Introduction to Tax Law and Policy: Outline Income Tax and the Concept of Income Haig-Simons Definition; Tax Base; Tax Enforcement; Fringe Benefits; Illegal Income; Imputed Income Glenshaw Glass Capital Gains and the Realization Doctrine Eisner v. Macomber Knetsch Tax Avoidance and Tax Shelters 1 The Income Tax: History In the 19th century, the main source of revenue for the US Federal government was from tariffs on imports Exception: income tax during the Civil War How efficient do you think tariffs were? 1894: Congress enacted an income tax (2% on income &gt; $4000) 2 The Income Tax: History 1895: Supreme Court struck down the income tax Violated the constitutional requirement that &quot;direct&quot; taxes be apportioned among the states in proportion to their population &quot;The Congress shall have the power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States . . . 3 1913: Sixteenth Amendment adopted: The Income Tax: History 1913: Congress enacts an income tax similar to that of 1894 1% on income over $3000 for individuals, or $4000 for married couples, plus &quot;surtax&quot; WWI: rates increased to a maximum of 77%; but, reduced after the war WWII: income tax expanded to cover most households (&quot;mass tax&quot;) 4 The Concept of Income What is the notion of &quot;income&quot; that the income tax taxes? Net income (accounting concept): Receipts Costs &quot;Taxable Income&quot; is defined by statute: 5 Section 61(a) General definition Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items: (1) Compensation for services, including fees, commissions, fringe benefits, and similar items; (2) Gross income derived from business; (3) Gains derived from dealings in property; (4) Interest; (5) Rents; 6 Section 61(a) (6) Royalties; (7) Dividends; (8) Alimony and separate maintenance payments; (9) Annuities; (10) Income from life insurance and endowment contracts; (11) Pensions; (12) Income from discharge of indebtedness; (13) Distributive share of partnership gross income; (14) Income in respect of a decedent; and (15) Income from an interest in an estate or trust. 7 The Concept of Income What is taxable income? &quot;Whatever the Internal Revenue Code is authoritatively interpreted to say that it is&quot; Sources of Tax Law: Statute Courts IRS Regulations 8 Haig-Simons Definition Income = Consumption + Net Increase in Wealth This defines the tax base for a given time period (e.g. one year) Income = &quot;power to consume&quot; i.e. net increases in wealth are included in &quot;income&quot; because they could have been used for consumption 9 Haig-Simons Definition Income = Consumption + Net Increase in Wealth Requires that the government be able to measure &quot;net increase in wealth&quot; Suppose you own a painting; under H-S, any increase or decrease in its value (i.e. what others are willing to pay to buy it) should be included in &quot;income&quot; whether or not you sell it 10 Income v. Consumption Taxation Income = Consumption + Net Increase in Wealth A &quot;consumption tax&quot; is any tax that has consumption as its base In effect, a consumption tax abandons the effort to measure and tax changes in wealth Restricts the tax base to actual, not potential, consumption 11 Income v. Consumption Taxation Tax Base = Consumption + Net Increase in Wealth 12 Income v. Consumption Taxation Tax Base = Consumption 13 Deductions The income tax system allows taxpayers to deduct certain expenses, including: Interest payments (for individuals, this is primarily restricted to mortgage interest) <a href="/keyword/charitable-donations/" >charitable donations</a> (to IRS-recognized charities); but, there are limits (generally, 50% of income) Extraordinary medical expenses (&gt; 7.5% of income) 14 Benefits Alice is a computer programmer who works for Unitech. Unitech pays her a salary of $10,000 a month, and she pays $1000 a month in rent for her apartment Now, suppose that Unitech decides to pay her rent directly (reducing her salary to $9000 a month) Should this affect her (taxable) income? 15 Benefits In general, noncash benefits are taxable However, there is an exception for employer-provided health insurance 16 Benefits A subsidy to employees, not employers Compensation received by an employee in the form of health insurance is exempt from taxation Thus, compensation in the form of health insurance is tax-favored 17 Illegal Income Emma is a bank officer who embezzles $100,000 from her employer in 2007 Should this constitute (taxable) income? Why or why not? Emma uses the money to bet on the Rose Bowl. She wins and replaces the money in 2008 18 Illegal Income Later that year, the bank discovers the theft and fires Emma. At this point, Emma has spent all her winnings, and has no other income or wealth Suppose Emma faced a 35% tax rate in 2007; how much of the returned money can the bank keep? 19 Scenario: Home Run Ball Does Adam's &quot;power to consume&quot; increase when he catches the ball? Does this depend on whether he sells the ball in 2008 or keeps it? If your employer gave you an Ellsworth Kelly painting instead of a cash salary, should it be taxable? Does this depend on whether you sell the painting? 20 Scenario: Home Run Ball Suppose Adam keeps the ball until 2009 and sells it for $1.5 million; does the ball's $0.5 million appreciation (increase in value) from 2008 to 2009 increase Adam's &quot;power to consume&quot;? 21 Scenario: Home Run Ball Suppose Adam gives the ball to Griffey: Note: gifts are generally not deductible to the donor What if Adam donates the ball to Habitat for Humanity, a charitable organization? Note: <a href="/keyword/charitable-donations/" >charitable donations</a> (to IRSrecognized charities) are deductible But, there are limits (generally, 50% of income) 22 Scenario: Home Run Ball Suppose Adam gives the ball to Griffey: Does Griffey have taxable income? Note: gifts are generally not treated as taxable income to the recipient What if Griffey sells the ball in 2008 for $1 million? What if Griffey sells the ball in 2009 for $1.5 million? 23