allows
       taxpayers to deduct home mortgage interest. Congress’ stated purpose in allowing
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       IV.               INTRODUCTION TO FEDERAL INCOME TAXATION                                                5


       the deduction of such a personal expense is to encourage home ownership. Section
       121, providing a substantial exclusion for gain on the sale of a principal residence,
       not only encourages home ownership, but minimizes tax as a factor in deciding
       whether to sell one’s home. Another familiar example of the use of tax as a tool of
       social policy is § 170, the charitable deduction provision. By providing a deduction
       for charitable contributions, the government indirectly subsidizes various social
       programs benefitting large segments of our population.
          Finally, Congress often uses the federal income tax to implement economic
       policy. For example, the accelerated cost recovery system of § 168 stimulates the
       economy by allowing businesses to depreciate certain tangible property rapidly,
       thereby encouraging businesses to invest in new equipment. Similarly, Congress
       occasionally enacts provisions intended to stimulate investment in particular
       activities, industries, or businesses, or in particular geographic areas or localities.
          Is it proper to use the tax system to influence an individual’s economic or
       personal decisions? Undoubtedly, many people significantly alter their economic
       behavior to take advantage of tax breaks. For example, a significant tax credit made
       available to first-time home buyers may encourage many individuals to purchase
       homes rather than to continue renting.
          When one views the entire body of tax law, the purposes and effects of which go
       far beyond the mere collection of revenues, its study becomes more interesting.
       Indeed, tax is not just a sterile game of questions and answers involving only
       arithmetic. Rather, it is a study in governmental policy.
          As you consider various aspects of the tax system during this course, ask yourself
       whether the provisions you are studying make sense not only from a revenue
       standpoint but also from an economic and social point of view. Begin evaluating the
       strengths and weaknesses of our tax system. Consider the administrability of the
       Code’s provisions. In addition, ask yourself what regulatory effect, if any, a
       provision has — does it discourage or encourage a certain course of conduct?

             B.   The Tax Practice
          And now for a few words about the tax practice. One would be very short-
       sighted to believe tax work is relegated to a very small part of the practicing bar.
       As a practical matter, almost every practitioner will encounter clients with tax
       problems. As a result, attorneys must understand the general principles of the tax
       law so that they can assist their clients in making business and personal planning
       decisions.
          Tax practice involves not only applying tax principles to past events or
       transactions but, more importantly, advising clients regarding the tax implications
       of actions they are about to undertake. For example, in representing a client in a
       divorce action, attorneys advise clients on numerous matters having significant tax
       consequences, e.g., property settlement, child support and alimony. While the tax
       tail should not wag the dog, the attorney nonetheless should carefully evaluate and
       explain to a client the tax consequences of any proposed settlement or
       arrangement.
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       6                            TAXATION OF INDIVIDUAL INCOME                                           CH. 1

          To advise a client and to predict the tax consequences of a particular course of
       action, one must have an understanding of the structure of our income tax law.
       Knowledge of the sources of the tax law is critical. Appendix 1 at the end of this
       book contains a section entitled “Sources of Tax Law.” Read the brief discussion of
       tax sources carefully and make an effort during the course to locate and examine
       the research sources described.

           C.       Resolution of Tax Issues Through the Judicial Process

              1.        Trial Courts
          If the Commissioner of the Internal Revenue Service asserts a deficiency in
       income tax, i.e., claims that the taxpayer has failed to pay all that is owed, the
       taxpayer may:
            (a)    refuse to pay the tax and petition the Tax Court for a redetermination of
                   the deficiency; or
            (b)     pay the deficiency, file an administrative claim for refund, and upon denial
                    of the claim, sue for refund in federal district court or the United States
                    Court of Federal Claims.
       Three courts have original jurisdiction in federal tax cases: the Tax Court, the
       United States District Courts and the United States Court of Federal Claims.

                   a.     The Tax Court
          Of the three courts having original jurisdiction in tax cases, the Tax Court is the
       most important. The Tax Court has often been referred to as the “poor person’s
       court” because the taxpayer commences an action in that court for redetermination
       of a deficiency without first paying the asserted deficiency. In contrast, actions for
       refund in the federal district courts and the Court of Federal Claims are, as the
       nature of the action indicates, commenced only after an asserted deficiency has
       been paid.
          Because the Tax Court hears only tax cases, it is the most sophisticated trial
       court from the standpoint of tax expertise. The Tax Court has 19 members. The
       Tax Court, known as the Board of Tax Appeals until 1943, was established in 1924.
       Prior to the Tax Reform Act of 1969, the Tax Court was technically an independent
       agency of the executive branch of the federal government. The 1969 Act renamed
       the court the “United States Tax Court” and gave it “constitutional status” under
       Article 1, Section 8, Clause 9 of the Constitution, so that it is now part of the
       judicial branch. The change to constitutional status gives the Tax Court the power
       to punish for contempt and to issue writs to enforce its decisions.
          Although the Tax Court has its headquarters in Washington, D.C., it regularly
       holds hearings in principal cities throughout the United States. Cases are tried
       without a jury by one judge, who submits an opinion to the chief judge for
       consideration. The chief judge will either allow the decision to stand or refer it to
       the full court for review. Reviewed opinions of the Tax Court are likely to be
       accorded greater weight. Published opinions of the Tax Court always indicate
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       IV.               INTRODUCTION TO FEDERAL INCOME TAXATION                                                7


       whether the opinion has been reviewed. Dissenting opinions are published.

                  b.    Federal District Courts
           The United States District Courts have jurisdiction in any tax case against the
       United States seeking a refund of tax, regardless of the amount involved. Unlike
       actions before the Tax Court, suits in the federal district courts may be tried before
       juries. The taxpayer must bring tax actions against the United States in the
       district in which the taxpayer resides, or, in the case of a corporation, in the district
       in which it has its principal place of business. As indicated above, a taxpayer cannot
       litigate a tax action in the federal district courts without first paying the amount in
       dispute and then commencing a refund action.

                  c.    The United States Court of Federal Claims
          The United States Court of Federal Claims was created by the Federal Courts
       Improvement Act of 1982. The court inherited substantially all of the jurisdiction
       formerly exercised by the United States Court of Claims. The Court of Federal
       Claims has jurisdiction over all tax suits against the United States regardless of
       amount. Jury trial is not available in the Court of Federal Claims. The jurisdiction
       of the court extends throughout the United States. Where one resides makes no
       difference. The principal office of the Court of Federal Claims is in the District of
       Columbia, but the court may hold hearings at such times and in such places as it
       may fix by rule of the court. Like the federal district courts, the Court of Federal
       Claims has no jurisdiction to hear deficiency cases. The taxpayer must pay the
       deficiency, thus converting the suit into a refund suit, before bringing an action
       before the court.

             2.        Appeals
          Appeals from the Tax Court are heard as a matter of right by the Federal
       Courts of Appeals of the United States. Jurisdiction is in the court for the circuit in
       which the taxpayer resides. Prior to its decision in Golsen v. Commissioner, 54 T.C.
       742 (1970), the Tax Court did not regard itself as bound by the decisions of any
       particular federal court of appeals, even the court which would hear the case in
       question on appeal. In Golsen, the Tax Court reversed itself and announced that it
       would follow a decision of the federal court to which an appeal from a Tax Court
       decision would be made, if the federal appeals court decision were squarely on
       point.
          Prior to 1982, decisions of the Court of Claims were reviewed by the Supreme
       Court under the certiorari procedure. The 1982 Court Improvement Act created
       the United States Court of Appeals for the Federal Circuit, which has exclusive
       jurisdiction of an appeal from a final decision of the United States Court of Federal
       Claims. Decisions of the Court of Appeals for the Federal Circuit are reviewable by
       the Supreme Court.
          Decisions of the federal district courts may, as a matter of right, be appealed to
       the appropriate federal court of appeals.
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       8                            TAXATION OF INDIVIDUAL INCOME                                           CH. 1


              3.      Selection of Forum
          As the above brief description of the various trial courts indicates, the taxpayer
       aggrieved by a decision of the Internal Revenue Service has a choice regarding the
       forum in which resolution of the tax issue may be sought. As a practical matter,
       one’s finances may prove controlling in choosing a court. Thus, because a taxpayer
       is not entitled to sue in federal district court or the United States Court of Federal
       Claims unless a deficiency is paid and a refund claim pursued, the Tax Court will
       often be the favored forum, since one may commence an action there without
       having paid the asserted deficiency. Other factors likely to influence taxpayers and
       their advisors in choosing a forum will be the desire for a jury trial, the expertise
       of the Tax Court judges, and the past record of the particular court on a given
       issue. For example, if a taxpayer’s claim for refund raises an issue on which the
       Court of Federal Claims has ruled favorably for other taxpayers, a taxpayer could
       be expected to bring a refund action in that court.


       V.        ANALYSIS OF THE COMPUTATION OF TAX LIABILITY
                 OF TOM AND CAROLINE TAXPAYER
          Chapter 1 is intended as an overview of individual income taxation. The problem
       presented requires you to think about the kinds of issues our tax system must
       address. It also introduces you to the method for computing an individual’s income
       tax liability. During the rest of the course, you will be studying the details of the
       outline presented in this problem. If you are feeling a little uncomfortable after
       wrestling with the problem in this Chapter, don’t despair. This problem and its
       analysis will make far more sense to you as you work through the materials in this
       casebook.

            A.      Basic Questions Addressed by an Income Tax System
         As the problem demonstrates, there are a number of questions our tax law must
       answer:
            First, what items of economic income or gain will be includable in gross income?
            Second, what costs will be allowable as deductions?
          Third, when is an amount included in income? When is the taxpayer entitled to
       claim a deduction for an amount that is deductible?
            Fourth, who is the taxpayer — who is going to be taxed on items of income?
            Fifth, what is the character of the items of income or the deductions?

            B.      Evaluating the Taxpayers’ Tax Liability
         To determine the tax liability of the Taxpayers, you will need to answer two
       questions:
            (a)    What is the applicable tax rate?
            (b)    What is the tax rate applied to — that is, what is the tax base?
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       V.                INTRODUCTION TO FEDERAL INCOME TAXATION                                                9


          The answer to the first of these two questions is relatively simple. Internal
       Revenue Code § 1(a) provides the rates for married individuals filing joint returns.
       The Taxpayers are entitled to use these tax rates. (See § 6013.) Tax rates have
       varied considerably over the years. For example, a major change in the rates
       occurred as part of the Tax Reform Act of 1986, when tax rates were significantly
       reduced — immediately prior to 1986 the maximum individual income tax rate was
       50%; and five years prior to that, the top rate was as high as 70%. Under current
       law, the maximum rate for individuals in 2010 is 35%, although there is a 28%
       maximum rate on “net capital gain” income and a 15% cap on “adjusted net capital
       gain.” § 1(a),(h),(i). Note that the income levels at which the higher rates apply vary
       according to the taxpayer’s filing status. Review the various subsections of § 1.
          As you read § 1(a), you will find that the appropriate tax rate is applied to the
       “taxable income” of the taxpayer. In calculating a taxpayer’s taxable income, the
       five questions discussed above become important. Section § 63(b) provides that, for
       individuals who do not itemize their deductions, the term “taxable income” means
       “adjusted gross income minus (1) the standard deduction, and (2) the deduction for
       personal exemptions provided in section 151.” For all other taxpayers, “taxable
       income” means “gross income minus the deductions allowed by this chapter
       [Chapter 1 of Subtitle A of the Internal Revenue Code] (other than the standard
       deduction).” § 63(a).

            1.      Gross Income
          In computing taxable income, the first order of business is to determine gross
       income. “Gross income” is defined in § 61: “Except as otherwise provided in this
       subtitle, gross income means all income from whatever source derived, including
       (but not limited to) the following items:” A list of 15 items follows.
          What does § 61 mean when it refers to “this subtitle”? The reference is to
       Subtitle A of Title 26 of the United States Code. Subtitle A includes all income tax
       provisions beginning with § 1 and ending with § 1563. Note that “gross income” is
       defined as “all income.” Thus, the definition really does not help us very much. As
       you might expect, there are numerous cases in which the courts have struggled
       with the meaning of the term “gross income.” Generally, courts have been
       expansive in their definition of income.
          Let us turn now to the problem and determine the Taxpayers’ gross income.
       First, Caroline’s university salary and the $150,000 in cash and checks Tom
       receives in his consulting business constitute gross income.
          The $10,000 value of the landscaping services rendered to Tom Taxpayer’s
       mother presents a tougher question. Tom Taxpayer rendered consulting services
       and received in exchange landscaping work he requested be done for his mother.
       The form of compensation one receives generally makes no difference in
       determining what constitutes gross income. Regulation § 1.61-1(a) specifically says
       gross income includes income realized in any form whether in money, property or
       services. Regulation § 1.61-2(d)(1) provides that “if services are paid for in
       exchange for other services, the fair market value of such other services taken in
       payment must be included in income as compensation. . . .” These rules regarding
       form of compensation are obviously very important in our tax system. But for these
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       10                            TAXATION OF INDIVIDUAL INCOME                                           CH. 1

       rules, taxpayers would be encouraged to barter for goods and services they need.
          Although it was Tom’s mother rather than Tom who received the landscaping
       services, the Taxpayers will nonetheless have to include the value of these services
       in their gross income. Otherwise, taxpayers in high tax brackets would constantly
       shift their income to related taxpayers in a lower bracket. The courts have
       fashioned the “assignment of income” doctrine to prevent income shifting, and
       numerous statutory provisions reflect congressional application of that doctrine.
       Thus, the Taxpayers are considered to have $285,000 in gross income.
          Can Tom’s business expenses noted above be deducted from the $285,000 in
       arriving at the Taxpayers’ gross income figure? The answer is “No” — § 61 says
       nothing about net income. As you will see, however, the Code specifically authorizes
       deductions for expenses incurred in one’s trade or business.
          Clients owed Tom $30,000 for consulting work performed during the current
       year. Is any of this amount includable in the Taxpayers’ gross income for the year?
       The answer is “No.” They are “cash method” taxpayers. Tom did not actually or
       constructively receive any of the $30,000. The Taxpayers therefore are not
       required to include any of the $30,000 in their gross income. As you will study later
       in the course, a cash method taxpayer includes income only when it is actually or
       constructively received. See § 451(a); Reg. § 1.446-1(c)(1)(i).
          The Taxpayers received $19,000 in interest income this year. This amount
       clearly constitutes gross income under § 61(a)(4). May the $1,000 management fee
       be deducted in arriving at gross income? As before, the answer is “No.” Instead,
       the $1,000 fee will be considered when the Taxpayers compute their deductions.
          The Taxpayers sold their stock in ABC Corporation for $15,000 more than they
       paid for it. This $15,000 gain must be included in their gross income under
       § 61(a)(3) as gain derived from dealing in property. Because they had held the stock
       as a capital asset for more than one year, the $15,000 gain will be characterized as
       long-term capital gain. That characterization will not affect the dollar amount of
       gross income. Note, however, that the maximum rate on “net capital gain” — a
       necessary component of which is long-term capital gain — is less than the
       maximum rate on ordinary income. § 1(h). Thus, the long-term capital gain
       characterization may ultimately prove beneficial for that reason. In addition, as we
       shall see in studying characterization in detail in Chapter 31, capital gain
       characterization can also be significant when a taxpayer has recognized capital
       losses. § 1211(b). Finally, the Taxpayers also received $1,000 in dividend income
       from the ABC stock. Dividends are included in income under § 61(a)(7). However,
       under current tax law, dividends are included in the computation of net capital
       gain, and thus are taxed at the preferential rate accorded net capital gain, rather
       than at ordinary income rates as high as 35%. § 1(h)(11). [Section 1(h)(11), however,
       is scheduled to sunset December 31, 2010. Unless Congress extends the sunset
       date, dividends will be taxed at ordinary income rates for taxable years beginning
       after December 31, 2010.]
          An additional point should be considered at this time. By the end of last year,
       the stock had appreciated in value by $10,000. Were the Taxpayers required to
       include any of that $10,000 in their gross income for last year? Is it appropriate to
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       V.                INTRODUCTION TO FEDERAL INCOME TAXATION                                               11


       permit them to exclude from last year’s income an amount which is clearly an
       economic gain? Assume they could have sold the stock and collected $10,000 of gain
       on December 31 last year. Alternatively, consider the administrative problems
       involved, and the forced sales that might result if taxpayers were required to
       account for the appreciation and the depreciation in assets during the year.
       Congress, the courts and the Service all agree no inclusion is required in these
       circumstances. The $10,000 appreciation in their stock is not considered to have
       been “realized” by the Taxpayers. Until such time as the appreciation is realized,
       e.g., the stock is sold, there will be no inclusion.

            2.      Adjusted Gross Income
          The Taxpayers had no other income in the current year. Thus, their gross
       income is $320,000 (consisting of Caroline’s $125,000 salary; the $150,000 in cash
       and checks Tom received in his consulting business; the $10,000 value of the
       landscaping services; $20,000 in interest and dividends; and the $15,000 gain on the
       stock sale). Having determined their gross income, you should now determine their
       adjusted gross income. Section § 62 defines adjusted gross income as gross income
       less certain deductions. Note that § 62 merely defines adjusted gross income; it is
       not a deduction granting provision! In general, only those deductions listed in
       § 62 are taken into account in computing adjusted gross income. Thus, there are
       two categories of deductions. The first category is comprised of deductions a
       taxpayer may consider in determining his or her adjusted gross income; these are
       referred to as “above-the-line” deductions. The second category of deductions
       consists of those deductions a taxpayer may take into account only after the
       adjusted gross income has been determined; these are referred to as “below-the-
       line” deductions.
          A few comments on adjusted gross income (AGI) are necessary at this point.
       Adjusted gross income may be viewed as an interim measure of taxable income.
       Prior to 1944, taxpayers simply itemized all of their deductions. Whatever business
       deductions they had and whatever personal deductions, e.g., charitable deductions
       and home mortgage interest deductions, they were allowed, all had to be listed
       separately on the return. In the early years of our modern tax history, this
       itemization was manageable from an administrative standpoint because relatively
       few people were required to file returns. However, in the early 1940s when ours
       became a mass system of taxation, this itemization was viewed as extremely
       burdensome not only for the taxpayer attempting to complete a tax return, but also
       for the Internal Revenue Service in reviewing the tax returns filed.
          In 1944, as part of a tax simplification act, Congress decided that, in lieu of
       itemizing their personal deductions, taxpayers should be given the right to elect a
       “standard deduction.” If a taxpayer elected to use the standard deduction rather
       than itemizing all of her personal deductions, the taxpayer would be entitled to
       deduct the amount specified by Congress regardless of what deductible personal
       expenses the taxpayer had actually incurred. If, in the aggregate, a taxpayer’s
       personal deductions exceeded the standard deduction, the taxpayer would not elect
       the standard deduction but would instead itemize her personal deductions.
       Regardless of whether a taxpayer elected the standard deduction, a taxpayer
       would be allowed to deduct her trade or business expenses. Thus, the standard
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       12                            TAXATION OF INDIVIDUAL INCOME                                           CH. 1

       deduction in effect eliminates the need for taxpayers with relatively small amounts
       of personal deductions to itemize those deductions and maintain records
       substantiating those deductions.
          In 1944, Congress provided that the standard deduction would be a percentage
       of the taxable income determined after taking into account trade or business
       expenses but before taking into account deductible personal expenses. There was
       not in existence, however, any interim measure of gross income less business
       expenses to which the standard deduction percentage could be applied. Congress
       therefore created an interim measure known as “adjusted gross income.”
       Beginning with the 1944 Act, a taxpayer would compute taxable income by
       deducting business expenses from gross income. This figure was the taxpayer’s
       adjusted gross income. The taxpayer would then elect either to itemize other
       deductions or to take the standard deduction. Disregarding the personal
       exemptions available, the taxpayer’s taxable income then equaled the difference
       between the adjusted gross income and either the taxpayer’s itemized deductions
       or the standard deduction.
          Note that the standard deduction under current law is a set dollar amount that
       is adjusted annually for inflation, rather than a percentage of adjusted gross
       income.1
          Adjusted gross income continues to serve as a dividing line between those
       deductions allowed to all taxpayers regardless of whether they itemize (the “above-
       the-line” deductions) and those deductions which may be taken only if the taxpayer
       itemizes (the “below-the-line” deductions). See § 63(e). AGI is also important
       because it is used to limit certain personal expenses (for example, the charitable
       deduction is limited to a percentage of AGI) and is used as a basis in calculating
       various other “tax-related” amounts.

               3.      Deductions
          The deduction provisions of the Code begin with § 161. Most deductions reflect
       the notion that our tax system permits a deduction for the costs incurred in
       producing income. As discussed previously, however, a number of deduction
       provisions are not integral to our tax system and exist only because of certain
       economic and social policies Congress seeks to implement. As you begin
       considering the deduction provisions, keep in mind that while gross income is given
       a very expansive definition, the courts consider deductions as a matter of
       “legislative grace.” Deduction provisions are, therefore, narrowly construed.
          When one thinks of deductions, one usually thinks in terms of some expenditure.
       Some expenditures are generally currently deductible. One example would be the
       wages an employer pays to an employee. Other expenditures are never deductible.
       Personal expenses, for example, are generally not deductible. § 262. Some
       expenditures are deductible, but not all at once; rather, they are deducted
       (accounted for) over a period of time. For example, if one purchases a building for

         1
            For example, the “basic standard deduction” on a joint return has risen to $11,400 for calendar year
       2010 on account of inflation adjustments. See § 63(c)(2)(A), (4), (7); Rev. Proc. 2009-50, 2009 I.R.B. LEXIS
       652.
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       use in one’s business, the cost of the building will not be deductible in the year of
       purchase but rather will be deductible during the life of the building. One final
       point must be emphasized regarding deductions. Every time you have an expense
       that you believe is deductible, you must find a specific Code section authorizing
       the deduction.
         With that background, consider what expenditures of the Taxpayers are
       deductible.
          Tom Taxpayer paid $60,000 in wages and $20,000 for various business-related
       expenses. Section 162(a) provides that these amounts will be deductible as trade or
       business expenses. As such, they are above-the-line deductions according to
       § 62(a)(1).
          Tom Taxpayer purchased a building during the current year costing $500,000.
       The building will provide a benefit to Tom’s business over many years. To permit a
       current deduction for the entire $500,000 would cause some distortion because the
       cost of the building is associated not only with producing income this year but also
       with producing income in subsequent years. Appropriately, § 263 requires the cost
       of the building to be capitalized. The building cost represents a capital expenditure
       according to Reg. § 1.263(a)-2(a). Section 168, which you will study in some detail
       later in this course, specifically allows the building to be depreciated. Depreciation
       represents an allowance for the reasonable exhaustion, wear, and tear of property
       used in a trade or business or property held for production of income. See § 167(a).
       Section 168 provides a spreading technique for recovering the cost of property
       used in business or for the production of income. For purposes of your
       computation, assume that the depreciation deduction allowed this year with respect
       to the building will be $10,000. In other words, on their tax return the Taxpayers
       will be allowed to deduct $10,000 of the $500,000 building cost this year and will
       deduct the remaining $490,000 in future years pursuant to § 168.
          The § 168 deduction represents a business expense and therefore is properly
       taken into account in computing adjusted gross income; it is an above-the-line
       deduction. § 62(a)(1).
          The Taxpayers incurred $5,000 in expenses in commuting to and from their
       respective work places each day. This amount is not deductible. Rather, it is viewed
       as a nondeductible personal expense. Reg. § 1.162-2(e) and § 1.262-1(b)(5). The
       theory underlying denial of a deduction in this case is that where one lives is a
       matter of personal preference. Hence, a person choosing to live miles away from
       his or her business should not be permitted to claim a deduction for commuting
       expenses.
          The bank’s fee for managing the Taxpayers’ investment account was $1,000.
       Does § 162(a) authorize a deduction for this expense? No. Investing in stocks and
       bonds and otherwise managing one’s investments has been held not to constitute a
       trade or business within the meaning of § 162. Higgins v. Commissioner, 312 U.S.
       212 (1941) (included in the materials in Chapter 12). This result seemed unfair
       since the dividends and interest produced by the stocks and bonds were taxable
       income. Congress, therefore, in response to Higgins, enacted § 212 which
       specifically provides a deduction for expenses paid or incurred during the taxable
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       14                            TAXATION OF INDIVIDUAL INCOME                                           CH. 1

       year “for the production or collection of income.” Thus, the management fee will be
       deductible as an investment activity expense under § 212.
          Is the management fee deductible above the line? No. Under § 62, only limited
       types of § 212 expenses are deductible above the line and the management fee is
       not one of them. This is a curious result because it seems that taxpayers should
       always be allowed to deduct expenses incurred in the production of taxable income.
       There is no good policy reason to deny above-the-line treatment to this expense,
       and yet Congress has done so. Thus, the expense will be significant only if the
       taxpayer has below-the-line expenses greater than the standard deduction. By
       contrast, were the management fee a business expense, it would be deductible
       above the line and would not be subject to the potential wastage or disallowance
       that below-the-line deductions face. See § 62(a)(1).
          The Taxpayers made mortgage payments in the amount of $24,000 — $6,000 of
       which represented principal payments. Are the principal payments deductible? No.
       Mortgage payments on one’s personal residence represent a personal expenditure.
       Generally, as noted, personal expenditures are not deductible. § 262. (For similar
       reasons, no depreciation deduction is allowed with respect to the residence.)
          Is the $18,000 interest portion of the mortgage payment deductible? Surely this
       is a personal expense just as a principal payment is a personal expense. Section
       163(a), however, specifically allows a deduction for “all interest paid or accrued
       within the taxable year on indebtedness.” Section 163(h) qualifies this general rule
       by providing that personal interest is generally not deductible. Personal interest,
       however, does not include so-called “qualified residence interest.” As you will study
       later in this course, home mortgage interest such as the Taxpayers paid in this
       problem may be “qualified residence interest” and thus be deductible. For
       purposes of this problem, we will assume that the interest is deductible under
       § 163. To the extent § 163(a) permits the Taxpayers to deduct interest on personal
       debt such as a home mortgage, it represents an exception to the general rule that
       personal expenditures are not deductible. Indeed, this section provides one of the
       significant tax breaks enjoyed by homeowners. Certainly, this deduction is not one
       mandated by a system which seeks to tax net income.
          Having determined that the $18,000 interest payment is deductible, the next
       question is whether the deduction is above or below the line. Recall that § 62 lists
       the above-the-line deductions. While interest expense may be an above-the-line
       deduction if it is incurred in a trade or business, per § 62(a)(1), interest expense
       incurred with respect to a personal debt is not listed as an above-the-line
       deduction. Thus, the $18,000 interest deduction may not be used in computing
       adjusted gross income. In this problem, it will be taken into account in computing
       the Taxpayers’ taxable income.
          The Taxpayers paid real property taxes of $4,400 on the family home. This
       represents a personal expense, and thus one might conclude it is nondeductible
       under § 262. Congress, however, authorizes in § 164 a deduction for certain taxes
       even though they are personal in nature. Among those taxes are real property
       taxes. See § 164(a)(2). The deduction is taken below the line.
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          May the Taxpayers deduct the state and local general sales tax and the state
       income tax they paid this year? Section 164(a)(3) allows a deduction for state
       income tax. Section 164(b)(5), however, puts the Taxpayers to an election: deduct
       either state and local incomes taxes or state and local general sales taxes. Because
       the total state income taxes paid ($14,000, i.e., $6,000 withheld by the university
       and the $8,000 of estimated state income taxes paid) are a greater amount, that is
       the deduction the Taxpayers will take.2 No deduction may be taken for federal
       income tax withheld or estimated federal income tax paid. As noted below, however,
       the Taxpayers will be given credit for any federal income taxes they paid. The state
       income tax deduction is a below-the-line deduction. The question remains: Since
       these taxes are personal in nature, should they be deductible at all?
         The Taxpayers made a contribution of $9,000 to their church. Section 170
       provides a deduction for charitable contributions. There are limits, however, on
       charitable deductions. In this case, § 170(b)(1)(A) limits the Taxpayers’ deduction to
       50% of their “contribution base.” Section 170(b)(1)(F) provides that “contribution
       base” means “adjusted gross income.” Thus, so long as the Taxpayers have an
       adjusted gross income of at least $18,000, they will be entitled to a full $9,000
       deduction for the charitable contribution. The charitable contribution deduction, as
       you might expect, is a below-the-line deduction.

              4.     Calculating Adjusted Gross Income
            The Taxpayers are thus “allowed” the following deductions:
       above-the-line deductions:
                               wages . . . . . . . . . . . . . . . . . . .          $60,000
                               office supplies, etc. . . . . . . . . .                20,000
                               depreciation . . . . . . . . . . . . . .              10,000
                               TOTAL . . . . . . . . . . . . . . . . . .            $90,000
       below-the-line deductions:
                               management fee . . . . . . . . . . .                   $1,000
                               interest . . . . . . . . . . . . . . . . . .           18,000
                               state income tax . . . . . . . . . . .                 14,000
                               real property taxes . . . . . . . . .                   4,400

                                       charitable contributions . . . . .             9,000
                                       TOTAL . . . . . . . . . . . . . . . . . .    $46,400

            Returning to the definition of adjusted gross income in § 62(a):
             AGI = Gross income less the above-the-line deductions
            Thus, AGI = $320,000 − $90,000 = $230,000


         2
           This election has been available only since 2005. General sales taxes were made nondeductible in
       1986 and remained so until 2005. While § 164(b)(5) expired December 31, 2009, it is anticipated that the
       provision will be extended through 2010 and will likely be extended thereafter on a year-to-year basis or
       made permanent.
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       16                            TAXATION OF INDIVIDUAL INCOME                                           CH. 1


               5.      Taxable Income
          Itemize or Use Standard Deduction? Next, you must determine the taxable
       income of the Taxpayers. As noted earlier, the formula for computing taxable
       income depends on whether the taxpayer itemizes deductions, i.e., elects to claim
       below-the-line deductions rather than taking the standard deduction. If the
       taxpayer does not itemize deductions, the taxpayer is entitled only to the standard
       deduction in lieu of any below-the-line deductions (other than the personal
       exemption, discussed infra). Note the definition for itemized deductions in § 63(d).
       Clearly, if a taxpayer’s below-the-line deductions exceed the standard deduction, as
       will be the case with the Taxpayers, the taxpayer should be advised to itemize.
          If they elect to itemize, the Taxpayers will determine their taxable income by
       subtracting from their gross income of $320,000 all of their allowable deductions.
       § 63(a). For taxpayers itemizing deductions, the computation of adjusted gross
       income is not specifically required by § 63(b); however, for taxpayers who have
       made charitable contributions or have other expenses, the deductibility of which
       depend on the amount of the adjusted gross income, their adjusted gross income
       must be determined. Having already computed the Taxpayers’ adjusted gross
       income, the only deductions which remain to be taken in computing their taxable
       income are the below-the-line deductions and the personal exemption.
          Section 67: the 2% Floor on Miscellaneous Itemized Deductions. Section 67
       provides that certain itemized deductions may not be deducted except to the extent
       that, in the aggregate, such deductions exceed 2% of the taxpayer’s adjusted gross
       income. This 2% floor on itemized deductions not only reduces the tax benefits of
       certain deductions, but also the number of taxpayers claiming the deductions. The
       floor relieves taxpayers of the burden of record keeping with respect to certain
       expenditures unless they expect that, in the aggregate, the expenditures will
       exceed the floor. In turn, the Internal Revenue Service’s work in auditing returns is
       reduced. With respect to each deduction studied in this course, ask yourself
       whether the deduction is subject to this 2% floor. Note that under § 67(b), the
       Taxpayers’ deductions for home mortgage interest, state income tax, real property
       tax, and charitable contributions are not subject to the 2% rule of § 67(a). The bank
       management fee of $1,000, however, is subject to the rule. It is clear that this
       $1,000 expense does not exceed 2% of the Taxpayers’ adjusted gross income of
       $230,000; therefore it will not be deductible. Thus, the Taxpayer’s itemized
       deductions are cut back from $46,400 to $45,400 by § 67.
          Personal Exemptions. Next, it is necessary to determine the deduction for the
       personal exemption. Section 151(a) provides that there will be a deduction for
       personal exemptions. Section 151(d)(1) sets the exemption amount, in general, at
       $2,000, adjusted for inflation after 1989 as set forth in § 151(d)(4).3
          How many exemptions may the Taxpayers claim? In the case of a joint return,
       there are two taxpayers, and therefore, as the applicable Treasury regulation
       provides, there will be two personal exemptions. Reg. § 1.151-1(b). In addition to
       the exemptions provided for the taxpayer, there are additional exemptions for each


        3
             For 2010, the inflation-adjusted personal exemption is $3,650. Rev. Proc. 2009-50, supra.
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       V.                    INTRODUCTION TO FEDERAL INCOME TAXATION                                           17


       dependent who meets the requirements set out in § 152. Here, the Taxpayers have
       two minor children who we will assume meet the requirements of § 152, specifically
       the “qualifying child” provisions of § 152(c). Assume the current inflation-adjusted
       exemption amount is $3,650. Since the Taxpayers will report four exemptions on
       their joint return, they will claim a total deduction of $14,600. Even if the
       Taxpayers did not elect to itemize, § 63(b) makes it clear that they are entitled to
       claim personal exemptions in addition to the standard deduction.
          The personal exemption and the standard deduction provide a floor assuring
       that taxpayers will not be taxed unless they have income greater than the
       combined amount of the personal exemptions allowed and the standard deduction.
       As noted in the legislative history of the 1986 Tax Reform Act, “[a]n overriding goal
       of the Committee is to relieve families with the lowest incomes from Federal
       income tax liability. Consequently, the Bill increases the amounts of both the
       personal exemption and the standard deduction . . . so that the income level at
       which individuals begin to have tax liability (the tax threshold) will be raised
       sufficiently to free millions of poverty-level individuals from Federal income tax
       liability.”4
                Calculating Taxable Income. Mr. and Ms. Taxpayers’ taxable income therefore
       is:
       Adjusted Gross Income . . . . . . . . . . . . . . . . . . . . . . . . .        $230,000
       less:      itemized deductions                                − 45,400
                  personal exemptions                                − 14,600           60,000
       Taxable Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   $170,000


                  6.     Tax Rates
           Next, you must apply the appropriate tax rate under § 1. Sections 1(a) and 1(i)
       list six different rates, or brackets: 10%, 15%, 25%, 28%, 33%, 35%. The income
       level at which the higher rates begin to apply depends on one’s filing status. In
       addition, the statutory brackets themselves are to be adjusted for inflation. § 1(f).
       Under the tax rate tables of § 1(a), for 2010,5 the tax on a joint return with taxable
       income of $170,000 is $26,687.50 on the first $137,300, plus 28% of the excess over
       $137,300. Thus computed, the Taxpayers’ preliminary § 1(a) tax liability is
       $35,843.50. This liability is preliminary because it can be affected by the maximum
       capital gains rate provision of § 1(h).
          Section 1(h) will apply when, as here, the taxpayer has a net capital gain. The
       purpose of § 1(h) is to provide preferential tax rates for net capital gain. The
       preferential rates may vary based on the taxpayer’s bracket and on the
       components of the net capital gain. Section 1(h) is remarkably complex and will be
       studied in detail in Chapter 31. It must suffice at this point to simply note: (1) Since
       the Taxpayers have $1,000 in dividend income, a $15,000 long term capital gain
       from the sale of the ABC stock, and no other capital gains or capital losses, their

         4
           H.R. 99-426 p. 82 (1985); Senate Rep. 99-313 p. 31, 32 (1986). See also General Explanation of the
       Tax Reform Act of 1986 prepared by the Staff of the Joint Committee on Taxation, p. 15.
            5
                The tax rate tables for 2010 are in Rev. Proc. 2009-50, supra.
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       18                            TAXATION OF INDIVIDUAL INCOME                                           CH. 1

       net capital gain is $16,000. §§ 1(h)(ii), 1222(11). (2) Under the facts of this problem,
       all of the net capital gain will be taxed at a 15% tax rate. § 1(h)(1)(C). Accordingly,
       under 1(h), the Taxpayers’ § 1 tax liability is limited to the sum of two amounts:
                 (1) the regular § 1(a) tax on $154,000, which is $31,363.50 (the $154,000
              figure represents the previously-determined taxable income of $170,000,
              less the net capital gain of $16,000 — which would otherwise be taxed at
              28%); plus
                 (2) the special § 1(h) tax rate of 15% on the $16,000 net capital gain,
              which equals $2,400. But for § 1(h), this $16,000 would be taxed at the
              higher rates of § 1(a) and (i).6 With § 1(h), the § 1 liability is thus $33,763.50.
          Credits. Are the computations finished? Not yet. Next, you must determine
       whether any credits may be taken against the tax. The Code sections providing tax
       credits are generally §§ 21-53. The most common credit is found in § 31 — the credit
       for withholding taxes paid through the year by employers on behalf of the
       employees. Allowance of this credit makes sense since, in effect, employees are
       prepaying their income taxes via the payment of the withholding tax. In this case,
       the university withheld $15,000 in federal tax on Caroline’s salary. The Taxpayers
       will claim this as a prepayment or credit against their tax liability.
          Tom Taxpayer is not subject to withholding tax because he is self-employed. He
       would, however, be required to make advance payments on the tax on his
       self-employment income. Here Tom paid $16,000. This type of advance payment is
       referred to as an estimated tax payment. Tom paid $16,000 estimated tax and that
       amount would also be deducted from the Taxpayers’ tax liability figure. As a result
       of these credits for withholding and estimated tax payments, the Taxpayers will owe
       the U.S. Treasury $2,763.50 ($33,763.50 minus $31,000).
         We might note one other credit the Taxpayers should consider. The Child Tax
       Credit of § 24 provides a credit of up to $1,000 per child, but the credit is completely
       phased out at the Taxpayers’ adjusted gross income. See § 24(b).
          At this point, you should consider the difference between a deduction and a
       credit. A credit reduces one’s tax on a dollar for dollar basis, whereas a deduction
       reduces taxable income, thus providing a reduction in tax that is dependent on the
       tax bracket of the individual. For example, a $1,000 deduction results in a $350 tax
       savings for a person in a 35% tax bracket, but only a $150 tax savings for a person
       in a 15% tax bracket. By contrast, a $1,000 tax credit saves a person $1,000 in taxes
       regardless of a person’s tax bracket.




          6
            It is assumed that the Taxpayers’ limitation will be determined under § 1(h)(1)(A)(i). An alternative
       § 1(h) limit can apply in some circumstances. See § 1(h)(1)(A)(ii). The alternative limitation is designed
       simply to ensure the 15% tax bracket is fully utilized before the higher capital gains rates are applied.
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       V.                INTRODUCTION TO FEDERAL INCOME TAXATION                                               19


                                                    Conclusion
          This chapter has provided you with the big picture.7 Now you will begin studying
       the details of the individual income tax system. You should return to this chapter
       throughout the course to refresh your memory on just how each specific detail fits
       into the overall picture.




         7
           Actually, for many taxpayers, an additional chore remains — namely determining whether
       additional tax will be imposed by the “alternative minimum tax” of § 55. The alternative minimum tax is
       considered in detail in Chapter 45; to introduce its complexities at this point would be premature.
0020                                              [ST: 1] [ED: 10000] [REL: 9]                              Composed: Wed Jul 7 10:25:04 EDT 2010
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