- Introduction - Basic Income Tax 2016-2017
Chapter One - The Government Raises Money: Introduction to Some Basic Concepts of Taxes and Taxing Income
1.1 - Introduction to Some Basic Concepts
1.2 - Taxing Income
1.3 - Some Definitions
1.4 - Layout of the Code
1.5 - Not All Income Is Taxed Alike
1.6 - Illustration of the Tax Formula:
1.7 - Sources of Tax Law and the Role of Courts
1.8 - Some Income Tax Policy and Some Income Tax Principles
1.9 - What We Tax: What Is Income?
- 1.1 - Introduction to Some Basic Concepts
Chapter Two - What Is Gross Income: Section 61 and the Sixteenth Amendment
2.1 - The Constitutional and Statutory Definitions of “Gross Income”
2.2 - The Constitutional and Statutory Definitions of “Gross Income:” Accessions to Wealth
2.3 - The Constitutional and Statutory Definitions of “Gross Income:” Realization
2.4 - The Constitutional and Statutory Definitions of “Gross Income:” Dominion and Control
- 2.1 - The Constitutional and Statutory Definitions of “Gross Income”
- Chapter Three - Exclusions from Gross Income
- Chapter Four - Loans and Cancellation of Indebtedness
- Chapter Five - Progressivity and Assignment of Income
- Chapter Six - Deductions: Business Expenses
- Chapter Seven - Personal Deductions
- Chapter Eight - Tax Consequences of Divorce and Intra-Family Transactions
- Chapter Nine - Timing of Income and Deductions: Annual Accounting and Ac-counting Principles
- Chapter Ten - Character of Income and Computation of Tax
Basic Income Tax
Tax Cuts and Jobs Act
Professor of Law
The University of Memphis
CALI eLangdell Press 2018
Professor William Kratzke is a Cecil C. Humphreys Professor of Law at the University of Memphis. He received his B.A. in Political Science and the Far Eastern & Russian Institute from the University of Washington in 1971. This naturally caused him to be interested in attending law school. He received his J.D. from Valparaiso University in 1974 and was a member of the Valparaiso University Law Review’s editorial board. He received his LL.M. from Georgetown University in 1977.
Professor William Kratzke teaches tax law courses at the University of Memphis. He has been a faculty member there since 1979. He has taught courses across the curriculum. In addition to tax courses, he has taught trademarks, torts, civil procedure, world trade law, economic analysis, and other courses. He visited Santa Clara University and the University of Mississippi. He received Fulbright Teaching Awards in 1997 (Moldova) and 2001-2002 (Russia).
Professor Kratzke has written in the areas of tax law, trademark law, tort law, and antitrust law.
This is the sixth edition of this casebook, updated May 01, 2018 and incorporating the Tax Cuts and Jobs Act. Visit http://elangdell.cali.org/ for the latest version and for revision history.
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This book is a basic income tax text. I intend this text to be suitable for a three-hour course for a class comprised of law students with widely different backgrounds.
Certain principles permeate all of tax law. I have found that certain axioms or principles will carry us a long way. For example, income is taxed once – or treated as if it has been taxed. Once it has been taxed, its investment gives the taxpayer basis – which I define not as cost but as money that will not be subject to tax again. Etc. The text returns to these principles throughout. I usually put these matters in text boxes.
At a minimum, I want students who have completed basic income tax to know these principles and to be able to apply them, i.e., to develop some “tax intuition.” This intuition will serve well the student who wishes to take more tax classes. I tried to identify what I want students to know before enrolling in corporate tax or partnership tax – and to make certain that I covered these principles in the basic course. Such intuition will also serve well the student for whom the basic course is a “one and done” experience. Like it or not, tax law affects most legal topics, and such intuition should at least give students working in other areas of the law an idea of when it is time to ask questions concerning lurking tax issues.
At the end of every chapter, I have included a short section entitled “What have you learned?” This page may be examined before beginning the study of a chapter. I intend it to be a statement of learning objectives: a student should have a solid understanding of the items listed.
In some areas, I have relied heavily on the CALI drills by Professor James Edward Maule (Villanova University). These drills both review and, in some instances, teach a little substance. Each zeroes in on a specific topic and should take a student about twenty minutes to complete if she has adequately prepared to do the drill. Of course, students can work through such drills at their own speed. With the assistance of CALI’s LessonLink, professors and students alike can monitor students’ understanding of the discrete topics of these drills.
I have tried to make this text very readable – so that students can easily understand. I have aimed at law students who “know” they have no interest in income tax – but who may find that they in fact have a considerable interest in tax law. With my political science background, I was such a student. I am proof that one does not have to have an accounting background to find income tax law both important and interesting. Additionally, Magdalene Smith and Jay Clifton III were two such students; they assisted me greatly in making this text as accessible as possible to all law students. I thank them now for their work.
I have alternated from one chapter to the next my usage of singular indefinite pronouns. I have used the feminine forms for chapters 1, 3, 5, 7, and 9. I have used the masculine forms for chapters 2, 4, 6, 8, and 10.
Memphis, Tennessee, July 2013, May 2016, and May 2017.
My use of pronouns referring to non-specific persons alternates between the feminine and masculine chapter by chapter.
In December 2017, Congress enacted the Tax Cuts and Jobs Act. This statute contains significant measures that alter several Code provisions important to this course. Some, but not all, of these measures are “temporary,” i.e., for calendar years 2018 to 2025. I anticipate that we will be in for a period of intense lobbying to make these changes permanent. I note and briefly describe the provisions that have been “suspended” – anticipating that these changes will be made permanent.
Memphis, Tennessee, May 2018
The word is out: the United States Government needs money in order to operate. The vast majority of us do want the government to operate and to continue to provide benefits to us. There are many ways in which the Government may endeavor to raise money, only one of which is to tax its own citizens on their income. A few examples follow:
Tariffs: The Government might impose tariffs (i.e., taxes) on imports or exports. To sell their wares in the United States, foreign merchants at one time had to pay very high tariffs. Tariffs would of course protect domestic producers of the same wares who did not have to pay such tariffs. However, this hardly helps domestic consumers of products subject to a tariff because they must either pay an artificially inflated price for an import or a higher price for a (lower-quality?) domestic product. Export duties could also have a pernicious effect. They encourage domestic producers to endeavor to sell their goods at home, rather than in foreign markets where they might have made more profits. Article 1, § 9, cl. 5 of the Constitution provides: “No Tax or Duty shall be laid on Articles exported from any State.” Notice: import tariffs are a cost that mostly the buyers and sellers of the products subject to them alone pay. Furthermore, the economic interests of different regions of the country are hardly uniform. The cotton-exporting southern states early on preferred low tariffs while northeastern manufacturing interests preferred the protection that high import tariffs provided. See generally, Douglas A. Irwin, Clashing over Commerce: A History of US Trade Policy (2017) (recounting history of import tariffs in the United States). The burden of paying for Government is not spread very evenly if tariffs are the means of raising revenue to support the Government. Nevertheless, tariffs were the most important source of revenue for our country’s government in its early days. This is not nearly so true any longer.
Government Monopoly: The Government might choose to enter a business and perhaps make competition in that business unlawful. Most states have lotteries that they run with no competition other than what they are willing to tolerate, e.g., low-stakes bingo games that charities operate. One argument favoring this means of financing government is that there is no compulsion to buy lottery tickets, i.e., willing buyers contribute to Government coffers. Many non-purchasers derive benefits from lottery proceeds at the expense of those willing to give up some of their wealth in the forlorn hope of hitting it big. Governments may also engage in other businesses. For example, some states own the liquor stores that operate within its borders. Governments may charge for services that they provide (e.g., access to parks) with a view to making profits that are spent in pursuit of other government objectives. There is always the risk that the Government might not be very good at running a particular business. Government-operated airlines are notorious money-losers. And again, why should consumers of certain products or services be saddled with the burden of paying for a government that (should) benefit(s) all of us?
Taxing Citizens: Instead of trying to raise money only from consumers of particular goods or services, Government may endeavor to spread the burden more evenly by taxing its citizens or residents. It may perhaps try to tax non-citizens or non-residents as well. This raises the question of what it is government should tax – or more formally, what should be the “tax base.” There are various possibilities.
The Head Tax: A head tax is a tax imposed on everyone who is subject to it, e.g., every citizen or resident, every voter. The tax is equal in amount for all who must pay it. A head tax has the advantage that it is only avoidable at a cost unacceptable to most (but not all) of us: leave the country, renounce one’s U.S. citizenship, surrender the right to vote. Its relative inescapability assures that most of those who derive some benefit from the existence of a government help to pay for it. A head tax of course has an obvious drawback. Its burden falls unequally on those subject to it. Some persons might hardly notice a head tax of $1000 per year while others might find such a tax to be an insurmountable hardship. Surely, we as a society have a better sense of fairness than that. With one notable exception, we hear very little of head taxes in the United States.
The notable exception was the poll tax that some southern states in the post-Civil War era imposed as a condition of exercising the right to vote. The very purpose of such a tax was to discourage recently emancipated and almost uniformly poor Black persons from exercising their constitutional right to vote. The unfairness of the relative tax burdens associated with this cost of voting led to adoption of the 24th Amendment to the Constitution, which made poll taxes unconstitutional.
Consumption Taxes: As the name implies, consumption taxes tax consumption. There are different variants of consumption taxes. Three important consumption taxes are the sales tax, the excise tax, and the value added tax (VAT).
|The Ramsey Principle: Taxes on items for which demand is inelastic raise the most revenue for the state. See F.P. Ramsey, A Contribution to the Theory of Taxation, 37 Econ. J. 47 (1927). For our purposes, “inelastic demand” means that the quantity that buyers buy does not change (much) as prices increase or decrease. A life-saving drug might be such an item. Taxes on items for which demand is inelastic will not divert consumers’ purchase to or from those items, i.e., they do not distort markets as much as other taxes might. Unfortunately, the things for which demand is inelastic are often things that poorer people must buy. Strict adherence to the Ramsey principle would create an excessive burden for those least well-off. Moreover, the burdens of such taxes would not fall evenly across those who benefit from them.|
Sales Tax: A sales tax is a tax on sales and is usually a flat percentage of the amount of the purchase. Sellers usually collect sales taxes at the point of sale. Many states and localities rely on a sales tax for a substantial portion of their revenue needs. Sales taxes are relatively easy to collect. By their very nature, sales taxes are not collected on amounts that citizens or residents save. Hence, their effect is more burdensome to persons who must spend more (even all) of their income to purchase items subject to a sales tax. While such taxes are nominally an equal percentage of all purchases, their effect is regressive (infra). Those who must spend all their income on items subject to a sales tax pay a higher percentage of their income in such a tax than those wealthy enough to be able to save some of their income.
In states that have sales taxes applicable to all purchases, every citizen or resident who buys anything pays some sales tax.1 Perhaps this is fairer than alternatives. The recent financial crisis has made clear that a state’s revenues are vulnerable to economic downturns. Unemployment causes citizens or residents to reduce their purchases and so the sales tax that they pay. Such downturns are the very occasions when states need more funds to finance services for which their citizens stand in greater need.
Excise Taxes: An excise tax is a sales tax that applies only to certain classes of goods, e.g., luxury items. Excise taxes on luxury items may be politically popular, but those excise taxes do not raise much revenue because they are avoidable. The demand for luxury items is usually highly elastic (see text box, The Ramsey Principle). Excise taxes on high-demand (arguably) non-necessities, e.g., cellular telephones, raise much more revenue. Tourist-destination states find excise taxes on services that out-of-state visitors are more likely to purchase than residents to be attractive, e.g., renting cars, staying in hotels, visiting tourist sites. There is nothing quite so politically attractive as making someone who cannot vote in state elections fill the state’s coffers.
Some states impose excise taxes on “sin” purchases, e.g., cigarettes, alcohol. The public health costs associated with activities such as smoking or drinking may be high, so states tax heavily the purchases of products that cause it to have to provide costly health services. Arguably, such taxes may discourage persons from making the purchase in the first place.
Value Added Tax: This tax is imposed on all sales, not only the sale to the ultimate consumer, i.e., it is imposed at every stage of production of a product. The seller pays the VAT to the government minus whatever tax the seller was assessed upon acquiring the unfinished good. Thus, the tax base is only a purchaser’s actual additions to the value of a product. The final consumer does not resell the product, and so pays a VAT on the full cost of the item. Many European countries favor a VAT, often in combination with an income tax.
A Progressive Consumption Tax: As we shall see infra from our discussion of the Schanz-Haig-Simons concept of income, it is quite possible for Government to collect a tax on consumption once per year instead of incrementally upon each and every purchase. We could simply use the information that we already collect or can easily begin collecting. We now know what an employee-taxpayer’s total wages are; every taxpayer who works for an employer receives a W-2 wage statement. If a taxpayer saves a portion of her earnings, the saving or investment institution could report resulting increases to a taxpayer’s total savings or investment. Similarly, such institutions could report the total amount of a taxpayer’s withdrawals from savings or investments. A taxpayer’s total consumption for the year would be her income minus increases to savings or investment plus withdrawals from savings or investment. Importantly, the tax on such consumption could be made progressive, i.e., the rate of tax increases as the amount of a taxpayer’s consumption increases (infra).
Wealth Taxes: We could tax wealth. There are two common forms of wealth taxes: estate taxes and property taxes. The estate tax is imposed on the estates of decedents and the amount of the tax depends on the size of the estate. Property taxes are imposed on taxpayers because they own property. Municipalities often rely on property taxes to raise the revenues they need. Notice that in the case of property taxes, the taxing authority can tax the same “wealth” again and again, e.g., every year. This is quite unlike an income tax, infra. The burden of wealth taxes falls upon those who hold wealth in the form subject to tax. Both persons subject to the tax and those not subject to the wealth tax may reap its benefits.
Wage Taxes: We could impose a flat percentage tax on all wages – no matter how high or how low. This is sometimes called a “payroll” tax. Some states rely on a payroll tax. It is collected from employers and therefore cheaper to administer than an income tax. Social Security taxes and Medicare taxes are also wage taxes. The tax base of the Social Security tax (6.2% on both employer and employee, §§ 3101, 3111) is limited to an amount indexed to take account of inflation, about the first $120,000 of wage income, § 3121(a)(1) (cross-referencing Social Security Act). The ceiling on the tax base of the Social Security tax creates a regressive effect (infra), i.e., those with incomes higher than the ceiling pay an effective rate that is lower than the effective rate that those whose income is below the ceiling must pay. The tax base of the Medicare tax (1.45% on both employer and employee) is not subject to a limit. For high-income earners,2 there is an additional 0.9% tax on wages or self-employment income. §§ 3101(b)(2), 1401(b)(2). The Social Security and Medicare programs mainly benefit all senior citizens – and both are funded by a flat tax on wages of those currently working. Contrary to the claims of some politicians and commentators, everyone who works for her income pays some federal tax. The flat tax on all wages of low- to middle-income persons (combined 7.65% plus a like amount paid by employers3) assures that many workers pay more in these flat taxes than they do in progressive income taxes. This point makes the burden of paying federal taxes of whatever type much less progressive than the brackets established by § 1 of the Internal Revenue Code imply.
Income Tax: And of course we could tax income. We recognize that this is what the United States and several states do. In the pages ahead, we examine the federal income tax. We describe just what we mean by “income,” i.e., the tax base. It might not be what you expect. We also describe the adjustments (i.e., reductions that are called “deductions”) we make to the tax base and the reasons for these adjustments. An income tax is difficult to avoid: a citizen or resident must have no income in order not to be subject to an income tax. Thus the burden of income taxes should be spread more evenly over those who derive benefits from government activities than the burden of other taxes.
The United States taxes the income of its citizens and permanent residents. This personal income tax accounts for about 54% of the United States Government’s revenues.4 The Government’s reliance on the personal income tax as a source of revenue has increased, and the proportion of its revenue from other taxes such as the corporate income tax or the estate and gift taxes has contracted. These facts alone provide some reason for law students to study the law of individual income tax.
Beyond this, title 26 of the United States Code (the Internal Revenue Code), the title that provides the federal rules of taxation, is one of the most comprehensive statements of policy in American law. It affects everyone with an income. It affects everyone who might die. Tax law is hardly the exclusive domain of accountants and number crunchers.5 Tax law is also the domain of anyone who cares about such matters as fairness, economic growth, and social policy – in short, everyone. The Code defines broadly the income on which it imposes a tax. It provides exceptions to these rules for those taxpayers Congress deems deserving of exceptions. Legislative exemption from an otherwise universal tax implicitly states policies on many subjects.
SOI Tax Stats at a Glance: Summary of Tax Collections Before Refunds by Type of Return, FY 2015
Far more persons will be subject to the Code’s rules year after year than will be tort victims or defendants, parties to a contract dispute, or victims of crime – although many persons reading these lines consider those topics much more important to their legal studies and eventually their legal careers. Such persons may be right, but they might be surprised at how much the individual income tax will affect their practices for the simple reason that the individual income tax affects the lives of nearly all Americans. Federal taxation is about money. Those who claim that they will avoid tax issues in their practices will find that they work for and with people who do care about money, and they will find that avoidance of tax issues can make for some less-than-satisfied clients and colleagues.
Multiple-Choice: In any law practice, there will be times when you can
A. Practice a little tax law.
B. Malpractice a little tax law.
There is no option C.
•Consider: P was injured in an automobile accident. P sued D for damages, prevailed, and collected damages. Tax consequences? Does it make any difference if P recovers only for her emotional distress? Does it make any difference if P recovers because her employer discriminated against her on the basis of sex?
•Consider: S is a law student. Her university awarded her a full tuition scholarship. Any tax issues?
•Consider: H and W are divorcing. They will divide their property (including their investments), arrange for alimony, and arrange for child support. Any tax issues?
•Consider: A sells Blackacre to B for $30,000 more than A paid for it. Any tax issues? Do the tax issues change if B agrees to pay A in ten annual installments?
•Consider: A wants to save money for her pension. If she understands some tax law, can she save some money – or more directly, enlarge her pension?
•Consider: The federal government has established a program whereby homeowners who owe money on a mortgage can have the principal of their loan reduced. Any tax issues?
•Consider: E’s employer permits E to purchase items that it sells for a discount. Tax consequences?
•Consider: R is an employer who mistakenly paid E, an employee, a bonus in December. After discovering the mistake, E repaid the bonus to R. Any tax issues?
•Consider: For tax purposes, how should a businessperson treat the costs of generating income? What if the businessperson purchases a machine that will generate income for at least several years into the future? What if the businessperson sells from inventory that she purchased?
•And so on. Do you really think that you can avoid issues such as these by ignoring them? See Robert W. Wood, 10 Tax Rules All Lawyers and Clients Should Know, 9 Tax Notes 755 (Feb. 6, 2017).
Tax Base: The tax base is what it is we tax. The tax base of the federal income tax is not all income, but rather “taxable income.” “Taxable income” is “gross income” minus deductions named in § 62, minus either a standard deduction or itemized deductions. In the remaining chapters, we examine the elements of the tax formula. Only the amount remaining after these subtractions is subject to federal income tax.
The Tax Formula:
MINUS deductions named in § 62
EQUALS (adjusted gross income (AGI))
MINUS (standard deduction or itemized deductions)
EQUALS (taxable income)
Compute income tax liability from tables in § 1 (indexed for inflation)
MINUS (credits against tax, including credit for dependents)
Learn this formula.
Notice that in the accompanying box (“The Tax Formula”), there is a line. We frequently refer to this as “the line.” The figure immediately beneath the line is “adjusted gross income” (AGI). In a very rough sense, § 62 deductions are for obligatory expenditures or for deferring income that will be subject to income tax at the time of consumption. Subtractions may be “above the line” or “below the line.” Taxpayer is entitled to § 62 deductions irrespective of and in addition to itemized deductions or the standard deduction.
When a subtraction is “below the line,” what happens above the line might be very relevant. The Code limits certain itemized deductions to the amount by which an expenditure exceeds a given percentage of a taxpayer’s AGI. For example, a taxpayer’s deduction for medical expenditures is only the amount by which such expenditures exceed 10% of a taxpayer’s AGI. Congress can use such a limitation to do some customization of such deductions. A 10%-of-AGI-floor on deductibility of medical expenses provides some rough assurance that the amount of a medical expense deduction requires a common level of “pain” among high- and low-income taxpayers.
A credit reduces the taxpayer’s tax liability dollar-for-dollar. The credit is usually a percentage of some expenditure that the taxpayer made. Some credits are “non-refundable.” This means that they cannot reduce a taxpayer’s tax liability to less than zero. Other tax credits are “refundable,” i.e., they can reduce a taxpayer’s tax liability to less than zero in which case the Government will pay the taxpayer the excess. You can see that a refundable credit functions as a Government benefit program because the taxpayer’s right to payment does not depend on owing the Government any money.
Assignment: Go to a search engine on your computer. Enter “Form 1040.” Print this form. Then enter “Schedule A.” Print this form. Examine these forms and notice how an individual’s computation of income tax liability tracks the tax formula described in the text box. What is the name of the figure on the last line of the first page and on the first line of the second page?
Progressive Tax Brackets, Progressive Tax Rates, or Progressive Taxation: Taxpayers do not attach the same importance to every dollar that they earn. To a person whose annual taxable income is $10 million, one dollar more or less has far less value (as gain or loss) than the same dollar has to a person whose annual taxable income less is than $1000.6 Hence, the person with $10 million of income who receives one more dollar might feel the same level of sacrifice if she must pay $0.90 of it in federal income tax – and so keeps only $0.10 of it – as the person with $1000 of income who receives one more dollar of income might feel if she must pay $0.05 of it in federal income tax and so keeps $0.95 of it. The Tax Code endeavors to require equal sacrifice by establishing progressive tax rates. Look at § 1 of the Code – preferably the latest table that the IRS has promulgated in a Revenue Procedure that adjusts tax rates for inflation. An understanding of the tax formula should lead you to conclude that the first dollars of a taxpayer’s income are not taxed at all. The next dollars above that threshold – and only those dollars – are subject to a tax of 10%. The next dollars above the next threshold – and only those dollars – are subject to a tax of 12%. And so on – at rates of 22%, 24%, 32%, 35%, and 37%. Tax brackets that increase as taxable income increases are “progressive” tax brackets. The highest individual tax bracket is 37%, but no taxpayer pays 37% of her taxable income in federal income taxes; do you see why?
|Progressive Rates and Income Redistribution: An argument favoring progressive tax brackets – aside from the declining marginal utility of money – is that the effect of progressive tax brackets is to redistribute income in favor of those who have less. After all, Government has only to spend the many dollars contributed by higher-income taxpayers for the benefit of those less well-off – and there will be income redistribution. Any person who is even slightly aware of current social conditions knows that the Tax Code has not proved to be a particularly effective instrument of income redistribution. Inequality in wealth distribution is at near historically high levels. Perhaps high-income taxpayers are able to keep more of their incomes and to pay less in taxes than serious efforts at redistribution require. Perhaps Government has become, for whatever reason, reluctant to spend tax revenues on (more) programs that benefit the poor. Or perhaps both.|
A regressive tax is one where the percentage that taxpayers pay decreases as their income increases. A flat tax is one where the percentage that taxpayers pay is equal at all income levels. Some flat taxes are regressive in effect, e.g., a flat sales tax imposed on the purchase of necessities, supra.
Effective tax rate: Because we have a progressive rate structure, not every dollar of taxable income is taxed at the same rate. Moreover, income derived from some sources is taxed differently than income derived from other sources. For example, an individual taxpayer’s “net capital gain” (essentially long-term capital gains plus most dividends) is taxed at a lower rate than her ordinary income. It may be useful for policy-makers to know what certain taxpayers’ “effective tax rate” is, i.e., (amount of tax)/(total income).
Marginal Tax Rate: A taxpayer’s marginal tax rate is the rate at which the next (or last) dollar is taxed. Because we have a progressive rate structure, this rate will be greater than the taxpayer’s effective tax rate. Among the reasons that the marginal tax rate is important is that it is the rate that determines the cost or value of whatever taxable-income-affecting decision a taxpayer might make, e.g., to work more, to have a spouse work outside the home, to incur a deductible expense, to accept a benefit that is excluded from her gross income in lieu of salary from an employer.
Tax Incidence: “Tax incidence” is a phrase used to name the person on whom the burden of paying a tax falls. The phrase is used to identify occasions where the ostensible payor of a tax can shift the burden to another.7 For example, a property owner may be responsible for payment of real property taxes, but if the landowner simply increases the rentals that her tenants must pay, the incidence of such a tax falls on the tenants of the property owner.
Exclusions from Gross Income: We (say that we) measure “gross income” by a taxpayer’s “accessions to wealth.” However, there are some clear accessions to wealth that Congress has declared taxpayers do not count in tallying up their “gross income,” e.g., employer-provided health insurance (§ 106), life insurance proceeds (§ 101), interest from state or local bonds (§ 103), various employee fringe benefits (e.g., §§ 132, 129, 119). Many exclusions are employment-based.8 Congressional exclusion of clear accessions to wealth from the income tax base creates certain incentives for those able to realize such untaxed gain – and for those who profit from supplying the benefit (e.g., life insurance companies, providers of medical services9) in exchange for untaxed dollars.
Deductions from Taxable Income: Congress permits taxpayers who spend their money in certain prescribed ways to subtract the amount of such expenditures from their taxable income. A deduction reduces income otherwise subject to income tax. Hence, the person who gives her time to work for a charity may not deduct the fair market value (fmv) of the time because taxpayer would not otherwise be taxed on the fmv of her time. From a tax perspective, this is the critical difference between an exclusion from gross income and a deduction from taxable income (or from adjusted gross income).
|The Upside Down Nature of Deductions and Exclusions: A taxpayer pays a certain marginal rate of tax on the next dollar that she derives in gross income. Hence, a high-income taxpayer who pays a 37% marginal tax rate gains $0.63 of additional spending power by earning one more dollar. The higher a taxpayer’s marginal tax bracket, the less an additional dollar of income will net the taxpayer. The same principle works in reverse with respect to deductions. The same taxpayer might be considering contributing $1 to her public radio station for which she would be entitled to a charitable contribution deduction. The public radio station would receive $1 while the taxpayer sacrifices only $0.63. On the deduction side, the higher a taxpayer’s marginal tax rate, the more an additional dollar of deduction will save the taxpayer in income tax liability. And the lower a taxpayer’s marginal tax rate, the less an additional dollar of deduction will save the taxpayer in income tax liability. A taxpayer whose marginal rate of tax is 10% must sacrifice $0.90 in order that her public radio station receives $1. The same principle applies to exclusions from gross income. A high-income taxpayer saves more on her tax bill by accepting employment benefits excluded from gross income than a low-income taxpayer, infra. These results might be the opposite of what policy-makers desire, i.e., they are “upside-down.” The magnitude of this “upside-downness” depends upon the degree of progressivity of tax rates. Raising tax rates on high income earners will increase the “upside-downness” of deductions and exclusion. On the other hand, flat credits against tax liability will reduce the “upside-downness” of these incentives.|
Alternative Minimum Tax: In response to news stories about certain wealthy people who managed their financial affairs in such a way that they paid little or nothing in federal income tax, Congress enacted the alternative minimum tax (AMT) scheme. I.R.C. §§ 55-59. The basic scheme of the AMT is to require all taxpayers to compute their “regular tax” liability and their “alternative minimum tax liability.” They compute their AMT liability under rules that adjust taxable income upward by eliminating or reducing the tax benefits of certain expenditures or of deriving income from certain sources. They reduce the alternative minimum taxable income by a flat standard deduction that is subject to indexing. A (nearly) flat rate of tax applies to the balance. Taxpayer must pay the greater of her regular tax or AMT. Congress aimed the AMT at high-income persons who did not pay as much income tax as Congress thought they should.10
Credits against Tax Liability: A taxpayer may be entitled to one or more credits against her tax liability. The Code allows such credits because taxpayer has a certain status (e.g., low-income person with (or without) children who works), because taxpayer has spent money to purchase something that Congress wants to encourage taxpayers to spend money on (e.g., childcare), or both (e.g., low-income saver’s credit). The amount of the credit is some percentage of the amount spent; usually (but not always) that percentage is fixed.
|The Right Side Up Nature of Tax Credits: The effect of a tax credit equal to a certain percentage of an expenditure is precisely the same as a deduction of the expenditure from taxable income for a taxpayer whose marginal tax rate is the same as the percentage of the expenditure allowed as a credit. Thus, if Congress wants to encourage certain expenditures and wants to provide a greater incentive to low-income persons than to high-income persons, it can establish the percentage of the expenditure allowed as a credit at a level higher than the marginal tax bracket of a low-income taxpayer but lower than the marginal tax bracket of a high-income taxpayer, e.g., 14%. Such a credit will benefit a lower-income bracket taxpayer more than a deduction would and a higher-income taxpayer less than a deduction would. If this is what Congress desires, the effect of a tax credit is “right side up.”|
Income Phaseouts and Deduction Caps: When Congress wants to reduce the income tax liability of a lower-income taxpayer for having made a particular expenditure but not the income tax liability of a higher-income taxpayer who made the same expenditure, it may phase the benefit out as a taxpayer’s income increases. Congress may also limit (i.e., “cap”) the amount a taxpayer may deduct. An example of both a phaseout and a cap is § 219, the deduction for interest paid on “qualified education loans.” The maximum deduction for such interest is $2500. § 219(b)(1). Section 219(b)(2) reduces the cap by a percentage that increases as a taxpayer’s “modified adjusted gross income” increases above an amount indexed for inflation. When the percentage reaches 100%, taxpayer may not deduct any amount for paying qualified education loan interest. Consider: what is the profile of a taxpayer who would benefit most from deducibility of student loan interest and what is the profile of a taxpayer that would benefit least?
Congress can apply phaseouts and caps to both credits and deductions. The precise mechanics and income levels of various phaseouts and caps differ. Income phaseouts and caps increase the complexity of the Code and so also increase the cost of compliance and administration. They can make it very difficult for a taxpayer to know what her effective tax rate is – as any change in AGI or deductions effectively changes this rate. Income phaseouts are a tool of congressional compromise. Perhaps Congress is so willing to enact income phaseouts because there are many inexpensive tax preparation programs available to taxpayers that perform all necessary calculations.
A Word about Employment Taxes: “Employment taxes” are the social security tax and the medicare tax that we all pay on wages we receive from employers.11 Employers pay a like amount.12 Self-employed persons must pay the equivalent amounts as “self-employment” taxes. The Government collects approximately 32% of its tax revenues through these taxes – much more than it collects from corporate income taxes, gift taxes, estate taxes, and excise taxes combined. Eligibility to be a beneficiary of the social security program or medicare program does not turn on a person’s lack of wealth or need. The federal government collects a lot of money from working people so that all persons – rich and poor – can benefit from these programs.
The Internal Revenue Code appears at title 26 of the United States Code. It is the law that Congress passed and that the President signed (unless there was a veto over-ride). The first part of your statutory supplement includes some of these provisions. The second part of your statutory supplement includes some of the regulations that the Department of the Treasury has promulgated. These regulations construe the Code. The Code provisions appear in your supplement without any reference to title 26, e.g., “sec. 61.” Regulations are denoted as “Reg.” The regulations that we study begin with a “1,” followed by the Code section that they construe. Each regulation is numbered according to the sequence in which Treasury promulgated it. Reg. § 61-8 is the eighth regulation that Treasury promulgated that construes section 61.
We will be studying only certain portions of the Internal Revenue Code. You should learn the basic outline of Code provisions that establish the basic income tax. This will give you a good hunch of where to find the answer to particular questions. Some prominent research tools are organized according to the sections of the Code. Specifically –
§§ 1 and 11 establish rates;
§§ 21-54AA provide credits against tax liability;
§§ 55-59 establish the alternative minimum tax;
§§ 61-65 provide some key definitions concerning “gross income,” “adjusted gross income,” and “taxable income;”
§§ 67-68 provide rules limiting deductions;
§§ 72-91 require inclusion of specific items (or portions of them) in gross income;
§§ 101-139G state rules concerning exclusions from gross income;
§§ 141-149 establish rules governing state and local bonds whose interest is exempt from gross income;
§ 152 establishes entitlement to a credit for dependents;
§§ 161-199A establish rules governing deductions available both to individuals and corporations;
§§ 211-223 establish rules governing deductions available only to individuals;
§§ 241-250 establish rules governing deductions available only to corporations;
§§ 261-280H deny or limit deductions that might otherwise be available;
§§ 441-483 provide various rules of accounting, including timing of recognition of income and deductions;
§§ 1001-1021 provide rules governing the recognition of gain or loss on the disposition of property;
§§ 1031-1045 provide rules governing non-recognition of gain or loss upon the disposition of property, accompanied by a transfer and adjustment to basis;
§§ 1201-1260 provide rules for defining and calculating capital gains/losses;
§§ 1271-1288 provide rules for original issue discount.
These are (more than) the code sections that will be pertinent to this course. Obviously, there are many more code provisions that govern other transactions.
Any accession to wealth, no matter what its source, is (or can be) included in a taxpayer’s “gross income.” However, not all taxable income is taxed the same. Notably, long-term capital gains13 (or more accurately “net capital gain”) plus most dividend income of an individual is taxed at a lower rate than wage or salary income. Interest income derived from the bonds of state and local governments is not subject to any federal income tax. Certain other income derived from particular sources is subject to a marginal tax rate that is less than the tax rate applicable to so-called ordinary income. This encourages many taxpayers to obtain income from tax-favored sources and/or to try to change the character of income from ordinary to long-term capital gain income. The Code addresses some of these efforts.
Three Levels of Tax Law: Tax law will come at you at three levels. The emphasis on them in this course will hardly be equal. Nevertheless, you should be aware of them. They are –
(1) Statute and regulation reading, discernment of precise rules and their limits, application of these rules to specific situations;
(2) Discerning and evaluating the policies underlying various provisions of the Internal Revenue Code;
(3) Consideration of the role of an income tax in our society. What does it say about us that our government raises so much of its revenue through a personal income tax? Other countries rely more heavily on other sources of revenue. A personal income tax raises a certain amount of revenue. Some countries raise less revenue and provide their citizens (rich and poor alike) fewer services. Other countries (notably Scandinavian ones) raise more revenue and provide their citizens (rich and poor alike) with more services. The tax share of national income in the United States is about 30%; in Great Britain, it is about 40%; in Sweden, it is about 55%. Thomas Piketty, Capital in the Twenty-First Century 476 (2014). Moreover, the United States provides middle- and high-income persons with more services and benefits than most people realize.
Take this illustration one step at a time. You may not grasp all its details early in the semester. Its purpose is to show some of the Code’s “moving parts” and their inter-relatedness. We apply the rates that Congress enacted for 2018.
Bill and Mary are husband and wife. They have two children, Thomas who is 14 and Stephen who is 10. Bill works as a manager for a large retailer. Last year, he earned a salary of $80,000. His employer provided the family with health insurance that cost $14,000. Mary is a school administrator who earned a salary of $75,000. Her employer provided her a group term life insurance policy with a death benefit of $50,000; her employer paid $250 to provide her this benefit. Their respective employers deducted employment taxes from every paycheck and paid each of them the balance. In addition to the above items, Bill and Mary own stock in a large American corporation, and that corporation paid them a dividend of $500. Bill and Mary later sold that stock for $10,000; they had paid $8000 for it several years ago. Bill and Mary have a joint bank account that paid interest of $400. Bill and Mary paid $4300 for daycare for Stephen. They also paid $3000 of interest on a student loan that Bill took out when he was in college. What is Bill and Mary’s tax liability? Assume that they will file as married filing jointly.
How much are Bill’s employment taxes? How much are Mary’s employment taxes?
•Answer: Employment taxes are 6.2% for “social security” and 1.45% for “Medicare.” The total is 7.65%. The tax base of employment taxes is wages. So:
- Bill: Bill’s wages were $80,000. 7.65% of $60,000 = $6120.
- Mary: Mary’s wages were $75,000. 7.65% of $5,000 = $5737.50.
How much is Bill and Mary’s “gross income?” You should see that this is the first line of the tax formula. We need to determine what is included in, and what is excluded from, “gross income.” See §§ 61, 79, and 106.
•Answer: Since Bill and Mary will file jointly, we pool their relevant income figures. Notice that the employment taxes do not reduce Bill and Mary’s gross income. Thus, they must pay income taxes on at least some of the employment taxes that they have already paid.
•“Gross income,” § 61, is a topic that we take up in chapter 2. It encompasses all “accessions to wealth.” However, there are some “accessions to wealth” that we do not include in a taxpayer’s “gross income.” We consider some of those in chapter 3. The Code defines these exclusions in §§101 to 139G. The Code also defines the scope of certain inclusions in §§ 72 to 91 – and implicitly excludes what is outside the scope of those inclusions.
•Bill and Mary must include the following: Bill’s salary (§ 61(a)(1)) of $80,000; Mary’s salary (§ 61(a)(1)) of $75,000; dividend (§ 61(a)(7)) of $500; capital gain (§ 61(a)(3)) of $2000; interest income (§ 61(a)(4)) from the bank of $400. TOTAL: $157,900.
•Bill and Mary do not include the amount that Bill’s employer paid for the family’s health insurance (§ 106)(a)), $14,000, or the amount that Mary’s employer paid for her group term life insurance (§ 79(a)(1)), $250. Bill and Mary certainly benefitted from the $14,250 that their employers spent on their behalf, but §§ 106 and 79 provide that they do not have to count these amounts in their “gross income.”
How much is Bill and Mary’s adjusted gross income (AGI)? See §§ 221 and 62(a)(17).
•Section 221 entitles Bill and Mary to deduct interest on the repayment of a student loan. While the couple paid $3000 in student loan interest, § 221(b)(1) limits the deduction to $2500.
•Section 221(b)(2) requires the computation of a phasedown. Section 221(b)(2)(A) provides that the deductible amount must be reduced by an amount determined as per the rules of § 221(b)(2)(B). Section 221(a)(2)(B) establishes a ratio.
•Since Bill and Mary are married filing a joint return, § 221(a)(2)(B)(i) establishes a numerator of: $157,900 − $135,000 = $22,900. [For 2018, the amount $100,000 (§ 221(b)(2)(B)(II)) after indexing for inflation is $135,000. Rev. Proc. 2017-58, § 3.28.
- Section 221(b)(2)(B)(ii) establishes a denominator of $30,000.
- The ratio that § 221(b)(2)(B) prescribes is 0.763.
- Section 221(b)(2)(B) requires that we multiply this by the amount of the deduction otherwise allowable, i.e., $2500 and then reduce $2500 by the resulting amount. $2500 − $1907.50 = $592.50.
•Section 62(a)(17) provides that this amount is not included in taxpayers’ AGI.
•Thus: Bill and Mary’s AGI = $157,900 − $592.50 = $157,307.50.
How much is Bill and Mary’s “taxable income”? See § 63.
•Answer: Section 63(a and b) defines ‘taxable income” as EITHER “gross income” minus allowable deductions OR AGI minus a standard deduction.14
•We are told of no deductions that would be “itemized,” so Bill and Mary will elect to take the standard deduction.
•The standard deduction for taxpayers who are married and filing jointly is $24,000.
•Do the math: $157,307.50 MINUS $24,000 equals $133,307.50 of “taxable income.”
How much is Bill and Mary’s income tax liability? See §§ 1(a and h), 1222(3 and 11).
•Answer: Remember, not all income is taxed alike. Long-term capital gain and many dividends are taxed at a maximum rate of 20%. § 1(h)(1)(D) and § 1(h)(11). Bill and Mary received $2000 in long-term capital gain and $500 in dividends. Bill and Mary’s taxable income will not be greater than $479,000, so this portion of their taxable income will be taxed at the rate of 15%, i.e., $375.
•The tax on the balance of their taxable income will be computed using the tables at § 1(a) of the Code. $133,307.50 MINUS $2500 equals $130,807.50. Go to § 1(j)(2)(A). Bill and Mary’s taxable income is more than $77,400 and less than $165,000. Hence their federal income tax liability on their ordinary income equals $8907 PLUS 22% of ($133,307.50 − $77,400) = $8907 + $12,299.65 = $21,206.65.
•Do you see the progressiveness in the brackets?
•Total tax liability = $375 + $21,206.65 = $21,581.65.
Are Bill and Mary entitled to any credits? If so, what is the effect on their income tax liability? See §§ 21 and 24.
•Answer: Section 21 provides a credit on a portion of up to $3000 for the “dependent care” expenses for a “qualifying individual.” Stephen is a “qualifying individual,” § 21(b)(1)(A). Thomas is not a “qualifying individual,” but Bill and Mary did not spend any money for Thomas’s “dependent care.” The credit is 35% of the amount that Bill and Mary spent on such care that is subject to a phasedown of 1 percentage point for each $2000 of AGI by which Bill and Mary’s AGI exceeds $15,000, down to a minimum credit of 20%. § 21(a)(2). Bill and Mary may claim a tax credit for dependent care expenses of 20% of $3000, i.e., $600.
•Bill and Mary may also claim a “child tax credit” for each of their children. § 24(a). Both Thomas and Stephen are “qualifying” children. § 24(c)(1). Section 24(h)(2) provides a $2000 credit for each of the children. There will be no phasedown of the credit because Bill and Mary’s “modified adjusted gross income” does not exceed $400,000. § 24(h)(3). Total credit: $4000.
•Section 24(h)(4)(A) provides a credit of $500 for other dependents. Bill and Mary qualify as dependents. Total credit: $1000.
•Total tax credits = $600 + $4000 + $1000 = $5600.
•The effect of a tax credit is to reduce taxpayers’ tax liability – not their AGI or “taxable income.” $21,581.65 minus $5600 equals $15,981.65.
What is Bill and Mary’s effective income tax rate?
•Answer: Bill and Mary’s federal income tax liability is $15,981.65. Their effective tax rate computed with respect to their “adjusted gross income” is $15,981.65/$157,307.50, i.e., 10.16%.
- Notice that we could use a different income figure to determine their effective tax rate, e.g., “gross income,” “gross income plus exclusions,” “taxable income.” We have included employment taxes in this determination.
What is Bill and Mary’s marginal tax bracket?
•Answer: 22%. You should recognize this as the multiplier that we obtained from the tax table.
•Question: If Bill and Mary made a deductible contribution of $1, how much would this save them in federal income tax liability?
- 22% of the amount they contributed, i.e., $0.78.
•Question: If the neighbors paid Bill $10 for mowing their lawn, how much additional federal income tax liability would Bill and Mary incur?
- 22% of the additional income that Bill and Mary received, i.e., $2.20.
Think of the sources of tax law and their authoritative weight as a pyramid. As we move down the pyramid, the binding power of sources diminishes. Moreover, every source noted on the pyramid must be consistent with every source above it. Inconsistency with a higher source is a ground to challenge enforcement.
At the pinnacle of the pyramid is the United States Constitution. Every source of tax law below the Constitution must be consistent with it. Immediately below the Constitution is the Internal Revenue Code, enacted pursuant to the lawmaking authority of Congress. Courts may construe provisions of the Code. Depending on the level of the court and the geographic area (i.e., federal circuit) subject to its rulings, those decisions are binding constructions of the Code’s provisions.15 The IRS may announce that it does or does not acquiesce in the decision of a court other than the Supreme Court.
Immediately below the Code are regulations that the Secretary of the Treasury promulgates. These regulations are generally interpretive in nature. So long as these regulations are consistent with the Code16 and the Constitution, they are law. The same subsidiary rules of court construction of the Code apply to construction of regulations.
A revenue ruling is a statement of what the IRS believes the law to be on a certain point and how it intends to enforce the law. Since the tax liability of a taxpayer is (generally) the business of only the taxpayer and the IRS,17 this can be very valuable information. A revenue procedure is an IRS statement of how it intends to proceed when certain issues are presented. The IRS saves everyone the expenses of litigating such questions as whether an expenditure is “reasonable,” “substantial,” or “de minimis” in amount. Revenue rulings and revenue procedures are not law, and courts may choose to ignore them.
A private letter ruling is legal advice that the IRS gives to a private citizen upon request (and the fulfillment of other conditions). These rulings are binding on the IRS only with respect to the person or entity for whom the IRS has issued the letter ruling. Publication of these rulings is in a form where the party is not identifiable. While not binding on the IRS with respect to other parties, the IRS would hardly want to establish a pattern of inconsistency.
Other statements of the IRS’s position can take various forms, e.g., technical advice memoranda, notices. These statements are advisory only, but remember: the source of such advice is the only entity who can act or not act on it with respect to a taxpayer.
The United States has adopted an income tax code, and the discussion now zeroes in on the statute that Congress has adopted and the policy questions it raises.
Fairness and Equity: Issues of fairness as between those who must pay an income tax arise. If two taxpayers have equal incomes, a reduction in one taxpayer’s taxable income reduces that taxpayer’s taxes. If the government is to raise a certain amount of money through an income tax, a reduction in one taxpayer’s tax liability necessarily means that someone else’s taxes must increase. Thus reduction of some taxpayers’ tax liability is a matter of concern for everyone else. The government may choose to discriminate in its assessment of tax liability. The policy considerations that justify reducing one taxpayer’s tax liability but not another’s are the essence of tax policy.
Enforcement of the Tax Laws and Court Review: The IRS, a part of the Department of the Treasury, enforces the federal tax code. It follows various procedures in examining tax returns – and we leave that to a course on tax practice and procedure or to a tax clinic. When it is time to go to court because there is no resolution of a problem, a taxpayer has three choices:
1. Tax Court: The Tax Court is a specialized court comprised of nineteen judges. It sits in panels of three judges. There is no jury in Tax Court cases. Taxpayer does not have to pay the amount of tax in dispute to avail herself of court review in Tax Court. Appeals from Tax Court are to the United States Court of Appeals for the Circuit in which the taxpayer resides.
2. Court of Claims. The Court of Claims hears cases involving claims – other than tort claims – against the United States. It sits without a jury. Taxpayer must pay the disputed tax to avail herself of review by the Claims Court. Appeals from a decision of the Court of Claims are to the United States Court of Appeals for the Federal Circuit.
3. Federal District Court. Taxpayer may choose to pay the disputed tax and sue for a refund in the federal district court for the district in which she resides. Taxpayer is entitled to a jury, and this is often the driving motivation for going to federal district court. Appeals are to the United States Court of Appeals for the federal circuit of which the federal district court is a part.
Three Guiding Principles: This leads us to observe that there are three norms against which we measure income tax rules:
1. Horizontal equity: Taxpayers with equal accessions to wealth should pay the same amount of income tax. Like taxpayers should be taxed alike. Of course, we can argue about which taxpayers are truly alike.
2. Vertical equity: Taxpayers with different accessions to wealth should not pay the same amount of income tax. Unlike taxpayers should not be taxed alike. Those with more income should pay more and pay a higher percentage of their income in taxes. Income tax rates should be progressive.
3. Administrative feasibility: The tax system only applies to persons who have incomes. The rules should be easy to understand and to apply – for both the taxpayer and the collection agency, the Internal Revenue Service.
Tax Expenditures: Congress may choose not to make citizens pay income tax on receipt of certain benefits or on purchase of certain items. For example, an employee who receives up to $13,460 (inflation-adjusted amount for 2016) from an employer for “qualified adoption expenses” may exclude that amount – as adjusted for inflation and subject to a phaseout – from her “gross income.” § 137. A taxpayer who pays such expenses may claim a credit equal to the amount that she paid. § 36C. A taxpayer who benefits from either of these two provisions enjoys a reduction in the federal income tax that she otherwise have to pay. We can view that reduction as a government expenditure. In fact, we call it a “tax expenditure.” These two tax expenditures were expected to be $0.4B in tax year 2016. Cong. Res. Serv., Tax Expenditures: Compendium of Background Material on Individual Provisions 775 (2014). The tax expenditure for employer contributions for employee health care was expected to be $143.0B. Id. at 5. Total tax expenditures for tax year 2016 were expected to be $1481.8B. Id. at 10. A government expenditure of more than $1.4 trillion should be a matter of some policy concern. See Edward D. Kleinbard, We Are Better Than This: How Government should Spend Our Money 241-63 (2015) (“The hidden hand of government spending”).
The first two of these principles are corollaries, i.e., each is little more than a restatement of the other. Without taking up administrative feasibility, consider how closely we can come to defining the “income” that should be subject to an income tax so that compliance with the first two principles would require little more than establishing the progressive rates that would produce (an acceptable level of) vertical equity.18
We may think of “income” as the amount of money we receive for working at a job or for investing money that we have saved. However, if we wish to tax alike all taxpayers whose situations are alike, our notion of income must expand. Surely two workers whose wages are the same should not be regarded as like taxpayers if one of them wins $1M in the state’s lottery. The difference between these two taxpayers is that one has a much greater capacity to consume (i.e., to spend) and/or to save than the other. This suggests that pursuing the policies of horizontal and vertical equity requires that we not limit the concept of “income” to the fruits of labor or investment. Rather we should treat the concept of “income” as a function of both spending and saving.
Personal income may be defined as the algebraic sum of (1) the market value of rights exercised in consumption and (2) the change in the value of the store of property rights between the beginning and end of the period in question.19
The economist Henry Simons propounded this very important definition. Derivation of the same formula is also attributed to Georg von Schanz and to Robert Murray Haig. We may refer to this formula to as the Schanz-Haig-Simons formula, the Haig-Simons formula, or the SHS formula.
If Algebra or Economics Scare You –
The algebra inherent in the SHS formula is not as daunting as might appear. The phrase “rights exercised in consumption” merely reflects what a taxpayer spent (or would have spent if she received something for which she did not have to pay) to purchase something. The phrase “additions to the storehouse of property rights” merely reflects a taxpayer’s saving money, perhaps by depositing some of her income in a savings account or in a more sophisticated investment.
The SHS definition is in fact an (enormously convenient) “algebraic sum.” If it is true that:
(Income) = (Consumption) + (Additions to the store of property rights)
then it is equally true that
(Income) − (Additions to the store of property right) = (Consumption).
This point is quite useful to those who (believe that they) want the government to tax consumption rather than income, perhaps because they believe that those who save rather than spend will pay less in taxes than they do under the current system. Use of the algebraic quality of this definition means that no matter what our tax base is, we would never have to bear the expense or endure the inconvenience of keeping keep track of what we individually spend on consumption. Anyone who has received a W-2 from an employer or a 1099-INT from a bank knows that we can expect an employer or a bank to provide the pertinent information about wages or savings with an acceptable degree of accuracy. We already understand that the disposition of these funds is either going to be consumption or additions to saving. From this information, the amount a taxpayer can determine what she spent on consumption by manipulating the SHS formula as above. When a(n odd) question arises outside the ambit of W-2s or 1099s, e.g., whether a taxpayer should include in her taxable income the value of a meal that she does not have to purchase for herself, an affirmative answer requires no more than to add that value to “Consumption” which in turn increases the algebraic sum that is “Income.” Identifying an item of consumption, savings, or income will drive the others. Income, consumption, and savings are functions of each other.
Some Obvious or Not-so-Obvious Implications of the SHS Definition of “Income”
If we choose to tax what we spend and what we save, then in some manner we are taxing only increments to a taxpayer’s overall well-being. Our tax code demands an annual accounting and assessment even though this can be inconvenient – and even inaccurate – for some taxpayers. What happens during the year is treated as an increment to what happened before, e.g., we added to a savings account that we already had, we consumed (only) a small portion of an asset we already own. We are not taxing accumulated wealth – property taxes and estate taxes do that. A concept integral to our income tax is “basis,” and its function is to assure that our income tax does not tax accumulated wealth but only increments to it.
a. Taxing Income Is Taxing Consumption Plus Increments to the Power to Consume
Focus for now only on additions to “the store of property rights” that a taxpayer may accumulate during a relevant period and not on the consumption element of the SHS definition. Taxing a taxpayer’s increments to savings and investment is equivalent to taxing additions to taxpayer’s unexercised power to consume. Taxation of income is therefore the taxation of consumption and additional increments to the power to consume.
People save money only if they value future consumption more than current consumption and believe that they can spend their savings on future consumption. Imagine living in a country where inflation is so high that a single unit of the local currency now buys virtually nothing.20 The savings rate in such a country will not be very high because such savings will not buy anything for consumption in the future.
The Unit of Measurement of Income, Consumption, and Savings – USD: Inflation in the United States or elsewhere affects the relative value of savings held in different currencies. We measure taxable income by the currency of the United States, i.e., dollars. Similarly, we measure basis in assets by dollars. We assume that the value of a dollar does not change because of inflation. (We might alter the ranges of income subject to particular tax rates – i.e., to index – but we do not alter the number of dollars subject to income tax.) We do not adjust the amount of income subject to tax because the value of a dollar fluctuates against other of the world’s currencies. Instead, we require that transactions carried out in other currencies be valued in terms of dollars at the time of the relevant income-determinant events, i.e., purchase and sale.
The citizens of a country may manifest their lack of confidence in the future spending power of their savings by biasing their spending decisions towards current consumption or by choosing to hold their wealth in more stable but perhaps illiquid forms. After the fall of the Soviet Union, Russian citizens did not save very much money in banks but chose instead to consume (e.g., trips abroad) or to purchase items such as Sony television sets that do not lose value as quickly as savings and whose consumption could be spread over many years. Purchase of a Sony television set had elements of both consumption and saving. The property in which the spending power of savings was most stable after the demise of the Soviet Union was the flats that former Soviet citizens received.
b. Income, Consumption, and Value
The measure of value is what a person is willing to pay for something she does not have or the price at which a person is willing to sell something she does have. A person cannot value something more than what she can give in exchange. There are no truly “priceless” things. A person should pay no more than the value she places on an item she wants or sell an item for less than the value she places on it.21
Taxing Only the Creation of Value? Voluntary exchanges are often essential to the creation of the income that the Internal Revenue Code subjects to income tax. Arguably, the Code should not subject to tax the payoff from events that everyone understands (probably) reduce a taxpayer’s wealth, but this is not the case. Court-ordered damages that a plaintiff deems inadequate to compensate for the loss of an unpurchased intangible (e.g., emotional tranquility) may nevertheless be subject to income tax. See § 104(a).
In fact, buyers try to purchase items at prices less than they value them. The excess is “buyer surplus.” Sellers try to sell items at prices higher than those at which they are willing to sell them. The excess is “seller surplus.” “Buyer surplus” plus “seller surplus” equals “cooperative surplus.” The cooperative surplus that buyer and seller create may or may not be shared equally – in fact there is no way to determine with certainty how they share the surplus. Those buyers or sellers with more market power than their counterparts – perhaps they have a monopoly or a monopsony – may capture all or almost all the cooperative surplus. Nevertheless, every voluntary transaction should increase the overall wealth of the nation, i.e., the sum of the values we all place on what we have.
We assume that taxpayers who voluntarily enter transactions know best what will increase surplus value to themselves, and that the choices each taxpayer makes concerning what to buy and what to sell are no concern of any other taxpayer. The Internal Revenue Code, insofar as it taxes income, assumes that all taxpayers make purchasing choices with income that has already been subject to tax. Indeed, § 262(a) reflects this by denying deductions to taxpayers for purchases of items for personal consumption, including expenditures for basic living expenses. The statement that an expenditure is “personal” implies a legal conclusion concerning deductibility. If the money used to purchase items for personal consumption is subject to income tax, as a matter of policy the choices of any taxpayer with respect to such purchases should be unfettered. This observation supports not taxing the money taxpayer spends to make purchases that she has no option not to purchase.
Three Principles to Guide Us Through Every Question of Income Tax: There are three principles (which are less than rules but close enough):
1. We tax income of a taxpayer once and only once.
2. There are exceptions to Principle #1, but we usually must find those exceptions explicitly defined in the Code itself. We define exceptions with precision.
3. If there is an exception to Principle #1, we treat the untaxed income as if it had been taxed and we accomplish this by making appropriate adjustments to “basis.”
Know these principles.
On the seller’s side, we should not have a tax code that favors selling one type of good or service over another. Sellers should be encouraged to utilize their resources in whatever trade or business maximizes their own seller surplus, even illegal ones.22 This is good for buyers because sellers should choose to produce those things whose sale will create buyer surplus. A seller’s choice of which good or service to offer should not depend on the cost of producing or providing that good or service. A necessary implication of this is that we should tax only the net income of those engaged in a trade or business – not gross proceeds. Section 162 implements this policy by allowing a deduction for ordinary and necessary trade or business expenses. One engaged in a trade or business generates profits by consuming productive inputs, and the cost of those inputs should not be subject to tax. If a taxpayer’s trade or business consumes productive inputs only slowly, i.e., over the course of more than a year, principles of depreciation23 require the taxpayer to spread those costs over the longer period during which such consumption occurs. See, e.g., §§ 167 and 168. Those who engage in activities that cannot create value but which really amount to a zero-sum game, e.g., gambling, should not be permitted to reduce the income on which they pay income tax to less than zero. See § 165(d).24
An Observation about the Tax Cuts and Jobs Act: In December 2017, Congress made significant changes to the Code. It eliminated some deductions altogether, e.g., the deduction for alimony paid. It suspended for eight years several provisions, e.g., the deductions for “miscellaneous deductions” and for moving expenses. At the same time, it doubled the standard deduction. For example, the standard deduction for a married couple filing jointly doubled to $24,000. It also decreased the income tax brackets. The effect of these provisions will be to make many more taxpayers “choose” the standard deduction over itemization. For them – irrespective of what their marginal tax bracket is – the income tax code has become more neutral. For example, the Code will no longer encourage them to give more to charity or to spend more on a more expensive house. Those who can itemize will be those with higher incomes. To the extent that the Code influences their choices, their marketplace choices will have greater impact on the economy than the choices of those not driven by the Code. If Congress wishes to influence the purchasing choices of those who can claim only the standard deduction, it must either provide a credit or provide that an expenditure is an adjustment to gross income.
If the choices of buyers and sellers concerning what to buy and what to sell are matters of self-determination, then their choices should theoretically generate as much after-tax value as possible. A “neutral” tax code will tax all income alike, irrespective of how it is earned or spent. In theory, such “tax neutrality” distorts the free market the least and causes the economy to create the most value possible. We recognize (or will soon recognize) that the tax code that the nation’s policy-makers, i.e. Congress, have created is not neutral. Rather, we reward certain choices regarding purchase and sale by not taxing the income necessary for their purchase or by taxing less the income resulting from certain sales. Such deviations from neutrality cost the U.S. Treasury because they represent congressional choices to forego revenue and/or to increase the tax burden of other taxpayers who do not make the same purchase and sale choices. Such deviations take us into the realm of tax policy.
Deviations from neutrality can ripple through the economy. They cause over-production of some things that do not increase the nation’s wealth as much as the production of other things would. We tolerate such sacrifices in overall value because we believe that there are other benefits that override such foregone value. When deviations are limited to transactions between two parties who can negotiate the purchase and sale of an item or benefit only from each other, e.g., employer and employee, one party may be able to capture more of the cooperative surplus for itself than it otherwise might. An employer might provide a benefit (e.g., group health insurance) to its employees, reduce employee wages by what would be the before-income-tax cost of the benefit, and pocket all the tax savings. Such capture might be contrary to what Congress intended or anticipated.
Basis – Or Keeping Score with the Government
The Essence of Basis: Adjusted basis represents money that will not again be subject to income tax, usually because it is what remains after taxpayer already paid income tax on a greater sum of money. More pithily: basis is “money that has already been taxed” (and so can’t be taxed again).
If Congress chooses to allow a taxpayer to exclude the value of a benefit from her gross income, we must treat the benefit as if taxpayer had purchased it with after-tax cash. By doing so, we assure ourselves that the value of the benefit will not “again” be subject to tax. This means that taxpayer will include in her adjusted basis of any property received in such a manner the value of the benefit so excluded. If the amount excluded from gross income is not added to taxpayer’s basis, it will be subject to tax upon sale of the item. See, e.g., § 132(a)(2) (qualified employee discount). That is hardly an “exclusion.”
Section 61(a)(3) informs us that a taxpayer’s “gross income” includes gains derived from dealings in property. Intuitively, we know that a gain derived from a dealing in property is the price at which taxpayer sells property minus the price that she paid for the property. In the context of an income tax, why should we subtract anything to determine what income arises from gains derived from dealing in property? “It’s obvious” is not an answer. After all, in the case of a property tax, the tax authorities would not care what price the owner of property paid except as evidence of its current fair market value.
Section 1001(a) instructs us how to determine the measure of gains derived from dealing in property. Subtract “adjusted basis” from the “amount realized,” i.e., the amount of money and the fair market value of any property received in the transaction. Hence, a taxpayer’s adjusted basis in an item is not subject to income tax. The reason for this is that a taxpayer’s adjusted basis represents savings that remain from income that has already been taxed. The purchase of something from a taxpayer’s “store of property rights,” to the extent that it is not for consumption, represents only a change in the form in which taxpayer holds her wealth. It does not represent an additional increment to wealth and so does not fall within the SHS definition of “income.” It should never again be subject to income tax lest we violate the first of our guiding principles by taxing the income necessary to purchase the item twice.
Investment, Basis, Depreciation, and Adjustments to Basis. An investment in an income-producing asset represents merely a change in the form in which a taxpayer holds after-tax wealth. A change in the form in which taxpayer holds wealth is not a taxable event. We assure ourselves that the change is not taxed by assigning basis to the asset. When the investment is in an asset that will eventually but not immediately be used up in the production of other income, income-producing consumption and “de-investment” occur simultaneously. The income-producing consumption is deductible – as is all (or almost all) income-generating consumption (§ 162) – and so reduces taxable income. This expense of generating income is separately accounted for in whatever name as depreciation, amortization, or cost recovery. The accompanying de-investment requires a reduction in the adjusted basis of the income-producing asset.
Section 1012(a) tells us that a taxpayer’s “basis” in something is its cost. Tax-payer will pay for the item with money that was already subject to tax upon its addition to her store of property rights. Section 1011(a) tells us that “adjusted basis” is basis after adjustment. Section 1016 tells us to adjust basis upwards or downwards according to whether taxpayer converts more assets from her store of property rights in connection with the property (§ 1016(a)(1)), i.e., improves it; or consumes some of it in connection with her trade or business, or in connection with an activity engaged in for profit (i.e., depreciation (cost recovery) or amortization) (§ 1016(a)(2)). The upshot of all this is that adjusted basis represents the current score in the game between taxpayer and the Government of what wealth has already been subject to tax and so should not be subject to tax again.
SHS Accounting for Spending Savings
Another implication of the SHS conception of income is that we might have to follow the money into or out of taxpayer’s store of property rights and/or her expenditures on consumption. If a taxpayer takes money from savings and spends it on instant gratification so that she acquires no asset in which she has an adjusted basis, intuitively we know that she does not have any income on which she must pay income tax. The SHS definition of income accounts for this by an off-setting decrease to taxpayer’s store of property rights and increase in rights exercised in consumption.
|The Relationship Between Basis and Deductions from Taxable Income. An important point concerning the fact that adjusted basis is income that has already been subject to tax is that deductions, i.e., reductions in taxable income allowed to the taxpayer because taxpayer spent income in some specified way, are only allowed if taxpayer has a tax basis in them. Section 170 permits a deduction of contributions made to charitable organizations. But: a charitable deduction only reduces the taxable income in which taxpayer has adjusted basis. This explains why the taxpayer may deduct the costs of transportation to get herself to the place where she renders services to a charity, but not the value of her services for which the charity pays her nothing. Presumably taxpayer incurred the costs of transportation from after-tax income, but paid no income tax on the income she did not receive.|
A taxpayer who borrows money may use the funds so borrowed either to exercise a right of consumption or to increase her store of property rights. In either case, SHS might provide that taxpayer has realized income. However, an obligation to repay accompanies any loan. This obligation counts as a decrease in taxpayer’s store of property rights. Hence, the addition to income is precisely offset by this decrease in the value of taxpayer’s store of property rights. Incidentally, the Code nowhere states that loan proceeds are not included in a taxpayer’s gross income.
AND: taxpayer may use loan proceeds to purchase an item for which she is credited with basis, just as if she had paid tax on the income used to make the purchase. Doesn’t this seem to violate the first principle of income taxation noted above? No. Taxpayer will repay the loan from future income that will be subject to tax. Taxpayer pays for her basis with money to be earned and taxed in the future. Repayment of loan principal is never deductible. Sometimes the cost of borrowing, i.e., interest, is deductible.
Building a Stronger Economy: Not taxing loan proceeds but permitting a taxpayer to use loan proceeds to acquire basis has tremendous implications for economic growth, long ago taken for granted. However, countries where credit is scarce have low growth rates. Not taxing loan proceeds until the time of repayment decreases the cost of borrowing. Basic rule of economics: When the cost of something goes down, people buy more. When the cost of borrowing money goes down, they borrow more; they invest what they borrow (or use it to make purchases for consumption); the economy grows.
In the pages ahead, we examine various topics concerning income tax. In all cases, keep in mind how they fit into the principles described in this chapter. Hopefully, the text will provide enough reminders to make this a relatively easy task.
Wrap-up Questions for Chapter 1
1. A major issue in recent presidential campaigns has been whether the income tax on high income earners should be increased. Can you think of any standard by which to determine the appropriate level of progressivity in the Code?
2. The more progressive the Code, the greater the “upside-downness” of deductions. How might this be a good thing? What would be the advantage of granting tax credits instead of deductions or exclusions?
3. What are phaseouts? Why would Congress enact them? How do they affect a taxpayer’s effective tax rate?
4. Taxpayer received a tax-free benefit, perhaps a gift from a company that wanted to increase its business. Why must taxpayer have a fmv basis in the item?
5. If taxpayer receives a benefit but has no choice regarding its consumption – the manager of a lighthouse must live with his family in the lighthouse – should taxpayer be taxed on the value of the benefit? Why or why not?
6. Taxpayer owned some commercial property. Taxpayer recorded the property on its corporate books at a certain value. Over the course of several years, the value of the property fluctuated up and down. Taxpayer did not pay income tax on the increase in the property’s value. Why should taxpayer not be permitted to deduct decreases in the property’s value?
What have you learned?
Can you explain or define –
- tax base, deductions, exclusions, income phaseouts
- tax formula, credit against tax
- progressive tax rates
- marginal tax rates
- upside-down nature of deductions and exclusion
- right-side up nature of tax credits
- employment taxes
- the Tax Code, regulations, revenue rulings, revenue procedures, private letter rulings
- tax disputes and the Tax Court, the Court of Claims, and the Federal District Court
- tax norms of horizontal equity, vertical equity, and administrative feasibility
- Schanz-Haig-Simons definition of income and its elements
- three guiding principles of the income tax
- tax expenditures
- income tax treatment of personal expenditures
- tax neutrality, distortion
- tax treatment of loans
Of course, state legislatures may carve out exceptions. Purchases of food might be subject to a sales tax that is lower than for other goods. Purchases of services might not be subject to a sales tax. Online pur-chases from out-of-state sellers who have no physical presence within a state are not (yet) subject to sales taxes. See Quill v. North Dakota, 504 U.S. 298 (1992).
- 2 Taxpayers who are married filing jointly are subject to this tax to the extent their wages or self-employment income exceed $250,000. Taxpayers who are married filing separately are subject to this tax to the extent their wages exceed one-half that amount. All other taxpayers are subject to this tax to the extent their wages exceed $200,000. I.R.C. §§ 3101(b)(2), 1401(b)(2). Moreover, an individual is subject to a 3.8% Medicare tax on her “net investment income” to the extent her modified AGI (adjusted gross income) exceeds a threshold amount. I.R.C. § 1411(a). The threshold amount is $250,000 for taxpayers who are married filing jointly, one-half that amount for taxpayers who are married filing separately, and $200,000 for all others. I.R.C. § 1411(b).
Self-employed taxpayers must pay both halves of these taxes. See § 1401.
This figure is derived from the accompanying table, SOI Tax Stats at a Glance. The portion of total tax revenues derived from corporate income taxes is 11.9%, from employment taxes (Social Security and Medicare) 31.3%, from excise taxes 2.4%, from gift taxes 0.1%, and from estate taxes 0.5%. Do these percentages surprise you?
- 5 Your author had a double major as an undergraduate – Political Science and the Far Eastern & Russian Institute. His LL.M. is not in tax law. He learned income tax law the same way you are going to: by read-ing the Code, studying texts, and talking to people.
- 6 We refer to this phenomenon as the declining marginal utility of money.
- 7 Constitutional scholars have observed that the phrase “direct taxes” (see Art. I, § 9, cl. 4 of U.S. Constitu-tion) refers to taxes whose burden cannot be transferred to another, e.g., head taxes. Implicitly, “indirect taxes” are taxes whose burden can be transferred to another, e.g., excise taxes. The point at which a transferee is not willing to pay the “indirect tax” constitutes a practical limit on congressional power to increase such taxes.
See William P. Kratzke, The (Im)Balance of Externalities in Employment-Based Exclusions from Gross Income, 60 THE TAX LAWYER 1 (2006).
See William P. Kratzke, Tax Subsidies, Third-Party Payments, and Cross-Subsidization: America’s Distorted Health Care Markets, 40 U. MEM. L. REV. 279, 311-12 (2009) (tax subsidized health insurance makes more money available to health care providers).
- 10 We will not spend any more time on the AMT. You should be aware that it exists and of its basic approach to addressing a particular (perceived) problem.
- 11 26 U.S.C. § 3101(a) (for “Old-Age, Survivors, and Disability Insurance;” 6.2%); 26 U.S.C. § 3101(b) (for “Hospital Insurance;” 1.45% and 2.35% for amounts over a certain threshold).
- 12 26 U.S.C. § 3111(a) (for “Old-Age, Survivors, and Disability Insurance;” 6.2%); 26 U.S.C. § 3111(b) (for “Hospital Insurance;” 1.45%).
- 13 That is, gain on the sale of property that a taxpayer owns for more than one year.
- 14 Section 63(b) provides for a reduction of taxable income by personal exemptions and of the deduction provided in § 199A. The personal exemption deduction has been suspended, and § 199A provides a deduction for certain pass-through entities. We leave these aside for purposes of this illustration.
See Marbury v Madison, 5 U.S. 137, 177 (duty of courts to say what the law is and to expound and interpret it). In other countries, court constructions of a code are persuasive authority only. The Code still prevails in such countries over court pronouncements insofar as they might guide persons other than parties to a particular case.
In Mayo Found. for Med. Educ. and Res. v. U.S., 562 U.S. 44 (2011) the Supreme Court held that reviewing courts should give Chevron deference when passing upon the validity of Treasury Department (i.e., IRS) regulations. 562 U.S. at 55-56 (upholding regulation providing that employee normally scheduled to work 40 or more hours per week does not perform such work incident to and pursuant to course of study; employer not exempt from paying employment taxes). Chevron, U.S.A. Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984) established a two-part framework by which courts determine whether to defer to administrative rulemaking: (1) Has Congress addressed the precise question at issue? If not: (2) Is the agency rule “arbitrary or capricious in substance, or manifestly contrary to the statute.” If not, then the reviewing court is to defer to the agency rule. 562 U.S. at 52-53. In King v. Burwell, ___ U.S. ___, ___ S. Ct. ___ (2015), the Court refused to defer to the IRS on the question whether the tax credits of 26 U.S.C. § 36B were available to those who purchased health insurance through federal exchanges rather through than state exchanges. An IRS regulation said “yes.” The Court nevertheless made its own determination because this was an extraordinary case.
The tax credits are among the Act’s key reforms, involving billions of dollars in spending each year and affecting the price of health insurance for millions of people. Whether those credits are available on Federal Exchanges is thus a question of deep “economic and political significance” that is central to this statutory scheme; had Congress wished to assign that question to an agency, it surely would have done so expressly.
Slip opinion at 8.
See Simon v. Eastern Kentucky Welfare Rights Organization, 426 U.S. 26, 40-45 (1976) (taxpayer unable to show that tax benefit given to other taxpayers caused injury to itself that any court-ordered relief would remedy).
See Boris I. Bittker, A “Comprehensive Tax Base” as a Goal of Income Tax Reform, 80 HARV. L. REV. 925, 934 (1967) (arguing that many of the changes necessary to create truly comprehensive tax base would be unac-ceptable).
- 19 Henry C. Simons, Personal Income Taxation 50 (1937).
- 20 The Zimbabwean dollar once fit this description.
- 21 A person tends to value what she already has more than what she does not have.
The only exception to this principle is the trade or business of trafficking in certain controlled substanc-es. See § 280E.
- 23 ... or amortization or cost recovery.
- 24 But see Commissioner v. Groetzinger, 480 U.S. 23 (1987) (full-time gambler who makes wagers solely for his own account is engaged in a “trade or business” within meaning of § 162).