CHAPTER I
INTRODUCTION AND THE REALIZATION REQUIREMENT
On January 2, 1993, Jones purchases a ten acre lot for
$20,000. In the middle of 1994, a decision is made to build a
superhighway near Jones's land, and the value of the land
increases to $50,000. On January 2, 1995, Jones sells the land
to Smith. Pursuant to the agreement of sale, Smith pays Jones
$50,000 in complete payment for the land.
A.
Introduction to the Income Tax
In order to pay its bills, the Federal government relies predominantly on
an income tax. These materials will acquaint you with the basic elements of
the income tax. You probably are already aware that certain payments received
by a taxpayer are income to the taxpayer under the tax law, and that certain
payments made by a taxpayer are allowed as deductions in calculating the
income on which a person is taxed. We will be spending much time this
semester identifying items of income and deduction.
It may be less obvious at first, but deciding which items are income and
which are proper deductions will not always end our inquiry. It is often more
important to know when an item is recognized as income and when it can be
deducted. These materials will focus on that question as well and will try to
clarify why it is important.
Finally, there is a logic to the tax law, to the way different parts of the
law fit together. I hope that some of that logic will become apparent as the
course progresses.
B.
General Definitions of Income
Let us turn our attention to the Jones example above. Does Jones have
income in this example? How you react to that question depends on what you
think "income" is. Naturally, you expect that the definition of income will be
one of the things that this course (and these materials) will help you to
understand--if you already knew what it was, why bother to take the course?
In this course, you will be learning what income is for purposes of the
Internal Revenue Code. However, we will spend the next couple of pages on
some general musings about the definition of income. The time spent
understanding how economists define income is not time misspent. Although
there is controversy surrounding the "perfect" definition of income, you will
2
Principles of Income Taxation
Ch. I
understand what goes on in this course better if you have a coherent concept of
what income is. That way, you can compare the actual rules to that concept.
We start with the Code's1 general definition of income in section 61:
Except as otherwise provided in this subtitle, gross income
means all income from whatever source derived, including (but not
limited to) the following items:
(1) Compensation for services, including
commissions, fringe benefits, and similar items;
fees,
(2) Gross income derived from business;
(3) Gains derived from dealings in property;
(4) Interest;
(5) Rents;
(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.
Considering this Code section, it appears that Jones may have derived
some "gains . . . from dealings in property." How much gain has Jones
1It should not come as a total surprise to learn that, when we speak of a generic
"Code" in this course, we are referring to the Internal Revenue Code.
Ch. I
The Realization Requirement
3
derived? The obvious2 answer is $30,000: Jones invested $20,000 in the
property and received $50,000 -- $30,000 more -- in return.
But when has Jones earned that income? Consider this classic definition
of income by the economist Henry Simons, Henrydefinition of income
"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."
H. Simons, Personal Income Taxation.
It may help you to understand Simons' definition to consider how a few
fact patterns would be treated under its standard. Remember that Simons
defines income as the sum of consumption (that's item (1) in his definition) and
changes in net worth (that's item (2)--net worth is the difference between the
value of what you own and your debts3).
T "earns" $10,000, saves $2,000 and spends $8,000. $8,000 of
consumption and $2,000 increased net worth mean $10,000 of income.
T "earns" $10,000 and spends $11,000. $11,000 of consumption and
$1,000 decrease in net worth mean income of $10,000. (Note: the
$1,000 of consumption in excess of earnings could come from savings
or a loan -- either way, it reduces net worth.)
T "earns" $10,000, spends $6,000, saves $3,000, and gives a $1,000
gift. There is at least $6,000 of consumption and $3,000 increase in net
worth. But, should we treat the giving of a gift as consumption for this
purpose? Under current law, if the gift is given to a "charity," the
taxpayer may be able to deduct it from income, thus ending up with
only $9,000 of income. Otherwise, the taxpayer would get no deduction
and would have $10,000 of income. Under Simons' definition, the
question is whether the gift is consumption.
2The obvious answer is not necessarily correct. See the discussion of the treatment of
inflation, and the discussion of the "double taxation" of income from property, at the
beginning of Chapter XII.
3There is a subtlety here that is worth noting even at this early date. In figuring what
you own, you must calculate values. But, on the liability side of the ledger, you look only to
the amount of the liabilities. If you owe $10,000, it will affect your net worth the same way
whether you pay 6% interest or 10% interest on the loan. In Chapter X we will consider more
carefully the nature of debt obligations.
4
Principles of Income Taxation
Ch. I
T earns $10,000, receives a gift of $5,000, spends $13,000 and saves
$2,000. Under Simons' definition, there is $13,000 of consumption and
$2,000 increase in net worth, resulting in $15,000 of income. Under
current law, the receipt of a gift is not income pursuant to section 102 of
the Code, and T would have only $10,000 of income.
T spends $5,000 to take potential clients to the Super Bowl. After the
game, the clients give T orders that produce $8,000 of profit for T. T's
net worth increases $3,000, but is all or part of the $5,000 treated as
consumption? Business expenses are not treated as consumption by
Simons, but we must examine the nature of the expenditures to know
whether they are "consumption." A similar question must be asked
under our income tax, as we will see before this course is over.
Simons' rather broad definition does not necessarily tell us what should
be taxed under our income tax system. Its breadth is typical of economists'
views of the definition of income. Judge has the following definition of
income, which is even broader than Simons'.
"The broadest definition of income would be all pecuniary and nonpecuniary
receipts, including not only leisure and (other) nonpecuniary income from
household production but also gifts, bequests, and prizes."
R. Posner, Economic Analysis of Law 463 (3d ed. 1986)
It seems that economists think Jones has income when the value of
Jones' land increases. Can you imagine that the tax law would tax people when
the value of their assets increases, before they have sold the assets?4
C.
The Policy of an Income Tax and Alternatives to It
Let us think a little about why we have an income tax, and what the
alternatives to an income tax might be. The government does not collect
money from taxes, add it up, and then decide how to spend it. Although the
actual process, with its political overtones, is far from simple, it is at least
closer to the truth to imagine that the government decides in one process how
much it is going to spend over the course of the coming year, how much it is
going to borrow, and how much it needs to collect in taxes. It then must also
4It may help you to deal with other "rhetorical" questions in the text to know that the
author has written a long article trying to answer "yes" to this question. See Shakow,
"Taxation without Realization: A Proposal for Accrual Taxation," 134 U. Pa. L.Rev. 1111
(1986).
Ch. I
The Realization Requirement
5
decide how much to collect from each person subject to tax.5 How should the
government make that decision?
The standard answer to this question, as with all policy-tinged tax
issues, is that it should consider three factors: equity, efficiency, and
administrability. Unfortunately, these factors are not easy to apply, but they
can suggest approaches to tax policy issues.
1. Equity
We ask first what tax system most fairly allocates the tax burden among
those who could be taxed. A number of possible tax systems present
themselves for evaluation:
-- this is a tax of a certain dollar amount that is exacted from everyone.
-- people are taxed based on the value of what they own. Local property taxes
in the United States (where owners of property are taxed at a fixed rate,
for example $1 for every $1,000 of assessed valuation) are wealth taxes
applied to real estate or other limited categories of wealth. In theory, a
wealth tax could be applied to all forms of wealth, although it might be
difficult to value many items people own.
-- people are taxed based on the amount that they spend on consumption -food, lodging, entertainment, etc. A sales tax (or a value added tax) is a
type of consumption tax. It is usually a proportional tax -- the same tax
rate is applied to all purchases that are subject to the tax. However, a
consumption tax could be applied to all forms of consumption, and a
higher rate of tax could be applied to higher levels of consumption.
Under such a tax, taxpayers would fill out a consumption tax return and
could be taxed in a manner similar to our income tax, with its
progressive6 rate structure.
5The text assumes we know who is subject to tax, but the question of who should be
taxed is not a trivial one. The United States taxes all its citizens, even those who are not living
in this country, and it taxes them on all their income, whether earned in the United States or
abroad. It also taxes many foreigners depending on their contacts with the United States. The
decision to tax United States citizens on all their income, wherever earned, is not self-evident,
and many other countries choose to tax persons only on income earned in that country.
6There is more than one way to measure whether a tax is "progressive." For our
purposes, we will say that a tax is progressive if those who are "better off" pay a higher
percentage tax than those who are less well off. For example, in the case of a consumption
tax, a person who consumed $10,000 in a year might pay 10% of that amount in taxes, while
someone who consumed $20,000 might pay 12%. However, no matter how progressive (or
proportional) the table of tax rates looks, the actual progressivity of the system can be
substantially influenced by the base to which the rates are applied. Consider the likely effects
6
Principles of Income Taxation
Ch. I
-- a tax is imposed on transfers of property, sometimes limited to transfers
outside a commercial context. Gift and estate taxes are examples of
such taxes. A parent who gives substantial gifts to a child may ba
required to fill out a tax return showing the value of the gifts, and to pay
a tax which is a function of that value. Other examples of transfer taxes
are real property and automobile transfer taxes that are imposed when
title to real estate or automobiles changes.
-- this is a selective consumption tax that applies only to certain expenditures.
Special taxes on cigarettes and liquor are examples of such taxes. So
are taxes on gasoline.
-- this is another form of selective tax, but it applies to goods or services that
are used by those who pay the tax. It is generally imposed in lieu of a
sales tax when a sale took place outside the jurisdiction imposing the
tax. For example, many states collect a use tax on automobiles
registered in the state when the automobile was purchased out-of-state.
-- this tax is imposed on users of a particular property or service. For example,
the Federal gasoline tax, although it might be called an excise tax, could
be viewed as a users tax to pay for the use of interstate highways.
-- this tax is based on the income one earns.
-- this tax is based on one category of income that persons earn, wages, and is
often imposed without reference to any expenses that the taxpayers may
incur.
A head tax could appear equitable if we feel that government supplies
the same services to all of its citizens. National defense might be viewed as an
example of such services. To consider a head tax equitable, we would also
have to conclude that each citizen should pay only for the benefit he or she gets
from society.
A wealth tax can be justified if we think that citizens benefit more from
government the greater the value of the property they own. It can be justified
independently if we think that citizens should support the government based on
their ability to pay taxes, and if we think that wealth is the best measure of
ability to pay. Note that the wealth tax need not be proportional: people with
greater wealth might be required to pay a higher percentage of their wealth as
tax than others.
of a flat 10% sales tax applied only to caviar and polo ponies compared to one applied only to
bowling and beer. The progressivity of our current system is considered briefly at the
beginning of Chapter V.
Ch. I
The Realization Requirement
7
A consumption tax is based on the idea that what people derive from
society can be measured by the goods of society that they consume. Savings
are excluded from the tax base because they reflect a decision by the taxpayer
to leave resources for productive use by society. The same percentage tax need
not be levied on everyone: taxpayers may be required to pay increasingly
greater percentages of their consumption in taxes as their consumption
increases. However, when the consumption tax takes the form of a sales tax,
much of the ability to levy the tax at different rates is lost. The only fairness
that can be added to a sales tax is the ability to exclude certain consumption
items (for example food, or just bread) from the base, and to levy the tax at
different rates on different items (for example, a higher rate of tax on fur coats
than on other clothing).
A transfer tax may be viewed as a wealth tax that is administratively
convenient and that has certain additional benefits. Both individuals and the
government may have independent reasons to want a record maintained of the
ownership of land and automobiles, for example, and the time of transfer is
likely to be an easy time to determine the value of the item transferred. When
compared to a wealth tax, a transfer tax is more likely to be justified on
administrative grounds than on grounds of equity. While guaranteeing the
validity of a transfer, and maintaining a record of it, are benefits supplied by
the government (particularly important in the case of land transfers, for
example), they do not justify the amount of the transfer tax. Moreover, they
are not likely to justify other categories of transfer taxes: estate and gift taxes.
To the extent an excise tax is often imposed on items that are viewed as
luxuries (such as theater tickets), they may be considered equitable for reasons
similar to those used to justify a wealth tax, although the arguments are not as
strong. Some excise taxes are imposed on items that are viewed as having
some moral weakness attached to them (such as tobacco and liquor), and those
taxes may be justified as attacks on the impropriety of the item in question. In
fact, excise taxes often remain on the books because it is convenient to collect
them. The Federal government had many excise taxes before 1966, when the
bulk of them were repealed. In 1990 Congress imposed a new excise tax on
the cost of certain luxury items above a specified threshold (for example, on the
price of cars in excess of $30,000).
Many jurisdictions have use taxes that operate in a fashion that is
parallel to the sales tax of that jurisdiction, but that applies to assets bought
outside of the jurisdiction and used in the jurisdiction. In practice, the use tax
generally is enforced only selectively. It is most commonly applied to
automobiles that have to be registered in the state of their owner's residence.
A users tax is like a fee for a service provided by the government. It is
therefore generally very fair standing alone, but does not serve as a general
revenue raising tax.
8
Principles of Income Taxation
Ch. I
The income tax is justified on the basis that it collects taxes from those
who are both able to pay and are likely to be getting benefits roughly
proportional to their incomes. While the income tax and the wealth tax have
similar justifications, the income tax is preferred to the extent that income is
easier to measure than wealth. Note that the choice between a wealth tax and
an income tax has a significant effect on the relative burden of the tax on
taxpayers in different age groups. An income tax will be relatively more
burdensome to young people with families, since they are likely to spend much
of their income on consumption items and won't increase their wealth
substantially. A wealth tax will impose a relatively greater burden on older
persons living on fixed incomes.
A wage tax can be justified for reasons similar to those supporting an
income tax, but its generally simpler structure may make it less equitable in its
application. The Social Security tax is imposed as a wage tax, with the added
bonus that it is a regressive7 tax: since the flat percentage Social Security tax is
imposed only up to a certain wage level, persons earning more than that
amount find that they pay a smaller percentage of their wages in Social
Security taxes than do those who earn less.8
2. Efficiency
The second basis for evaluating a tax provision is efficiency. To what
extent will the rule cause taxpayers to change their behavior from the
7A tax is regressive if those who are better off pay a lower percentage tax than those
who are less well off. For example, a tax of 5% on the first $10,000 of consumption, and 1%
on all consumption above $10,000, would be a regressive consumption tax. The Social
Security tax is a flat tax on all earnings up to a fixed amount. Earnings above that amount are
not taxed.
8To take a simple case, suppose a 10% Social Security tax is collected on the first
$50,000 of wages. Anyone earning up to $50,000 in wages pays a 10% Social Security tax.
However, someone who earns $100,000 pays only 10% of $50,000, or $5,000, which is just
5% of that person's wages.
While we spend little time in these materials on Social Security taxes, their
significnace should not be slighted. Social insurance taxes and contributions were 37.9% of
all Federal receipts in 1992. The Individual income tax was 43.6% of all receipts and the
corporate income tax was another 9.2%. House Committee on Ways and Means, Overview of
the Federal Tax System 253 (1993).
Some readers may be troubled by the inclusion of Social Security taxes in this
discussion, since the "tax" that is paid can be viewed as an investment in a pension. If you
feel that way, try asking your contracts teacher whether you will be able to enforce the
Government's obligation to pay that pension when it comes due.
Ch. I
The Realization Requirement
9
economically efficient decision that they would otherwise make in the untaxed
market economy? While we will examine some simple examples of efficiency
arguments later on in these materials, this is not a test that can easily be applied
without significant technical background.
3. Administrability
The third test of a tax rule is its administrability. How simple is the rule,
both for taxpayers and for tax administrators? This is not a trivial issue.
Theoretical decisions about the proper method of taxing individuals cut no
mustard with the tax law if the conclusions cannot be applied in the real world.
Indeed, the reason that Jones, in our example above, is taxed on the sale
of land rather than at the earlier point when the land increases in value is the
perceived need to have a simple way to measure the actual increase in value of
the taxpayer's assets, and to be sure, in most cases, that the taxpayer will have
the wherewithal (in the form of the proceeds of sale) to pay any tax imposed.
To introduce the technical terminology used in the tax literature, the time Jones
is taxed is a function of the realization requirement that has been assumed from
the introduction of the income tax in the United States to be a part of the
income tax system.
4. The Policy of an Income Tax
We will turn to the details of the realization requirement shortly.
But first, consider the implications of basing our tax system mainly on a
taxpayer's income. Presumably we do this because categorizing taxpayers on
the basis of income is considered a fair method of classification. Here is a
discussion of that decision from a pamphlet published by the Joint Committee
on Taxation.9
.c.STAFF OF THE JOINT COMMITTEE ON TAXATION, METHODOLOGY AND
ISSUES IN MEASURING CHANGES IN THE DISTRIBUTION OF TAX BURDENS
JCS 7-93, pages 82-88 (June 14, 1993)
IV. DISCUSSION OF THE INCOME CLASSIFIER
A. In General
9The Joint Committee on Taxation is a Congressional committee that serves both the
House and the Senate--hence, Joint Committee. Its staff is highly regarded and its output is
relatively nonpartisan.
10
Principles of Income Taxation
Ch. I
Economics is the study of the allocation of resources. This
allocation of resources determines the well-being of individuals. Wellbeing is usually measured by economists with reference to utility. "Utility"
is a term economists use to conceptualize welfare or preferences. If, in
the comparison of two equal-cost alternatives -- A and B -- an individual
prefers A, then it is said that A provides the individual with more utility; the
individual values A more than B. One's preferences among equal cost
alternatives reveal which alternative offers the most utility or value.
Utility can only be observed indirectly, through an individual's
choices, for example, so there is a need for a measurable proxy. The
dollar value of income and the dollar value of total consumption over a
specified period of time are often used as proxies for utility. Observable
concepts like income and consumption, although easily measurable, do
not fully capture the concept of an individual's well-being. A person's
income, for instance, does not convey job satisfaction.
Despite the incomplete picture of utility that income provides, many
economists believe that it is an appropriate measure of utility because it
measures an individual's potential command over resources (goods and
services). There is, however, no consensus on the specification of
income that best reflects utility.
One of the most well-known concepts of income used by
economists is the Haig-Simons definition. 137 Haig and Simons maintained
that income, defined as the individual's increase in purchasing power
during the tax year, most closely reflects utility. Haig-Simons income is
defined as the "total value of rights exercised in the market, together with
the accumulation of wealth in that period."
One can also measu re Haig-Simons income as annual personal
income (imputed income from durable goods consumption plus cash
receipts for wages, interest, dividends, etc.) plus accrued capital gains
(change in the value of assets held at the beginning of the tax year). This
is equivalent to the consumption-based definition above when changes in
net worth are taken into account. Haig and Simons argued that
distinctions based on the sources of income (labor income, capital
income) or uses (consumption or savings, accruals or realizations) are
irrelevant in the formulation of the tax base. All increases in purchasing
power -- regardless of their source -- are part of Haig-Simons income.
137Robert M. Haig, "The Concept of Income: Economic and Legal Aspects" in
Robert M. Haig, (ed.), The Federal Income Tax, (New York: Columbia University Press),
1921, and Simons, Personal Income Taxation.
Ch. I
The Realization Requirement
11
There are numerous specifications that attempt to measure
"economic income," which would include the annual flow of all resources
at the command of an individual. Haig-Simons income represents only
one attempt, 138 though most variations attempt to capture Haig-Simons.
Economists often use Haig-Simons income as the basis for distributional
studies, because this concept most completely reflects command over
economic resources. 139
The definition of income used to classify taxpayers into groups for
the purpose of examining distributional issues is referred to as an income
classifier. The choice of income definition to be utilized in a particular
study will be determined by data availability, as well as by the goals of the
research. The JCT staff uses an income specification that, like HaigSimons, attempts to measure economic income. The JCT income
classifier does not fully reflect economic income, however, because it is
constructed from limited data sources. The classifier employs adjusted
gross income as a base, and expands upon AGI (as detailed below) by
including certain income items excluded from this definition.
Consequently, the income classifier used by the JCT is referred to as
"expanded income."
Most studies of the distribution of resources in an economy are
based on an annual measures of income. Some analyses, however,
attempt to measure well-being, not by annual income, but by other
empirical concepts. Consumption and average lifetime income represent
two commonly used alternative measures of well-being. The following
section discusses the advantages and disadvantages of representing
well-being by annual income, average income, lifetime income, and
consumption.
B. Alternative Classifications of Economic Well-Being
Current-year vs. lifetime or permanent income
138For example, see Frank Cowell, "The Structure of American Income
Inequality," Review of Income and Wealth, 30 September, 1984. Cowell defined income
as labor income plus capital income plus transfers. Also, see Joel Slemrod, "Taxation
and Inequality: A Time-Exposure Perspective", in James M. Poterba (ed.), Tax Policy
and the Economy, 6, (Cambridge: The MIT Press), 1992. Slemrod defines income as
adjusted gross income plus excluded capital gains plus excluded dividends plus
adjustments minus net tax liability.
139Victor Thuronyi, "The Concept of Income", Journal of Taxation and
Investment, 9, Winter, 1992.
12
Principles of Income Taxation
Ch. I
The "life-cycle hypothesis" suggests that there is a correlation
between an individual's current expenditures, current income and
expectations of future income as the individual moves from school,
through the working years, and into retirement. The income measure
upon which the individual's consumption decisions are based under this
hypothesis is referred to as "permanent income". 140 Many economists
argue that permanent or average lifetime income provides a better
measure of a person's long-term economic well-being than an annual
measure of income. These economists note several advantages that
permanent income has over current income as a measure of economic
well-being.
Because people can save and consume out of accumulated
savings, annual income may fluctuate more than annual consumption.
For instance, individuals experiencing brief periods out of the labor force
may have temporarily low incomes without having to change
consumption patterns much. Similarly, individuals may have some years
in which income is much higher than usual earnings. Using current year
income may be a misleading measure of well-being in that it would make
the individual having such a year appear to be better off or worse off than
would a permanent income measure.
Under the life cycle hypothesis, current year income generally
follows a pattern throughout an individual's life cycle. In general, income
is low in the beginning years of working life, rises throughout the working
years, and then declines with retirement. A household in its peak
earnings years will also be saving for retirement, and will have both high
current labor income and high asset income. Yet this same household
will have reduced labor income and lower asset income once it reaches
retirement and begins to decumulate assets. Although the household
that saved during working years may be no worse off in terms of
consumption of goods and services (well-being) during retirement,
classifying the household using current income may result in it being
placed in a relatively high income category while working but a relatively
low category in retirement.
140Franco Modigliani (with R. Brumberg), "Utility Analysis and the Consumption
Function, in K.K. Kurihara (ed.), Post Keynesian Economics, (New Brunswick, New
Jersey: Rutgers University Press), 1954, and Milton Friedman, A Theory of the
Consumption Function, (Princeton: Princeton University Press), 1957, are associated
with the development and empirical testing of the permanent income and life cycle
hypothesis. Modigliani's version of this theory addresses the saving-spending pattern of
an individual's finances as he or she ages and moves from work to retirement.
Ch. I
The Realization Requirement
13
How large are these effects? Some analysts have reported that
mobility among income quintiles is substantial, but that the effect of shortterm fluctuations in income is larger than the effect of life-cycle
fluctuations. 141 Given this finding, a better measure of economic wellbeing than current year income might be average income over the lifecycle.
However, it is not clear that average lifetime income is an
appropriate measure of economic well-being in all situations. Lifetime
income measures current well-being only if people have the ability to
smooth their consumption by borrowing and saving. College students
with little current income but with expectations of high earnings in the
future might have a high level of current well-being if they can borrow
against their future income. However, if they cannot borrow, or can only
borrow at exorbitant rates, then they might have a low level of current
well-being, even though their permanent income is high. Similarly, if
someone enjoyed a high income in the past but spent it, then although
lifetime well-being might be high, the individual's current economic wellbeing might be low. Whether the tax system should view this person as
having high or low economic well-being depends on which concept of
well-being (current or average lifetime) is preferred.
Income from transitory sources (e.g., lottery winnings, assets
sales) may exhibit great variation from year to year. Because of
transaction costs associated with selling assets, people may choose to
sell large dollar values of assets at one time in order to spread a fixed
transaction cost over a large volume of assets. Using a current year
income measure, individuals selling assets with large amounts of accrued
capital gains might appear to be better off in the year they sell assets
than they are in years where no such sales occur. As a result, annual
measures of income may overstate economic well-being in the year in
which transitory income is realized.
The JCT staff has decided to use a single -year measure of income
in its distributional analyses, despite the potentially distorting effects of
transitory income realizations. Income measures that try to average
annual income over a period of years require data sets that follow taxreturn units over potentially lengthy periods of time. This type of data set
is referred to as panel data. Although the IRS has compiled small panel
tax return data sets, there is no panel data source available that
141For example, see Poterba, "Lifetime Incidence and the Distributional Burden
of Excise Taxes," [American Economic Review, 79, May 1989] and Office of Tax
Analysis, U.S. Treasury Department, "Household Income Mobility During the 1980's: A
Statistical Assessment Based on Tax Return Data," June 1, 1992.
14
Principles of Income Taxation
Ch. I
accurately represents the population with enough detail for the purpose of
analyzing proposed tax legislation. 142 Statistics of Income (SOI)
Table 6 illustrates the difference in the distribution of a single-year
income measure and a multi-year measure of income. Table 6 is a
contingency table which presents the distribution of persons in the [ sic]
each decile of 1989 expanded income across deciles of five-year average
expanded income. 143 The row labels refer to deciles of single-year
income. 144 The column labels refer to deciles of five-year average
expanded income. The cell entries across each row present the
percentage of observations in the corresponding decile of 1989 expanded
income that fall into each decile of five-year average income. For
example, in the first row, 70 percent of the persons in the first income
decile according to 1989 expanded income also belonged to the first
decile of five-year average income and 17 percent fell into the second
decile of average income. At the end of this row, the table reveals that
noone (in fact, approximately one tenth of one percent) in the first decile
of income in 1989 belonged to the top three deciles of five-year average
income. These observations represent taxpayers whose yearly income
varies from year to year.
142In 1957, the SOI [Statistics of Income--an IRS publication that compiles
statistical data from tax returns--Ed.] initiated a panel of individuals' returns beginning
with the 1987 tax year. Delivery of edited and weighted data for the first several years is
expected early in 1994. JCT staff do not plan to use the panel to develop models. Rather
they plan to introduce the longitudinal characteristics of the panel into their model which
will continue to be based primarily on the annual SOI cross-sectional sample. Introducing
longitudinal characteristics to the model is particularly important in such areas of tax
policy as capital gains, where measuring the effects of policy on individual behavior over
time may be quite different from measuring changes in aggregates. JCT staff also expect
to incorporate longitudinal characteristics in its model within the next few years. For a
discussion of this panel data, see Susan Hostetter, "Managing Multiple Uses of Panels,"
1992 Proceedings of the Section on Social Statistics, American Statistical Association,
1992.
143This table is based on information in the Sale of Capital Assets (SOCA) Panel,
a panel data set compiled as part of the Statistics of Income project to study capital gains
activity. The SOCA panel records the tax returns of 13,000 taxpaying units between 1985
and 1989. Because of its emphasis on capital gains, this data set tends to over-represent
wealthy taxpayers.
144The upper bounds of 1989 expanded income deciles in the Sales of Capital
Assets Panel: $8,119; $12,495; $16,736; $20,693; $25,918; $32,538; $40,345; $45,854;
$66,360. Five-Year average income decile breakpoints are: $9,012; $13,222; $17,744;
$21,820; $27,891; $34,466; $42,699; $51,792; $68,685.
Ch. I
The Realization Requirement
15
The cells along the diagonal of this table represent the group
whose ranking by annual income decile is the same as their ranking by
decile of five-year average income. Observations in these cells report
incomes which remain fairly constant over the years. For these persons,
annual income and permanent income are closely correlated. Cells
immediately next to the diagonal represent taxpayers whose relative
income ranking varied little when ranked by one-year income or five-year
income. If an annual income measure is a good classifier for analyzing
distributional issues, most observations would fall into the same decile of
single-year and five-year average income, that is, along the diagonal of
the matrix. Table 6 reveals that, in these data, annual income is
reasonably representative of permanent income. In each row, a majority
of observations falls into the diagonal cell or immediately next to the
diagonal cell. This table supports the argument that, for most taxpayers,
single-year income measures are reasonably good indicators of
permanent income. 145
Table 6. -- 1989 Expanded Income by Five-Year Average Expanded
Income Deciles
FIVE-YEAR AVERAGE EXPANDED INCOME DECILES
1989
EXPANDED
INCOME
DECILE 1st
1st
2nd
3rd
4th
5th
6th
7th
8th
70
20
4
2
1
1
0
0
1
2nd
3rd
4th
5th
6th
7th
8th
9th
17
54
18
3
3
0
0
0
9
15
42
17
6
4
1
0
1
4
22
48
18
6
1
0
1
3
7
21
47
20
2
1
1
1
2
7
19
47
21
7
1
1
4
1
3
18
55
26
0
2
0
0
2
1
15
46
0
0
0
0
0
2
2
17
10th
0
0
0
0
1
1
1
3
145In Slemrod, "Taxation and Inequality: A Time-Exposure Perspective," [note
138, above] Slemrod tests a panel data set (the Continuous Work History Panel) for
differences in the distribution of expanded income, for 1983, and the distribution of
average expanded income, from 1979 to 1985. His results were very similar to the results
derived in the SOCA panel. Again, the distributions between single year measures of
income do not differ significantly from average income measures. Similar findings appear
Don Fullerton and Diane Lim Rogers "Lifetime vs Annual Perspectives on Tax
Incidence," NBER Working Paper 3750, June, 1991.
16
9th
10th
Principles of Income Taxation
1
1
0
0
0
0
0
0
1
0
2
1
Ch. I
5
1
15
2
57
10
17
84
1Five-year
average expanded income represents the average of 1985 through
1989 income, expressed in 1989 dollars.
Consumption/expenditure
Some of the problems of the annual income classifier could be
solved by using a consumption classifier. If people behave according to
the life-cycle hypothesis, then even if income varied significantly over the
life-cycle, consumption would be less variable from year to year than
income. In this case, consumption might reflect well-being more
accurately than income. On the other hand, if people do not smooth
consumption over time, either because of borrowing constraints or lack of
foresight, then annual consumption expenditures might mirror annual
income. The college students who consumed little because they could
not borrow even though anticipating large future incomes would not be
classified as having a high level of economic well-being with a
consumption classifier.
One potential problem with using consumption as a classifier is
that any wealth (accumulated from labor or capital income) left as a
bequest is never consumed within the earner's lifetime. Thus, some
individuals might have high annual incomes every year, and hence great
command of economic resources, but (under a consumption-based
classification scheme) they would not be classified as having high
economic well-being if their annual consumption of goods and services
were not also high. People who save for the future consumption or for
precautionary reasons may die earlier than expected and, thereby, leave
an unintended bequest. These people derive as much utility from saving
as from consuming income. If people explicitly choose to leave a
bequest, it must be because they get at least as much utility from
increasing the potential consumption of their heirs as they would from
current personal consumption. Thus, using annual consumption as a
classifier would make people who leave bequests appear to be less welloff than an income classifier. One way to solve this problem would be to
treat bequests as consumption in the last period of the individual's life.
To the extent that the consumption value of bequests accrues over more
than one year, however, characterizing bequests as last-year
consumption would not be appropriate. The value of the bequest should
be amortized over the life of the taxpayer, but this calculation would be
impractical.
A more serious problem with using consumption as a classifier is
that it is more difficult to compare pre-tax and after-tax situations. This
comparison is an important element of tax policy. It is very difficult to
Ch. I
The Realization Requirement
17
compare pre-tax and after-tax consumption, because one would need to
know what consumption would have been in the absence of the tax under
consideration. Since the tax might have reduced both consumption and
saving, simply adding the tax to consumption could be misleading. 146
There exist a number of situations, furthermore, where the
relationship between consumption and well-being is not straightforward.
Some illustrative examples include persons incurring large medical
expenses or who support a large number of children. In addition, the
annual consumption of the services from durable goods is not easily
measurable. Finally, the primary data source available to the JCT staff
are income tax returns. Tax returns do not reflect consumption; their
purpose is to report income. Consequently, the JCT staff has less
reliable information about the consumption/expenditure patterns of
individuals and households than about their sources and amounts of
income. For these reasons, the JCT staff has decided not to use
consumption as the classifier in distributional analyses. However, the
JCT staff does attempt to highlight and correct the cases in which income
clearly misrepresents current well-being (as discussed in the section
below).
__________
DISCUSSION
Although the discussion above is substantially from the standpoint of
economists, it reflects policy concerns that lawyers should worry about. For
example, is it fairer to base taxes on one year's income or five years' income?
If you think five years is a better time frame, does it necessarily follow that the
tax law should change to such a system? In fact, the tax law used to have an
averaging mechanism in sections 1301-1305 of the Code. How would you
think such an averaging system could be structured?
Do you think a consumption tax would be better than an income tax?
Before you answer, remember that the base of the tax (that is, the amount on
which tax is imposed) can be decided independently of the tax rates. If, for
example, you think consumption is not a good base because people with little
means still need to consume a fair amount, don't forget that tax rates could be
146Note, however, that both consumption and income classifiers have a similar
problem with respect to measuring pre-tax economic positions. The JCT staff currently
assumes that pre-tax income is equal to after-tax income plus the amount of tax paid. To
the extent that the existence of the tax system changes the amount of work and saving
that people do, this measure of pretax income does not equal the income people would
have received in the absence of the tax system.
18
Principles of Income Taxation
Ch. I
very low on low levels of consumption and then rise rapidly as consumption
increases.
D.
The Realization Requirement
The realization requirement is not an easy doctrine to understand, and
its limits are far from clear even to the expert. We will look at some court
decisions that consider the issue.
The classic exploration of the realization requirement is found in Eisner
v. . In order to understand Macomber10 and to appreciate the problem that it
raises, a few preliminary remarks may be helpful. (Students who already know
all about corporations can skip the material below.)
are entities separate from their owners (the shareholders). If you make
a contract with a corporation, you can normally expect performance from the
corporation only, not from the corporation's shareholders. If the corporation
can't pay a bill that it owes to you, you normally cannot look for payment from
the shareholders of the corporation. That is not the only way a business can be
organized. For example, if the business is a partnership, each of the partners
may be personally liable for the debts of the partnership.
You can become a part owner of a corporation by buying stock in the
corporation. The corporation sells stock directly to shareholders. One can also
become a shareholder by buying stock from a current shareholder.
As the corporation becomes more valuable (for example, because it
made a profit from its operations), a shareholder would expect an ownership
interest in the corporation to increase in value. The corporation may choose to
distribute some of its profits by paying dividends to its shareholders. However,
it normally has no obligation to distribute those profits.
Contrast the position of the shareholder with that of the creditor. If,
instead of buying the corporation's stock, an individual lends money to the
corporation (or buys a debt instrument, such as a bond, issued by the
corporation), the individual can expect to be paid interest on a regular basis.
10There is a little trick that arises in naming tax cases that allows older practitioners to
lord it over neophytes. For a long period, taxpayers who wished to challenge their tax
liabilities sued individual employees of the tax collecting agency (such as Mr. Eisner), rather
than suing the United States or the generic Commissioner. Just as any reasonable lawyer
would identify a case called United States v. Jones as Jones rather than United States, so tax
lawyers should identify a case like Eisner v. Macomber as Macomber, who was the taxpayer,
rather than as Eisner, who was only the tax collector in New York at the time the suit was
brought.
Ch. I
The Realization Requirement
19
For example, if an individual buys a $1,000, 9% bond11 of a corporation, the
individual can expect to be paid $90 (9% of $1,000) in interest each year.
Moreover, the individual can expect to be paid even if the corporation has no
profit, for if the corporation does not pay its debts, it normally risks being
forced into bankruptcy. No such threat arises in the case of the corporation that
chooses not to pay dividends.
Shareholders who own preferred stock are generally in a stronger
position than holders of common stock, although their position is not as strong
as that of creditors. In general, owners of preferred stock are assured that
dividends will be paid to them before dividends are paid to the holders of
common stock. Also, on final liquidation of the company, they will normally
receive their investment back before the holders of common stock. However,
in general the dividend paid on their stock is limited to a fixed amount which is
not increased no matter how profitable the company is.
In summary, a corporation pays its creditors first. If it has profits, it
pays its preferred shareholders next, followed by its common shareholders.
With that background, let us consider the problem in Macomber. Many
corporations are treated as taxpayers in their own right and are taxed separately
from their shareholders. For those corporations, the question arises: When is a
shareholder to be taxed on the earnings of the corporation?
252 U.S. 189 (1920)
MR. JUSTICE PITNEY delivered the opinion of the court.
This case presents the question whether, by virtue of the Sixteenth
Amendment, Congress has the power to tax, as income of the
11For those who are unfamiliar with the terminology used in the text, a bond is an
obligation of a corporation to pay a certain amount to the owner of the bond at some point in
the future. The owner of the bond has a security interest in some property of the corporation,
which makes the bond a relatively safe investment. (An obligation of a corporation with no
security interest is called a "debenture.") The amount that the corporation has agreed to pay
the owner of the bond is called the "face amount" of the bond, $1,000 in our case. While that
will normally be the amount that was paid to the corporation when the bond was issued, it is
not necessarily the same amount. In addition, the corporation normally (again, not always)
agrees to make interest payments to the owner of the bond. Those payments are generally
expressed as a percentage of the face amount of the bond, here 9%. The normal practice is for
half of the total annual interest payment to be made every six months. Thus, the owner of a
$1,000, 9% bond would expect to receive $45 in interest every six months, or $90 (9% of
$1,000) per year.
20
Principles of Income Taxation
Ch. I
stockholder and without apportionment, a stock dividend made lawfully
and in good faith against profits accumulated by the corporation since
March 1, 1913. a . . .
The facts, in outline, are as follows:
On January 1, 1916, the Standard Oil Company of California, a
corporation of that State, out of an authorized capital stock of
$100,000,000, had shares of stock outstanding, par value $100 each,
amounting in round figures to $50,000,000. In addition, it had surplus and
undivided profits invested in plant, property, and business and required
for the purposes of the corporation, amounting to about $45,000,000, of
which about $20,000,000 had been earned prior to March 1, 1913, the
balance thereafter.
In January, 1916, in order to readjust the
capitalization, the board of directors decided to issue additional shares
sufficient to constitute a stock dividend of 50 per cent. of the outstanding
stock, and to transfer from surplus account to capital stock account an
amount equivalent to such issue. Appropriate resolutions were adopted,
an amount equivalent to the par value of the proposed new stock was
transferred accordingly, and the new stock duly issued against it and
divided among the stockholders.
Defendant in error, bein g the owner of 2,200 shares of the old
stock, received certificates for 1,100 additional shares, of which 18.07 per
cent., or 198.77 shares, par value $19,877, were treated as representing
surplus earned between March 1, 1913, and January 1, 1916. She was
called upon to pay, and did pay under protest, a tax imposed under the
Revenue Act of 1916, based upon a supposed income of $19,877
because of the new shares; . . .
*
*
*
*
In Towne v. Eisner, the question was whether a stock dividend
made in 1914 against surplus earned prior to January 1, 1913, was
taxable against the stockholder under the Act of October 3, 1913, . . . ,
which provided . . . that net income should include "dividends," and also
"gains or profits and income derived from any source whatever." . . .
When the case came here, [we said:] "'A stock dividend really takes
nothing from the property of the corporation, and adds nothing to the
interests of the shareholders. Its property is not diminished, and their
interests are not increased. . . . The proportional interest of each
a[The Sixteenth Amendment, which gave Congress the power to levy an income
tax on individuals, was effective on March 1, 1913. Congress has not attempted to tax
income that accrued, in an economic sense, prior to March 1, 1913.--Ed.]
Ch. I
The Realization Requirement
21
shareholder remains the same. The only change is in the evidence which
represents that interest, the new shares and the original shares together
representing the same proportional interest that the original shares
represented before the issue of the new ones.' Gibbons v. Mahon, . . .
In short, the corporation is no poorer and the stockholder is no richer than
they were before. . . . If the plaintiff gained any small advantage by the
change, it certainly was not an advantage of $417,450, the sum upon
which he was taxed. . . . What has happened is that the plaintiff's old
certificates have been split up in effect and have diminished in value to
the extent of the value of the new."
*
*
*
*
. . ., [I]n view of the importance of the matter, and the fact that
Congress in the Revenue Act of 1916 declared (39 Stat. 757) that a
"stock dividend shall be considered income, to the amount of its cash
value," we will deal at length with the constitutional question, incidentally
testing the soundness of our previous conclusion.
The Sixteenth Amendment must be construed in connection with
the taxing clauses of the original Constitution and the effect attributed to
them before the Amendment was adopted. . . .
. . . [T]he Sixteenth Amendment . . . merely removed the
necessity which otherwise might exist for an apportionment among the
States of taxes laid on income. . . .
*
*
*
*
In order . . . that . . . Article I of the Constitution may have proper
force and effect, save only as modified by the Amendment, and that the
latter also may have proper effect, it becomes essential to distinguish
between what is and what is not "income," as the term is there used; and
to apply the distinction, as cases arise, according to truth and substance,
without regard to form. . . .
The fundamental relation of "capital" to "income" has been much
discussed by economists, the former being likened to the tree or the land,
the latter to the fruit or the crop; the former depicted as a reservoir
supplied from springs, the latter as the outlet stream, to be measured by
its flow during a period of time. For the present purpose we require only
a clear definition of the term "income," as used in common speech, in
order to determine its meaning in the Amendment; and, having formed
also a correct judgment as to the nature of a stock dividend, we shall find
it easy to decide the matter at issue.
22
Principles of Income Taxation
Ch. I
After examining dictionaries in common use . . . , we find little to
add to the succinct definition adopted in two cases arising under the
Corporation Tax Act of 1909 . . . : "Income may be defined as the gain
derived from capital, from labor, or from both combined," provided it be
understood to include profit gained through a sale conversion of capital
assets, . . .
Brief as it is, it indicates the characteristic and distinguishing
attribute of income essential for a correct solution of the present
controversy. The Government, although basing its argument upon the
definition as quoted, placed chief emphasis upon the word "gain," which
was extended to include a variety of meanings; while the significance of
the next three words was either overlooked or misconceived. " Derived -from -- capital"; -- "the gain -- derived -- from -- capital," etc. Here we
have the essential matter: not a gain accruing to capital, not a growth or
increment of value in the investment; but a gain, a profit, something of
exchangeable value proceeding from the property, severed from the
capital however invested or employed, and coming in, being "derived,"
that is, received or drawn by the recipient (the taxpayer) for his separate
use, benefit and disposal; -- that is income derived from property.
Nothing else answers the description.
The same fundamental conception is clearly set forth in the
Sixteenth Amendment -- "incomes, from whatever source derived" -- the
essential thought being expressed with a conciseness and lucidity
entirely in harmony with the form and style of the Constitution.
Can a stock dividend, considering its essential character, be
brought within the definition? To answer this, regard must be had to the
nature of a corporation and the stockholder's relation to it. . . .
Certainly the interest of the stockholder is a capital interest, and
his certificates of stock are but the evidence of it. . . . Short of
liquidation, or until dividend declared, he has no right to withdraw any part
of either capital or profits from the common enterprise; on the contrary,
his interest pertains not to any part, divisible or indivisible, but to the
entire assets, business, and affairs of the company. Nor is it the interest
of an owner in the assets themselves, since the corporation has full title,
legal and equitable, to the whole. The stockholder has the right to have
the assets employed in the enterprise, with the incidental rights
mentioned; but, as stockholder, he has no right to withdraw, only the right
to persist, subject to the risks of the enterprise, and looking only to
dividends for his return. If he desires to dissociate himself from the
company he can do so only by disposing of his stock.
Ch. I
The Realization Requirement
23
. . . [A] dividend normally is payable in money, under exceptional
circumstances in some other divisible property; and when so paid, then
only (excluding, of course, a possible advantageous sale of his stock or
winding-up of the company) does the stockholder realize a profit or gain
which becomes his separate property, and thus derive income from the
capital that he or his predecessor has invested.
*
*
*
*
A "stock dividend" shows that the company's accumulated profits
have been capitalized, instead of distributed to the stockholders or
retained as surplus available for distribution in money or in kind should
opportunity offer.
Far from being a realization of profits of the
stockholder, it tends rather to postpone such realization, in that the fund
represented by the new stock has been transferred from surplus to
capital, and no longer is available for actual distribution.
The essential a nd controlling fact is that the stockholder has
received nothing out of the company's assets for his separate use and
benefit; on the contrary, every dollar of his original investment, together
with whatever accretions and accumulations have resulted from
employment of his money and that of the other stockholders in the
business of the company, still remains the property of the company, and
subject to business risks which may result in wiping out the entire
investment. Having regard to the very truth of the matter, to substance
and not to form, he has received nothing that answers the definition of
income within the meaning of the Sixteenth Amendment.
*
*
*
*
We are clear that not only does a stock dividend really take
nothing from the property of the corporation and add nothing to that of the
shareholder, but that the antecedent accumulation of profits evidenced
thereby, while indicating that the shareholder is the richer because of an
increase of his capital, at the same time shows he has not realized or
received a income in the transaction.
It is said that a stockholder may sell the new shares acquired in
the stock dividend; and so he may, if he can find a buyer. It is equally
true that if he does sell, and in doing so realizes a profit, such profit, like
any other, is income, . . . [W]ithout selling, the shareholder, unless
possessed of other resources, has not the wherewithal to pay an income
tax upon the dividend stock. Nothing could more clearly show that to tax
a stock dividend is to tax a capital increase, and not income, than this
demonstration that in the nature of things it requires conversion of capital
in order to pay the tax.
24
Principles of Income Taxation
*
*
*
Ch. I
*
We have no doubt of the power or duty of a court to look through
the form of the corporation and determine the question of the
stockholder's right, in order to ascertain whether he has received income
taxable by Congress without apportionment. But, looking through the
form, we cannot disregard the essential truth disclosed; ignore the
substantial difference between corporation and stockholder; treat the
entire organization as unreal; look upon stockholders as partners, when
they are not such; treat them as having in equity a right to a partition of
the corporate assets, when they have none; and indulge the fiction that
they have received and realized a share of the profits of the company
which in truth they have neither received nor realized. We must treat the
corporation as a substantial entity separate from the stockholder, not only
because such is the practical fact but because it is only by recognizing
such separateness that any dividend -- even one paid in money or
property -- can be regarded as income of the stockholder. Did we regard
corporation and stockholders as altogether identical, there would be no
income except as the corporation acquired it; and while this would be
taxable against the corporation as income under appropriate provisions of
law, the individual stockholders could not be separately and additionally
taxed with respect to their several shares even when divided, since if
there were entire identity between them and the company they could not
be regarded as receiving anything from it, any more than if one's money
were to be removed from one pocket to another.
Conceding that the mere issue of a stock dividend makes the
recipient no richer than before, the Government nevertheless contends
that the new certificates measure the extent to which the gains
accumulated by the corporation have made him the richer. There are two
insuperable difficulties with this: In the first place, it would depend upon
how long he had held the stock whether the stock dividend indicated the
extent to which he had been enriched by the operations of the company;
unless he had held it throughout such operations the measure would not
hold true.
Secondly, and more important for present purposes,
enrichment through increase in value of capital investment is not income
in any proper meaning of the term.
The complaint contains averments respecting the market prices of
stock such as plaintiff held, based upon sales before and after the stock
dividend, tending to show that the receipt of the additional shares did not
substantially change the market value of her entire holdings. This tends
to show that in this instance market quotations reflected intrinsic values -a thing they do not always do. But we regard the market prices of the
securities as an unsafe criterion in an inquiry such as the present, when
Ch. I
The Realization Requirement
25
the question must be, not what will the thing sell for, but what is it in truth
and in essence.
It is said there is no difference in principle between a simple stock
dividend and a case where stockholders use money received as cash
dividends to purchase additional stock contemporaneously issued by the
corporation. But an actual cash dividend, with a real option to the
stockholder either to keep the money for his own or to reinvest it in new
shares, would be as far removed as possible from a true stock dividend,
such as the one we have under consideration, where nothing of value is
taken from the company's assets and transferred to the individual
ownership of the several stockholders and thereby subjected to their
disposal.
*
*
*
*
Upon the second argument, b the Government, recognizing the
force of the decision in Towne v. Eisner, supra, and virtually abandoning
the contention that a stock dividend increases the interest of the
stockholder or otherwise enriches him, insisted as an alternative that by
the true construction of the Act of 1916 the tax is imposed not upon the
stock dividend but rather upon the stockholder's share of the undivided
profits previously accumulated by the corporation; the tax being levied as
a matter of convenience at the time such profits become manifest through
the stock dividend. If so construed, would the act be constitutional?
That Congress has power to tax shareholders upon their property
interests in the stock of corporations is beyond question; and that such
interests might be valued in view of the condition of the company,
including its accumulated and undivided profits, is equally clear. But that
this would be taxation of property because of ownership, and hence
would require apportionment under the provisions of the Constitution, is
settled beyond peradventure by previous decisions of this court.
*
*
*
*
Thus, from every point of view, we are brought irresistibly to the
conclusion that neither under the Sixteenth Amendment nor otherwise
has Congress power to tax without apportionment a true stock dividend
made lawfully and in good faith, or the accumulated profits behind it, as
income of the stockholder. The Revenue Act of 1916, in so far as it
imposes a tax upon the stockholder because of such dividend,
contravenes the provisions of Article I, §2 cl. 3, and Article I, §9, cl. 4, of
b[The
case was argued twice in the Supreme Court -- Ed.]
26
Principles of Income Taxation
Ch. I
the Constitution, and to this extent is invalid notwithstanding the Sixteenth
Amendment.
Judgment affirmed.
MR. JUSTICE HOLMES, dissenting.
I think that Towne v. Eisner, . . . , was right in its reasoning and
result and that on sound principles the stock dividend was not income.
But it was clearly intimated in that case that the construction of the statute
then before the Court might be different from that of the Constitution.
. . . I think that the word "incomes" in the Sixteenth Amendment should
be read in "a sense most obvious to the common understanding at the
time of its adoption." . . . The known purpose of this Amendment was to
get rid of nice questions as to what might be direct taxes, and I cannot
doubt that most people not lawyers would suppose when they voted for it
that they put a question like the present to rest. I am of opinion that the
Amendment justifies the tax. . . .
MR. JUSTICE DAY concurs in this opinion.
MR. JUSTICE BRANDEIS, dissenting, delivered the following opinion,
in which MR. JUSTICE CLARKE concurred.
Financiers, with the aid of lawyers, devised long ago two different
methods by which a corporation can, without increasing its indebtedness,
keep for corporate purposes accumulated profits, and yet, in effect,
distribute these profits among its stockholders. . . .
*
*
*
*
It is conceded that if the stock dividend paid to Mrs. Macomber had
been made by the more complicated method . . . [of] issuing rights to
take new stock pro rata and paying to each stockholder simultaneously a
dividend in cash sufficient in amount to enable him to pay for this pro rata
of new stock to be purchased -- the dividend so paid to him would have
been taxable as income, whether he retained the cash or whether he
returned it to the corporation in payment for his pro rata of new stock. But
it is contended that, because the simple method was adopted of having
the new stock issued direct to the stockholders as paid-up stock, the new
stock is not to be deemed income, whether she retained it or converted it
into cash by sale. If such a different result can flow merely from the
difference in the method pursued, it must be because Congress is without
power to tax as income of the stockholder either the stock received under
the latter method or the proceeds of its sale; for Congress has, by the
provisions in the Revenue Act of 1916, expressly declared its purpose to
make stock dividends, by whichever method paid, taxable as income.
Ch. I
The Realization Requirement
*
*
*
27
*
. . . The term "income" when applied to the investment of the
stockholder in a corporation, had, before the adoption of the Sixteenth
Amendment, been commonly understood to mean the returns from time
to time received by the stockholder from gains or earnings of the
corporation. A dividend received by a stockholder from a corporation
may be either in distribution of capital assets or in distribution of profits.
Whether it is the one or the other is in no way affected by the medium in
which it is paid, nor by the method or means through which the particular
thing distributed as a dividend was procured. . . .
Likewise whether a dividend declared payable from profits shall be
paid in cash or in some other medium is also wholly a matter of financial
management. If some other medium is decided upon, it is also wholly a
question of financial management whether the distribution shall be, for
instance, in bonds, scrip or stock of another corporation or in issues of its
own. And if the dividend in paid in its own issues, why should there be a
difference in result dependent upon whether the distribution was made
from such securities then in the treasury or from others to be created and
issued by the company expressly for that purpose? So far as the
distribution may be made from its own issues of bonds, or preferred stock
created expressly for the purpose, it clearly would make no difference in
the decision of the question whether the dividend was a distribution of
profits, that the securities had to be created expressly for the purpose of
distribution. If a dividend paid in securities of that nature represents a
distribution of profits Congress may, of course, tax it as income of the
stockholder. Is the result different where the security distributed is
common stock?
*
*
*
*
. . . It has been said that a dividend payable in bonds or preferred
stock created for the purpose of distributing profits may be income and
taxable as such, but that the case is different where the distribution is in
common stock created for that purpose. Various reasons are assigned
for making this distinction. One is that the proportion of the stockholder's
ownership to the aggregate number of the shares of the company is not
changed by the distribution. But that is equally true where the dividend is
paid in its bonds or in its preferred stock. Furthermore, neither
maintenance nor change in the proportionate ownership of a stockholder
in a corporation has any bearing upon the question here involved.
Another reason assigned is that the value of the old stock held is reduced
approximately by the value of the new stock received, so that the
stockholder after receipt of the stock dividend has no more than he had
before it was paid. That is equally true whether the dividend be paid in
28
Principles of Income Taxation
Ch. I
cash or in other property, for instance, bonds, scrip or preferred stock of
the company. The payment from profits of a large cash dividend, and
even a small one, customarily lowers the then market value of stock
because the undivided property represented by each share has been
correspondingly reduced. The argument which appears to be most
strongly urged for the stockholders is, that when a stock dividend is
made, no portion of the assets of the company is thereby segregated for
the stockholder. But does the issue of new bonds or of preferred stock
created for use as a dividend result in any segregation of assets for the
stockholder? In each case he receives a piece of paper which entitles
him to certain rights in the undivided property. Clearly segregation of
assets in a physical sense is not an essential of income. The year's
gains of a partner are taxable as income, although there, likewise, no
segregation of his share in the gains from that of his partners is had.
The objection that there has been no segregation is presented al so
in another form. It is argued that until there is a segregation, the
stockholder cannot know whether he has really received gains; since the
gains may be invested in plant or merchandise or other property and
perhaps be later lost. But is not this equally true of the share of a partner
in the year's profits of the firm or, indeed, of the profits of the individual
who is engaged in business alone? And is it not true, also, when
dividends are paid in cash? The gains of a business, whether conducted
by an individual, by a firm or by a corporation, are ordinarily reinvested in
large part. Many a cash dividend honestly declared as a distribution of
profits, proves later to have been paid out of capital, because errors in
forecast prevent correct ascertainment of values. Until a business
adventure has been completely liquidated, it can never be determined
with certainty whether there have been profits unless the returns have at
least exceeded the capital originally invested. . . .
. . . The Governme nt urges that it would have been within the
power of Congress to have taxed as income of the stockholder his pro
rata share of undistributed profits earned, even if no stock dividend
representing it had been paid. Strong reasons may be assigned for such
a view. . . . The undivided share of a partner in the year's undistributed
profits of his firm is taxable as income of the partner, although the share
in the gain is not evidenced by any action taken by the firm. Why may
not the stockholder's interest in the gains of the company? The law finds
no difficulty in disregarding the corporate fiction whenever that is deemed
necessary to attain a just result. . . . The stockholder's interest in the
property of the corporation differs, not fundamentally but in form only,
from the interest of a partner in the property of the firm. There is much
authority for the proposition that, under our law, a partnership or joint
stock company is just as distinct and palpable an entity in the idea of the
law, as distinguished from the individuals composing it, as is a
Ch. I
The Realization Requirement
29
corporation. No reason appears, why Congress, in legislating under a
grant of power so comprehensive as that authorizing the levy of an
income tax, should be limited by the particular view of the relation of the
stockholder to the corporation and its property which may, in the absence
of legislation, have been taken by this court. But we have no occasion to
decide the question whether Congress might have taxed to the
stockholder his undivided share of the corporation's earnings. For
Congress has in this act limited the income tax to that share of the
stockholder in the earnings which is, in effect, distributed by means of the
stock dividend paid. In other words, to render the stockholder taxable
there must be both earnings made and a dividend paid. Neither earnings
without dividend -- nor a dividend without earnings -- subjects the
stockholder to taxation under the Revenue Act of 1916.
*
*
*
*
MR. JUSTICE CLARKE concurs in this opinion.
__________
DISCUSSION
To consider the alternatives available to the Court in Macomber,
imagine yourself in the following five factual circumstances. In each case, you
start the year with 100 shares worth $20 each ($2000 total) with a par value of
$10 each ($1000 total). Also, assume (for ease of analysis) that $1 held by the
corporation at the corporate level is reflected in $1 of added value at the
shareholder level.
1.
The corporation pays a $10 cash dividend on each share of
stock.
2.
The corporation offers each shareholder the option to receive
stock or cash ($10 cash or $10 par value stock that is worth $10
for each share of stock).
3.
The corporation issues $10 of debt in respect of each share of its
stock.
4.
Eisner v. Macomber situation: Rather than issue $1,000 of debt,
the corporation transfers earned surplus on its books into paid-in
capital, and issues $10 of new stock in respect of each
outstanding share of its stock representing the new paid-in
capital. For example, in our case, assume the $1,000 difference
between the par value and market value of the stock reflected
$1000 of prior earnings at the corporate level. The corporation
could issue 100 new shares at $10 par value, transferring the
$1,000 earned surplus into paid-in capital on its books. The
result is that each shareholder has a greater par value holding but
30
Principles of Income Taxation
Ch. I
has no additional stock holding in terms of value, since the
shares previously held represented all prior earnings of the
corporation. To the corporation, the only change is in the
location of its earnings on its books.
5.
The corporation "splits" its stock two-for-one. "Splitting" is a
term of art in the corporate area. A purchaser of stock from a
corporation pays a minimum of "par value" for the stock. That
amount goes into the corporation's "paid-in capital".
If, before a two-for-one stock split, each share has a par value of
$10 (i.e. it represents $10 of paid-in capital), then after the stock
is split, the par value of each share will be $5, but there will be
twice as many shares outstanding. Therefore, the corporation
will have the same total amount of paid-in capital, and each
shareholder will have the same percentage ownership of the
corporation, the same total par value represented in its stock, but
twice as many shares of stock.
DISREGARDING TAX CONSEQUENCES, answer the following
questions:
1.
In which of these cases (if any) would you have property worth
more than you had before?
2.
Which of the alternatives above would you prefer (if any)?
3.
How do these alternatives compare to a world in which the
corporation attends to its business and earns $1000 in respect of
your stock ($10 per share) during the year?
Having evaluated these five alternatives without reference to tax
consequences, now consider how your answers to these questions are affected
by the tax consequences of the alternatives. In evaluating the various
alternatives, it is not sufficient just to think about the immediate consequences
of the transaction at issue. You must consider too how future transactions will
be taxed. This is the essence of sensible tax planning. For example, consider
how your desire for a dividend payment now might be affected by the rate of
tax on the corporation as compared to your rate of tax. Here is a very simple
example.
Ch. I
The Realization Requirement
31
Assume there is $100 sitting in a corporation that will be taxed as a
dividend when distributed to shareholders. Assume further that anyone can
earn a 10% return on capital.12
CASE I. The corporate tax rate is 20% and the individual rate is
40%. If a corporation keeps the $100, it earns $10, yielding $8 after
tax, and the shareholder, on distribution, keeps 60% of that--$4.80. The
shareholder can then also get the $100 out, keeping $60, for a total of
$64.80
If the corporation distributes the $100 first, the shareholder keeps
$60 on which it earns $6. The shareholder keeps only $3.60 of this $6,
for a total of $63.60.
CASE II. The corporate tax rate is 40%, and the individual rate
is 20%. If the corporation keeps the $100, it earns $10, which leaves $6
after tax, and the shareholder, on distribution, keeps 80% of that--$4.80.
Shareholder can then also get the $100 out, keeping $80, for a total of
$84.80.
If the corporation distributes the $100 first, the shareholder keeps
$80, on which it earns $8, of which it keeps $6.40, for a total of $86.40.
CASE III. The corporate tax rate is 40%, and the individual rate
is 40%. If a corporation retains the $100, it earns $10, which yields $6
after tax. The shareholder, on distribution, keeps 60% of that--$3.60.
Shareholder can then also get the $100 out, keeping $60, for a total of
$63.60.
If the corporation distributes the $100 first, the shareholder keeps
$60, on which it earns $6. It keeps $3.60 of that $6, for a total of
$63.60.
The next case, Davis, involves a transfer of property incident to . There
are a few problems to be dealt with in the context of Davis. Suppose A and B
own ten acres of land together as . If they decide to terminate their joint
relationship, they might divide the property in two, with each co-owner
becoming sole owner of five acres of land.
12That means that, however much you save, you earn 10% annually. If you have
$100 of savings, you earn $10; if you have $1,000, you earn $100. Saying that everyone
earns the same 10% return (a most unrealistic assumption, as you are probably aware) means
that $1,000 left in a corporation will also generate earnings of 10% for the corporation.
32
Principles of Income Taxation
Ch. I
Would that be a taxable event? One could certainly argue that it would.
Each of the co-owners previously owned a one-half interest in ten acres of land.
After the division, each is sole owner of five acres of land. If thereafter one of
the five acre parcels became more valuable than the other, the decision to
dissolve the co-ownership arrangement would have had a substantial practical
effect. Nevertheless, under the tax law, a mere division of property by coowners is not a taxable event. Each co-owner would take sole possession of
part of the property after the division with no tax consequences.
In a number of states, coownership of property arises as a matter of law
in the case of certain property purchased by persons who are married. In these
"" states, any property acquired by the married "community" is deemed to be
owned equally by husband and wife. As a result, if the marriage ends in
divorce, any division of property incident to the divorce could qualify for
untaxed treatment under the IRS's position regarding the division of property
by co-owners. The question presented to the Supreme Court in the next case,
Davis, was how taxpayers in common law states should be treated upon a
division of property incident to a divorce. In a common law state, the
ownership of property by husband and wife is generally determined as if they
were unrelated parties, with no special rule to give one spouse any ownership
interest in particular property of the other spouse. The wife in those states
usually has general property rights against her husband, and a divorce
settlement can involve a relinquishment of claims in respect of those marital
rights in exchange for property. Davis considers how that different form
affects the tax consequences of divorce.
A little tax terminology will help you to understand Davis. If you
wanted to calculate gain on the sale of property, you would probably subtract
the purchase price from the sale price. Section 1001 of the Code tells you that
a taxpayer calculates gain on a sale of property by subtracting the "adjusted
basis" of the property from the amount realized on the sale. "Amount realized"
is pretty much the same as sale price, but what is "adjusted basis"?
Section 1011 of the Code tells you that the adjusted basis of property is
generally its "basis," determined under section 1012, "adjusted as provided in
section 1016." But when you move to section 1012, you find that, indeed,
basis is normally cost, although section 1016 gives a whole laundry list of
"adjustments" to basis.
It is good exercise to trace through these sections on your own. The
concept of adjusted basis is a central one in the tax law, and it really isn't the
same as cost. We will begin to consider what basis means more thoroughly in
the next chapter. Essentially, basis is the amount the tax law uses as the cost of
property, the amount against which it determines whether a gain or loss has
been realized. But, as we will see, many different events are reflected in a
property's basis.
Ch. I
The Realization Requirement
33
UNITED STATES v. DAVIS
370 U.S. 65 (1962)
MR. JUSTICE CLARK delivered the opinion of the Court.
These cases involve the tax consequences of a transfer of
appreciated property by Thomas Crawley Davis to his former wife
pursuant to a property settlement agreement executed prior to divorce
. . .
In 1954 the taxpayer and his then wife made a voluntary property
settlement and separation agreement calling for . . . the transfer of
certain personal property to the wife. Under Delaware law all the property
transferred was that of the taxpayer, subject to certain statutory marital
rights of the wife including a right of intestate succession and a right upon
divorce to a share of the husband's property. Specifically as a "division in
settlement of their property" the taxpayer agreed to transfer to his wife,
inter alia, 1,000 shares of stock in the E.I. du Pont de Nemours & Co.
The then Mrs. Davis agreed to accept this division "in full settlement and
satisfaction of any and all claims and rights against the husband
whatsoever (including but not by way of limitation, dower and all rights
under the laws of testacy and intestacy) . . ." Pursuant to the above
agreement which had been incorporated into the divorce decree, one-half
of this stock was delivered in the tax year involved, 1955, and the
balance thereafter.
Davis' cost basis for the 1955 transfer was
$74,775.37, and the fair market value of the 500 shares there transferred
was $82,250. . . .
I.
The determination of the income tax consequences of the stock
transfer described above is basically a two-step analysis: (1) Was the
transaction a taxable event? (2) If so, how much taxable gain resulted
therefrom? . . . The matter was considered settled until the Court of
Appeals for the Sixth Circuit, in reversing the Tax Court, ruled that,
although such a transfer might be a taxable event, the gain realized
thereby could not be determined because of the impossibility of
evaluating the fair market value of the wife's marital rights. . . . In so
holding that court specifically rejected the argument that these rights
could be presumed to be equal in value to the property transferred for
their release. This is essentially the position taken by the Court of Claims
in the instant case.
II.
We now turn to the threshold question of whether the transfer in
issue was an appropriate occasion for taxing the accretion to the stock.
34
Principles of Income Taxation
Ch. I
There can be no doubt that Congress, as evidenced by its inclusive
definition of income subject to taxation, i.e., "all income from whatever
source derived, including . . . [gains] derived from dealings in property," 4
intended that the economic growth of this stock be taxed. The problem
confronting us is simply when is such accretion to be taxed. Should the
economic gain be presently assessed against taxpayer, or should this
assessment await a subsequent transfer of the property by the wife? The
controlling statutory language, which provides that gains from dealings in
property are to be taxed upon "sale or other disposition," 5 is too general
to include or exclude conclusively the transaction presently in issue.
Recognizing this, the Government and the taxpayer argue by analogy
with transactions more easily classified as within or without the ambient
of taxable events. The taxpayer asserts that the present disposition is
comparable to a nontaxable division of property between two co-owners, 6
while the Government contends it more resembles a taxable transfer of
property in exchange for the release of an independent legal obligation.
Neither disputes the validity of the other's starting point.
In support of his analogy the taxpayer argues that to draw a
distinction between a wife's interest in the property of her husband in a
common-law jurisdiction such as Delaware and the property interest of a
wife in a typical community property jurisdiction would commit a double
sin; for such differentiation would depend upon "elusive and subtle
casuistries which . . . possess no relevance for tax purposes," Helvering
v. Hallock, . . ., and would create disparities between common-law and
community property jurisdictions in contradiction to Congress' general
policy of equality between the two. The taxpayer's analogy, however,
stumbles on its own premise, for the inchoate rights granted a wife in her
husband's property by the Delaware law do not even remotely reach the
dignity of co-ownership. . . .
4Internal
Revenue Code of 1954 § 61 (a).
5Internal
Revenue Code of 1954 §§ 1001, 1002 [now § 1001(c) -- ed.].
6Any suggestion that the transaction in question was a gift is completely
unrealistic. Property transferred pursuant to a negotiated settlement in return for the
release of admittedly valuable rights is not a gift in any sense of the term. To intimate
that there was a gift to the extent the value of the property exceeded that of the rights
released not only invokes the erroneous premise that every exchange not precisely equal
involves a gift but merely raises the measurement problem discussed in Part III, infra,
. . .
Ch. I
The Realization Requirement
35
. . . [T]his Court in the past has not ignored the differing effects
on the federal taxing scheme of substantive differences between
community property and common-law systems. . . .
Our interpretation of the general statutory language is fortified by
the long-standing administrative practice as sounded and formalized by
the settled state of law in the lower courts. The Commissioner's position
was adopted in the early 40's by the Second and Third Circuits and by
1947 the Tax Court had acquiesced in this view. This settled rule was
not disturbed by the Court of Appeals for the Sixth Circuit in 1960 or the
Court of Claims in the instant case, for these latter courts in holding the
gain indeterminable assumed that the transaction was otherwise a
taxable event. Such unanimity of views in support of a position
representing a reasonable construction of an ambiguous statute will not
lightly be put aside. It is quite possible that this notorious construction
was relied upon by numerous taxpayers as well as the Congress itself,
which not only refrained from making any changes in the statutory
language during more than a score of years but re-enacted this same
language in 1954.
III.
Having determined that the transaction was a taxable event, we
now turn to the point on which the Court of Claims balked, viz., the
measurement of the taxable gain realized by the taxpayer. The Code
defines the taxable gain from the sale or disposition of property as being
the "excess of the amount realized therefrom over the adjusted basis
. . ." I.R.C. (1954) § 1001 (a). The "amount realized" is further defined
as "the sum of any money received plus the fair market value of the
property (other than money) received." I.R.C. (1954) § 1001 (b). In the
instant case the "property received" was the release of the wife's
inchoate marital rights. The Court of Claims, following the Court of
Appeals for the Sixth Circuit, found that there was no way to compute the
fair market value of these marital rights and that it was thus impossible to
determine the taxable gain realized by the taxpayer. We believe this
conclusion was erroneous.
It must be assumed, we think, that the parties acted at arm's length
and that they judged the marital rights to be equal in value to the property
for which they were exchanged. There was no evidence to the contrary
here. Absent a readily ascertainable value it is accepted practice where
property is exchanged to hold, as did the Court of Claims in Philadelphia
Park Amusement Co. v. United States, . . . that the values "of the two
properties exchanged in an arms-length transaction are either equal in
fact, or are presumed to be equal." . . . To be sure there is much to be
said of the argument that such an assumption is weakened by the
36
Principles of Income Taxation
Ch. I
emotion, tension and practical necessities involved in divorce
negotiations and the property settlements arising therefrom. However,
once it is recognized that the transfer was a taxable event, it is more
consistent with the general purpose and scheme of the taxing statutes to
make a rough approximation of the gain realized thereby than to ignore
altogether its tax consequences. . . .
Moreover, if the transaction is to be considered a taxable event as
to the husband, the Court of Claims' position leaves up in the air the
wife's basis for the property received. In the context of a taxable transfer
by the husband, 7 all indicia point to a "cost" basis for this property in the
hands of the wife. Yet under the Court of Claims' position her cost for this
property, i.e., the value of the marital rights relinquished therefor, would
be indeterminable, and on subsequent disposition of the property she
might suffer inordinately over the Commissioner's assessment which she
would have the burden of proving erroneous, . . . Our present holding
that the value of these rights is ascertainable eliminates this problem; for
the same calculation that determines the amount received by the
husband fixes the amount given up by the wife, and this figure, i. e., the
market value of the property transferred by the husband, will be taken by
her as her tax basis for the property received.
Finally, it must be noted that here, as well as in relation to the
question of whether the event is taxable, we draw support from the prior
administrative practice and judicial approval of that practice. . . . We
therefore conclude that the Commissioner's assessment of a taxable gain
based upon the value of the stock at the date of its transfer has not been
shown erroneous.
__________
DISCUSSION
A. Does the figure used by the Court as the amount realized by Mr.
Davis make sense to you?
B. Davis reflects a point that was implicit in our earlier discussion of
the case: substantive rules of law affect the Federal tax consequences of a
transaction. For that reason, the study of taxes can be particularly difficult,
since the student must absorb rules of law in various areas (particularly in a
commercial context) before embarking on the application of the tax law to the
facts.
7Under the present administrative practice, the release of marital rights in
exchange for property or other consideration is not considered a taxable event as to the
wife. . . .
Ch. I
The Realization Requirement
37
One particular way in which non-tax law affects Federal tax law is that
the interpretation of State law will affect tax consequences. This raises the
specter of the beloved Erie R. Co. v. Tompkins, 304 U.S. 64 (1938). In the tax
arena, there is played out a variation on Erie. Often, particularly in the
application of the estate tax, a state court determination of the disposition of
property, for example, will affect how a Federal tax is to be calculated. To
what extent should the determination of a State court in a case brought by
private litigants determine the taxes that the Federal Government can collect,
when it was not a party to the original litigation? For those infused with the
learning of Erie, the answer might seem to be "always". But, lurking in the
Erie-like question posed above is the possibility that the "parties" to the State
litigation (if it was, in fact, contested) may not have included anyone arguing
for the position that the Federal Government might take in order to maximize
its tax collections. Under those circumstances, should the State court decision
govern?
In Commissioner v. Estate of 387 U.S. 456 (1967), the Supreme Court
explained how a state court decision should be applied in a subsequent Federal
tax case involving one of the state court litigants. The Supreme Court held that
the Federal courts should follow a decision of the highest state court as an
authoritative statement of state law as applied to this taxpayer's situation, but
that decisions of other courts of a state need only be given "proper regard." In
adopting this position, the Court rejected a Government suggestion that a state
court's decision be accepted only when it was the result of a true adversary
proceeding in State court.13
You should realize that the states become quite sensitive to Federal tax
issues when they discover that minor changes in their own laws can have a
significant impact on their citizens' Federal tax liabilities. For example, as a
consequence of Davis, it became important to know the nature of a spouse's
rights in the other spouse's property at the time of a property settlement incident
to a divorce. Where statutes provided for "equitable distribution" of property,
the courts had to decide whether the interest of the spouse who did not formally
own the property was similar to the wife's in Davis (in which case a transfer
would be a taxable event), or whether it was more like that of a spouse in a
community property state (in which case there would be no taxable event on
transfer). The effect of Bosch could be seen clearly as the Tenth Circuit
13Whether Bosch took the right approach is still a matter of controversy. See Paul
Caron, "Bosch and the Allure of Adversariness," Tax Notes, August 1, 1994, p. 673; Bernard
Wolfman, "Bosch Revisited," Tax Notes, July 11, 1994, p.269; and articles cited therein.
38
Principles of Income Taxation
Ch. I
decided in favor of non-taxability in two cases14 and in favor of taxability in
another.15
As a consequence of cases like these, some state legislatures tried to
copy the statutes in those states where the courts had ruled that divorce-related
transfers were not taxable. The new statutes provided that the rights of the
spouse without formal legal title became vested at the commencement of a
divorce action.16 While this had little if any effect on the substance of the rights
of the two parties, it persuaded the Federal courts to rule in favor of nontaxability.
Congress has also gotten into the act. Section 66 provides relief of
various sorts for spouses in community property states. To see the unfortunate
consequences where such relief is not available, see United States v. 403 U.S.
190 (1971).
C. It is not always easy to see who are the winners and who are the
losers in a tax case. For example, Mr. Davis clearly lost in Davis. Since, in the
majority of divorces, it is husbands who transfer property to wives, Davis
would seem to be a blow for wives and against husbands everywhere. Under
the current Code, section 1041 supersedes the specific holding in Davis. Read
section 1041, which was passed in 1984. If you had represented a "husbands
lobby" in 1984, would you have been in favor of this amendment or against it?
What if you had represented a "wives lobby"?
D. Look at the language of section 1041. It says that no gain or loss
"shall be recognized" on certain transfers. We have been speaking up to now
of income being "realized." What is the meaning of the word "recognized"?
The concept of realization that we have been talking about is a
"common law" tax concept. That is, the courts have viewed it as a requirement
of the tax law with no specific statutory basis for that conclusion.
The concept of recognition is a clearer concept.
14Collins v. Commissioner, 412 F.2d 211 (19th Cir. 1969 (Oklahoma law); Imel v.
United States, 523 F.2d 853 (10th Cir. 1975) (Colorado law).
15Wiles v. Commissioner, 499 F.2d 255 (10th Cir.), cert. denied, 419 U.S. 996 (1974)
(Kansas law).
16See generally Malman, Unfinished Reform: The Tax Consequences of Divorce;, 61
N.Y.U. L. Rev. 363, 384-86 (1986).
Ch. I
The Realization Requirement
39
Once
income--or
loss--is realized, it
normally will be
recognized,
unless
the statute itself says
otherwise.
Sections such as section 1041 are non-recognition sections. They provide that
certain realized items are not to be recognized.
E. Note that there is a taxable event in Davis because section 1001(a)
says gain or loss is recognized if it arises from a "sale or other disposition" of
property. We think of a sale as involving a transfer of property in exchange for
cash. The most obvious "other" disposition of property is an "exchange"--the
transfer of property in exchange for other property. Although, as Davis shows,
it is possible to characterize many transactions as "exchanges," Congress
drafted section 1001 using the broad language "other dispositions" so that
taxpayers could not easily avoid recognition on the transfer of property.
Usually taxpayers try to avoid recognition, at least when their property
has unrealized gain. But, particularly if property has loss inherent in it, a
taxpayer may want to create a recognition event. We will study some Code
provisions that prevent certain events from being recognized for tax purposes.
Section 1.1001-1(a) of the Regulations contains an additional
requirement for recognition. It says "the exchange of property for other
property differing materially either in kind or in extent" is a taxable event. A
reasonable implication of that statement is that there is no exchange if the two
properties do not differ materially.
See Cottage Savings Assn. v.
Commissioner, 113 L.Ed. 2d 589 (1991), reproduced in Chapter 3. So, if you
own a bushel of corn and want to recognize a loss on it, you can't simply
exchange it for another bushel of corn. This provision of the Regulations is not
as important as it otherwise might be because, under section 1031, no gain or
loss is recognized on most "like-kind exchanges" in any event.
F. and Davis are classic cases in this very difficult area of the law.
Curiously, neither would govern a case arising with their facts today. The
stock dividend issue in Macomber is now dealt with in section 305 of the Code,
which mandates the result reached by the Court in that case. Despite the
Court's rhetoric, the consensus view is that the Constitution would not bar
taxation of a stock dividend.17 The result in Davis is changed by section 1041
of the Code, as noted above.
17See,
e.g., M. Chirelstein, Federal Income Taxation; par.5.01, at 71 (7th ed. 1994).
40
Principles of Income Taxation
Ch. I
While the specific holdings in the two cases are now covered by
statutory provisions, the cases remain of vital importance under the tax law.
The realization requirement is of central importance to our income tax, and
those two cases illustrate how the realization rules function.
G. Davis is particularly worth studying, because the Court was prepared
to create a taxable exchange when it might well have concluded that no
exchange occurred. It could have said that coowners were simply dividing up
property that they own, which, as noted above, even the IRS agrees can take
place tax-free. Be sure you understand why Davis is different.
There is another important issue that is touched on in passing in Davis.
When the Court creates an exchange in a situation where the parties have not
negotiated price in the normal way, how does the tax law measure the amount
realized on the transaction? The Court refers to an earlier Court of Appeals
decision that is the best statement on this issue.
.t.PHILADELPHIA PARK AMUSEMENT CO. v. UNITED STATES
126 F.Supp. 184 (Ct. Cl. 1954)
LARAMORE, JUDGE, delivered the opinion of the court:
The taxpayer corporation sues to recover $42,864.50, with interest
thereon, representing alleged overpayment of income taxes for the
calendar years 1944 and 1945. . . . The issue presented in this case is
whether or not the taxpayer is entitled to include as a part of the cost of
its franchise, for purposes of determining depreciation and loss due to
abandonment, the undepreciated cost of a bridge exchanged for a 10year extension of the franchise. The facts which have been stipulated by
the parties may be summarized as follows: The taxpayer's predecessor
was granted on July 6, 1889, by the City of Philadelphia, a franchise to
construct, operate, and maintain for 50 years a passenger railway in
Fairmount Park at its own cost and expense. Upon the expiration of the
50-year term the franchise was to continue indefinitely for additional
successive 10-year terms unless the City gave one year's written notice
of its wish to terminate it at the end of the 50-year term or the 10-year
term then in duration. . . .
Pursuant to the franchise the taxpayer's predecessor constructed
the bridge in question, commonly known as Strawberry Bridge, over the
Schuylkill River at a cost of $381,000. . . . Early in 1934 the City, in
writing the taxpayer, pointed out that Strawberry Bridge was in need of
extensive repairs, that it was taxpayer's obligation to make the repairs at
taxpayer's expense, and threatened to close the bridge unless the repairs
were made promptly. The taxpayer wrote the City explaining that its
financial condition prevented the making of extensive repairs to the bridge
Ch. I
The Realization Requirement
41
and offered to transfer the ownership of the bridge to the City in exchange
for a 10-year extension of the railway franchise. The City accepted the
offer and on August 3, 1934, Strawberry Bridge was transferred to the
City. The taxpayer reserved its right-of-way over the bridge for the
duration of its franchise and agreed to maintain its facilities thereon. On
November 14, 1934, the City amended the franchise and extended it from
July 24, 1939, to July 24, 1949. The adjusted basis, i. e., the
undepreciated or unrecovered cost of Strawberry Bridge at the time of the
exchange was $228,852.74.
The taxpayer's bookkeeper took
depreciation on the bridge for the part of 1934 that taxpayer owned it and
promptly wrote the asset off the books by a direct debit to surplus of
$228,852.74, without reporting any gain or loss on the exchange or
adding the undepreciated cost or fair market value of the bridge to the
cost of the franchise. . . .
In 1946 the taxpayer . . . abandoned its franchise. In its 1946 tax
return the taxpayer claimed a loss due to abandonment of the railroad of
$336,380.04, $74,445.89 of which was claimed to represent the
undepreciated cost of the franchise. . . .
*
*
*
*
This brings us to the question of what is the cost basis of the 10year extension of taxpayer's franchise. Although defendant contends that
Strawberry Bridge was either worthless or not "exchanged" for the 10year extension of the franchise, we believe that the bridge had some
value, and that the contract under which the bridge was transferred to the
City clearly indicates that the one was given in consideration of the other.
The gain or loss, whichever the case may have been, should have
been recognized, and the cost basis . . . under section [1012] of the
Code, of the 10-year extension of the franchise was the cost to the
taxpayer. The succinct statement in section [1012] that "the basis of
property shall be the cost of such property" although clear in principle, is
frequently difficult in application. One view is that the cost basis of
property received in a taxable exchange is the fair market value of the
property given in the exchange. The other view is that the cost basis of
property received in a taxable exchange is the fair market value of the
property received in the exchange. As will be seen from the cases and
some of the Commissioner's rulings the Commissioner's position has not
been altogether consistent on this question. The view that "cost" is the
fair market value of the property given is predicated on the theory that the
cost to the taxpayer is the economic value relinquished. The view that
"cost" is the fair market value of the property received is based upon the
theory that the term "cost" is a tax concept and must be considered in the
light of . . . the prime role that the basis of property plays in determining
42
Principles of Income Taxation
Ch. I
tax liability. We believe that when the question is considered in the latter
context that the cost basis of the property received in a taxable exchange
is the fair market value of the property received in the exchange.
When property is exchanged for property in a taxable exchange
the taxpayer is taxed on the difference between the adjusted basis of the
property given in exchange and the fair market value of the property
received in exchange. For purposes of determining gain or loss the fair
market value of the property received is treated as cash and taxed
accordingly. To maintain harmony with the fundamental purpose of these
sections, it is necessary to consider the fair market value of the property
received as the cost basis to the taxpayer. The failure to do so would
result in allowing the taxpayer a stepped-up basis, without paying a tax
therefor, if the fair market value of the property received is less than the
fair market value of the property given, and the taxpayer would be
subjected to a double tax if the fair market value of the property received
is more than the fair market value of the property given. By holding that
the fair market value of the property received in a taxable exchange is the
cost basis, the above discrepancy is avoided and the basis of the
property received will equal the adjusted basis of the property given plus
any gain recognized, or that should have been recognized, or minus any
loss recognized, or that should have been recognized.
Therefore, the cost basis of the 10-year extension of the franchise
was its fair market value on August 3, 1934, the date of the exchange.
The determination of whether the cost basis of the property received is its
fair market value or the fair market value of the property given in
exchange therefor, although necessary to the decision of the case, is
generally not of great practical significance because the value of the two
properties exchanged in an arms-length transaction are either equal in
fact, or are presumed to be equal. The record in this case indicates that
the 1934 exchange was an arms-length transaction and, therefore, if the
value of the extended franchise cannot be determined with reasonable
accuracy, it would be reasonable and fair to assume that the value of
Strawberry Bridge was equal to the 10-year extension of the franchise.
The fair market value of the 10-year extension of the franchise should be
established but, if that value cannot be determined with reasonable
certainty, the fair market value of Strawberry Bridge should be
established and that will be presumed to be the value of the extended
franchise. This value cannot be determined from the facts now before us
since the case was prosecuted on a different theory.
The taxpayer contends that the market value of the extended
franchise or Strawberry Bridge could not be ascertained . . . . If the
value of the extended franchise or bridge cannot be ascertained with a
reasonable degree of accuracy, the taxpayer is entitled to carry over the
Ch. I
The Realization Requirement
43
undepreciated cost of the bridge as the cost basis of the extended
franchise. . . . However, it is only in rare and extraordinary cases that
the value of the property exchanged cannot be ascertained with
reasonable accuracy. We are presently of the opinion that either the
value of the extended franchise or the bridge can be determined with a
reasonable degree of accuracy. . . .
*
*
*
*
We, therefore, conclude that the 1934 exchange was a taxable
exchange and that the taxpayer is entitled to use as the cost basis of the
10-year extension of its franchise its fair market value on August 3, 1934,
for purposes of determining depreciation and loss due to abandonment,
as indicated in this opinion.
*
*
*
__________
*
DISCUSSION
A. The tax years at issue in Philadelphia Park were 1945 and 1946, yet
all the discussion revolves around wht happened in 1934. Do you understand
why? Is there a statute of limitations issue lurking here?
B.
The taxable event in Philadelphia Park is an
deductionsabandonment. Explicit authority for taking a deduction when
property is abandoned can be found in Treas. Regs. § 1.165-2(a)
(nondepreciable property) and 1.167(a)-8 and 1.167(a)-9 (depreciable
property).18 Explicit authority is helpful in allowing the deduction, because the
courts have accepted the view that allowance of deductions is a matter of
"legislative grace." Commissioner v. 356 U.S. 27, 28 (1958).
C. In the court's view, what would be the tax result to the transferor if
neither asset in the exchange could be valued? The statement in the case that
"only in rare and extraordinary cases" can the value of property not be
ascertained can be found in Treas. Regs. § 1.1001-1(a).
D. Note that there are two issues dealt with in Philadelphia Park. The
more important one is that, if an exchange occurs and the on only one side of
18"Depreciable property" is property that can be expected to decrease in value over
time, like a machine. The tax law allows taxpayers to take "depreciation" deductions
reflecting those expected decreases in value. "Nondepreciable property" is property whose
value over time cannot be predicted with assurance, such as land. We will be studying these
concepts in great detail later on in this course.
44
Principles of Income Taxation
Ch. I
the exchange can be valued easily, the second side is considered to be of equal
value to the first.
The second point of the case, which is of lesser importance because it
occurs rarely, deals with an exchange of properties of . The case holds that,
under those circumstances, the fair market value of the item received is treated
as the amount realized, and the basis of the property received is also made
equal to that fair market value.
While the substance of that rule is not of great practical importance, the
reason it is troublesome to the court is worth exploring. Imagine Jack
exchanging a cow with a $100 basis and a fair market value of $1,000 for a
beanbag worth $1. (Jack was told that the beans were magic beans, but,
unfortunately, they turn out to be magic beans only in fairy tales.) Ultimately,
Jack sells the beanbag for its $1 value.
Now, when the dust has cleared, we see that Jack started with property
with a basis of $100 and ended up with $1 in cash. The logic of the tax law
tells us that Jack should have a loss of $99 on the two transactions, net.
Surprisingly, we don't get that result from a simple reading of the Code.
First, Jack exchanges the cow for the beanbag. Section 1001 tells us that Jack's
loss is measured by the difference between the amount realized (the value of
the beanbag, $1) and the basis of the property (the cow) given up ($100).
That's a $99 loss, which looks like a good start on our problem.
However, section 1012 tells us that the basis of property is its cost.
When property is purchased with other property, the natural understanding of
"cost" is the value of what was given up in the exchange. So, in our case, the
cost should be the value of the cow that Jack gave up, $1,000.
But that messes up our calculation grandly. For if Jack's basis in the
beanbag is $1,000, Jack will have an additional loss of $999 when the beanbag
is sold for $1. Thus, the tax loss calculated by following the Code apparently
exceeds by a substantial amount the $99 loss that we said "should" result from
the tax calculations.
Go back now to the court's discussion of the issue in Philadelphia Park.
You will see that the court is clearly unwilling to accept this result. Given the
problem that results from following both section 1001 and section 1012, the
court opts for section 1001, and interprets section 1012 to make basis a pure
"tax concept." Thus, there is a $99 loss on the exchange of cow for beanbag.
However, the beanbag is given only a $1 basis, a basis equal to its value, rather
than the cost basis mandated by the Code. As a tax concept, the $1,000 basis
for the beanbag could be accepted only if we said that the amount realized on
the exchange was the $1,000 value of the cow given up (not our normal
understanding of "amount realized"). The logic of the tax law compels the
Ch. I
The Realization Requirement
45
court to insure that, once the beanbag is sold for $1, the total loss on the
transaction will be precisely $99.
The lesson here is a very important one. Part of your job in this course
is to understand the logic of the tax law, since it is strong enough to override
even a clear statement of the Code.
ASIDE: Where's the beef? Some of you, particularly those who are
sympathetic to country bumpkins who are cheated out of their cows,
may think that I have just pulled a fast one on you. After all, poor Jack
just got cheated out of a $1,000 cow for a $1 beanbag. Hasn't he
suffered a loss of $999, not the meager $99 I have allotted?
The answer again comes from the logic of the tax law and the rules of
realization. Suppose Jack first sold the cow for $1,000 and then paid
the $1,000 for the beanbag. A sale for $1,000 produces a $900 gain
($1,000 amount realized minus $100 basis). The beanbag, bought for
$1,000, surely has a $1,000 basis, and when it is sold for $1, might
produce a $999 loss. (We will have to study section 165 before we can
be sure that Jack can take that $999 loss for tax purposes, but that is a
matter for another day.) The $900 gain and the $999 loss net out to our
$99 loss--no more than that.
Under the facts in our original example, although Jack is losing value
when the $1,000 cow is exchanged for the $1 beanbag, $900 of the
value that is being lost is unrealized value, and thus it is value that we
don't take account of in the tax system.19 The realization requirement is
paramount.
One final, confusing rule: Suppose I go into a supermarket and pay for
a $1.50 box of Turbo Mutant Ninja Goldfish Food with a dollar bill and a 50
cent manufacturer's cents off coupon which I received in the mail. It looks like
I have received 50 cents in value in exchange for a coupon which cost me
nothing. Does Davis tell me that I have income of 50 cents?
It should strike you at once that such a rule would be an administrative
nightmare. Fortunately, the tax law has found its way out of such a mess by
analyzing situations like this one as price reductions which do not result in
taxable income. Indeed, even if you buy a car from your local Ferrari dealer
and then get a $5,000 rebate directly from the manufacturer, the IRS treats you
as having gotten a non-taxable rather than income. Rev. Rul. 76-96, 1976-1
C.B. 23.
19That
point is made explicitly in Hort v. Commissioner,; in Chapter II.
46
Principles of Income Taxation
Ch. I
The next realization case involves a transaction which has many
possible choices for a realization event. The difficult issue considered by the
Court is which event to choose. Try to understand the logic of the various rules
advanced to deal with the issue of lessee improvements.
HELVERING v. BRUUN
309 U.S. 461 (1940)
MR. JUSTICE ROBERTS delivered the opinion of the Court.
*
*
*
*
. . . [O]n July 1, 1915, the respondent, as owner, leased a lot of
land and the building thereon for a term of ninety-nine years.
The lease provided that the lessee might , at any time, upon giving
bond to secure rentals accruing in the two ensuing years, remove or tear
down any building on the land, provided that no building should be
removed or torn down after the lease became forfeited, or during the last
three and one-half years of the term. The lessee was to surrender the
land, upon termination of the lease, with all buildings and improvements
thereon.
In 1929 the tenant demolished and removed the existing building
and constructed a new one which had a useful life of not more than fifty
years. July 1, 1933, the lease was cancelled for default in payment of rent
and taxes and the respondent regained possession of the land and
building.
The parties stipulated "that as at said date, July 1, 1933, the
building which had been erected upon said premises by the lessee had a
fair market value of $64,245.68 and that the unamortized cost of the old
building, which was removed from the premises in 1929 to make way for
the new building, was $12,811.43, thus leaving a net fair market value as
at July 1, 1933, of $51,434.25, for the aforesaid new building erected
upon the premises by the lessee."
On the basis of these facts, the petitioner determined that in 1933
the respondent realized a net gain of $51,434.25. The Board overruled
his determination and the Circuit Court of Appeals affirmed the Board's
decision.
The course of administrative practice and judicial decision in
respect of the question presented has not been uniform. In 1917 the
Treasury ruled that the adjusted value of improvements installed upon
leased premises is income to the lessor upon the termination of the lease.
Ch. I
The Realization Requirement
47
The ruling was incorporated in two succeeding editions of the Treasury
Regulations. In 1919 the Circuit Court of Appeals for the Ninth Circuit
held in Miller v. Gearin, . . . , that the regulation was invalid as the gain, if
taxable at all, must be taxed as of the year when the improvements were
completed.
The regulations were accordingly amended to impose a tax upon
the gain in the year of completion of the improvements, measured by their
anticipated value at the termination of the lease and discounted for the
duration of the lease. Subsequently the regulations permitted the lessor
to spread the depreciated value of the improvements over the remaining
life of the lease, reporting an aliquot part each year, with provision that,
upon premature termination, a tax should be imposed upon the excess of
the then value of the improvements over the amount theretofore returned.
In 1935 the Circuit Court of A ppeals for the Second Circuit decided
in Hewitt Realty Co. v. Commissioner, . . . that a landlord received no
taxable income in a year, during the term of the lease, in which his tenant
erected a building on the leased land. The court, while recognizing that
the lessor need not receive money to be taxable, based its decision that
no taxable gain was realized in that case on the fact that the improvement
was not portable or detachable from the land, and if removed would be
worthless except as bricks, iron, and mortar. It said . . . : "The question
as we view it is whether the value received is embodied in something
separately disposable, or whether it is so merged in the land as to
become financially a part of it, something which, though it increases its
value, has no value of its own when torn away."
This decision invalidated the regulations then in force.
In 1938 this court decided M.E. Blatt Co. v. United States, . . .
There, in connection with the execution of a lease, landlord and tenant
mutually agreed that each should make certain improvements to the
demised premises and that those made by the tenant should become and
remain the property of the landlord. The Commissioner valued the
improvements as of the date they were made, allowed depreciation
thereon to the termination of the leasehold, divided the depreciated value
by the number of years the lease had to run, and found the landlord
taxable for each year's aliquot portion thereof. His action was sustained
by the Court of Claims. The judgment was reversed on the ground that
the added value could not be considered rental accruing over the period
of the lease; that the facts found by the Court of Claims did not support
the conclusion of the Commissioner as to the value to be attributed to the
improvements after a use throughout the term of the lease; and that, in
the circumstances disclosed, any enhancement in the value of the realty
48
Principles of Income Taxation
Ch. I
in the tax year was not income realized by the lessor within the Revenue
Act.
The circumstances of the instant case differentiate it from the Blatt
and Hewitt cases; but the petitioner's contention that gain was realized
when the respondent, through forfeiture of the lease, obtained
untrammeled title, possession and control of the premises, with the added
increment of value added by the new building, runs counter to the
decision in the Miller case and to the reasoning in the Hewitt case.
The respondent insists that the realty, - a capital asset at the date
of the execution of the lease, - remained such throughout the term and
after its expiration; that improvements affixed to the soil became part of
the realty indistinguishably blended in the capital asset; that such
improvements cannot be separately valued or treated as received in
exchange for the improvements which were on the land at the date of the
execution of the lease; that they are, therefore, in the same category as
improvements added by the respondent to his land, or accruals of value
due to extraneous and adventitious circumstances. Such added value, it
is argued, can be considered capital gain only upon the owner's
disposition of the asset. The position is that the economic gain
consequent upon the enhanced value of the recaptured asset is not gain
derived from capital or realized within the meaning of the Sixteenth
Amendment and may not, therefore, be taxed without apportionment.
We hold that the petitioner was right in assessing the gain as
realized in 1933.
*
*
*
*
The respondent can not successfully contend that the definition of
gross income in § 22 (a) of the Revenue Act of 1932 is not broad enough
to embrace the gain in question. That definition follows closely the
Sixteenth Amendment. Essentially the respondent's position is that the
Amendment does not permit the taxation of such gain without
apportionment amongst the states. He relies upon what was said in
Hewitt Realty Co. v. Commissioner, supra, and upon expressions found
in the decisions of this court dealing with the taxability of stock dividends
to the effect that gain derived from capital must be something of
exchangeable value proceeding from property, severed from the capital,
however invested or employed, and received by the recipient for his
separate use, benefit, and disposal. 8 He emphasizes the necessity that
the gain be separate from the capital and separately disposable. These
8See
Eisner v. Macomber, . . . .
Ch. I
The Realization Requirement
49
expressions, however, were used to clarify the distinction between an
ordinary dividend and a stock dividend. They were meant to show that in
the case of a stock dividend, the stockholder's interest in the corporate
assets after receipt of the dividend was the same as and inseverable
from that which he owned before the dividend was declared. We think
they are not controlling here.
While it is true that economic gain is not always taxable as income,
it is settled that the realization of gain need not be in cash derived from
the sale of an asset. Gain may occur as a result of exchange of property,
payment of the taxpayer's indebtedness, relief from a liability, or other
profit realized from the completion of a transaction. The fact that the gain
is a portion of the value of property received by the taxpayer in the
transaction does not negative its realization.
Here, as a result of a business transaction, the respondent
received back his land with a new building on it, which added an
ascertainable amount to its value. It is not necessary to recognition of
taxable gain that he should be able to sever the improvement begetting
the gain from his original capital. If that were necessary, no income could
arise from the exchange of property; whereas such gain has always been
recognized as realized taxable gain.
Judgment reversed.
__________
NOTE
In the tradition of the other realization cases we have looked at,
Macomber and Davis, note that the result in Bruun has been reversed by
statute. See sections 109 and 1019.
At the time that Bruun was decided, a law review article attempted to
put it into perspective.
S. .m.SURREY, THE SUPREME COURT AND THE FEDERAL INCOME TAX SOME
IMPLICATIONS OF THERECENT DECISIONS
35 Ill. L. Rev. 779, 781-84 (1941)
The present Court has already indicated that the steady
broadening of the concept of income which characterized the past
decade will continue, but at a pace so accelerated that it almost dwarfs
the progress of that decade. When Eisner v. Macomber was decided in
1920 the Court may well have regarded it as the cornerstone of the
edifice which later decisions were to complete. The discussion of the
concept of income was painstaking and lengthy.
The views of
50
Principles of Income Taxation
Ch. I
economists, the statements of the lexicographers and the learning of prior
decisions were all examined before the Court pronounced the fateful
words:
Here we have the essential matter: Not a gain accruing to
capital, not a growth or increment of value in the investment; but a gain,
a profit, something of exchangeable value proceeding from the property,
severed from the capital however invested or employed, and coming in,
being "derived," that is, received or drawn by the recipient (the taxpayer)
for his separate use, benefit and disposal; -- that is income derived from
property. Nothing else answers the description.
The awesome finality of that last sentence has never been fulfilled.
The cornerstone was laid, but the Court proceeded no further with its task
of building upon it a concept of income. Each succeeding opinion paid its
respects to the principle of realization which was the core of the Court's
pronouncement in Eisner v. Macomber, but went on to a result which
never matched the rigor of that pronouncement. The principle of
realization did become the cornerstone of an income tax literature, which
the many-tongued opinions of lawyers, economists, accountants and
judges made a tax Tower of Babel. The decision last term in Helvering v.
Bruun perhaps for the first time showed clearly how different was that
tower from the building actually constructed by the Court.
*
*
*
*
Where the taxpayer had one asset before the exchange and an
essentially different asset after the exchange, his lack of concern over the
future of the first asset justifies a tax at that time on its appreciation in
value. The character of the second asset is immaterial. But the problem
before the Court was a very different one. A taxpayer owns land and a
building, but they are subject to a lease which postpones his enjoyment of
that building. When the lease terminates and he obtains possession of
the building, shall he then be taxed on the value added to the land by the
building? His interest in the future course of that land and building -- their
future fluctuations in value -- remains the same. The situation does not in
this sense differ from one in which the land has increased in value
because of an improvement on adjoining property. Yet the value added
to the land by the building is held taxable. And it is held taxable because
it is not necessary that the improvement begetting the gain be severable
from the original property. Such an answer goes far beyond the
reasoning advanced in its support. Stated in such terms it is a complete
denial of the doctrine that is the heart of Eisner v. Macomber.
If we interpret it correctly, Helvering v. Bruun marks the end of one
era in our tax history. What had commenced as a highly conceptual view
of the realization of income has in the intervening twenty years become
Ch. I
The Realization Requirement
51
no more than a recognition of an expedient procedure. Economic gain
occurs each year as an asset appreciates. The income tax, however,
does not reach that gain because the more precise measure of yearly
income that would result from inclusion of the increase in value does not
justify the cost to Government and taxpayer of yearly valuations. But the
gain is there, and if events occur which bring about a change with respect
to the asset making measurement desirable the reckoning should be
made. The change need not be such as to make the measurement of
value any the easier. It is enough that it marks a variation which warrants
a halt in the postponement of a tax on admitted gain. If increase in value
of property be conceded income in the economic sense the decision not
to tax that increase for one reason or another is simply a decision to base
the income tax for the time being on something less than a taxpayer's
total income. When an event occurs which legislators, and through them
administrative officials, 12 feel is sufficient to end the postponement, a
realization of income has occurred in the legal sense. It is beside the
point that many an event selected by the legislators or administrators is
hardly very significant. In selecting that event they may well have thought
that taxation at the time of the event involves fewer difficulties than a
requirement that various events differing only slightly in degree must
somehow be classified and placed on two sides of a line. It is enough
therefore that a recognizable variation is present. The taxpayer whose
land has increased in value because the adjoining land has been
improved may not be in a different economic position respecting that
increase from the taxpayer in the Bruun case. Each has experienced
economic gain. But the taxpayer in the Bruun case now has possession
of the building and before the lease expired he did not. The change in
circumstances is easily recognizable and therefore warrants the taxing of
admitted economic gain. The increase in the other case, however, is not
traceable to a variation capable of routine handling by administrative
officials, and therefore it is not taxed.
__________
NOTE
Here is one more case that raises the realization issue in a somewhat
peculiar context.
12The decision of administrative officials that the realization of income has
occurred will, if that decision is a reasonable one, determine the question where the
legislature is silent. E.g. Helvering v. Bruun, . . .; Helvering v. Horst, . . . .
52
Principles of Income Taxation
Ch. I
.t.CESARINI v. UNITED STATES
296 F.Supp. 3 (N.D. Ohio 1969), aff'd, 428 F.2d 812 (6th Cir. 1970)
YOUNG, DISTRICT JUDGE: * * *
. . . In 1957, the plaintiffs purchased a used piano at an auction
sale for approximately $15.00, and the piano was used by their daughter
for piano lessons. In 1964, while cleaning the piano, plaintiffs discovered
the sum of $4,467.00 in old currency, and . . . reported the sum of
$4,467.00 on their 1964 joint income tax return as ordinary income from
other sources. . . .
Plaintiffs make three alternative contentions . . . First, that the
$4,467.00 found in the piano is not includable in gross income under
Section 61 of the Internal Revenue Code. . . . Secondly, even if the
retention of the cash constitutes a realization of ordinary income under
Section 61, it was due and owing in the year the piano was purchased,
1957, and by 1964, the statute of limitations provided by 26 U.S.C.
§ 6501 had elapsed. [The third contention relates to capital gain
treatment and is omitted here. -- Ed.]
. . . [T]his Court has concluded that the taxpayers are not entitled
to a refund of the amount requested, . . . .
The starting point in determining whether an item is to be included
in gross income is, of course, Section 61(a) . . . , and that section
provides in part:
"Except as otherwise provided in this subtitle, gross income
means all income from whatever source derived, including (but not
limited to) the following items: . . ." (Emphasis added.)
. . . The decisions of the United States Supreme Court have
frequently stated that this broad all-inclusive language was used by
Congress to exert the full measure of its taxing power under the Sixteenth
Amendment to the United States Constitution.
Commissioner v.
Glenshaw Glass Co., . . .
*
*
*
*
Although not cited by either party, and noticeably absent from the
Government's brief, the following Treasury Regulation appears in the
1964 Regulations, the year of the return in dispute:
"§ 1.61-14 Miscellaneous items of gross income.
"(a) In general. In addition to the items enumerated in
section 61(a), there are many other kinds of gross income . . . .
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Treasure trove, to the extent of its value in United States currency,
constitutes gross income for the taxable year in which it is reduced
to undisputed possession." (Emphasis added.)
. . . This Court is of the opinion that Treas. Reg. § 1.61-14(a) is
dispositive of the major issue in this case if the $4,467.00 found in the
piano was "reduced to undisputed possession" in the year petitioners
reported it, for this Regulation was applicable to returns filed in the
calendar year of 1964.
This brings the Court to the second contention of the plaintiffs that
if any tax was due, it was in 1957 when the piano was purchased, . . .
[T]his Court finds that the $4,467.00 sum was properly included in gross
income for the calendar year of 1964. Problems of when title vests, or
when possession is complete in the field of federal taxation, in the
absence of definitive federal legislation on the subject, are ordinarily
determined by reference to the law of the state in which the taxpayer
resides, or where the property around which the dispute centers is
located. Since both the taxpayers and the property in question are found
within the State of Ohio, Ohio law must govern as to when the found
money was "reduced to undisputed possession within the meaning of
Treas. Reg. § 1.61-14 . . .
. . . [I]n the instant case if plaintiffs had resold the piano in 1958,
not knowing of the money within it, they later would not be able to
succeed in an action against the purchaser who did discover it. Under
Ohio law, the plaintiffs must have actually found the money to have
superior title over all but the true owner, and they did not discover the old
currency until 1964. . . . Therefore, this Court finds that the $4,467.00 in
old currency was not "reduced to undisputed possession" until its actual
discovery in 1964, . . .
. . . Since it appears to the Court that the income tax on these
taxpayers' gross income for the calendar year of 1964 has been properly
assessed and paid, this taxpayers' suit for a refund in the amount of
$836.51 must be dismissed, and judgment entered for the United States.
An order will be entered accordingly.
__________
DISCUSSION
Although it may surprise you at first, there is little controversy in the tax
law over the proposition that one who finds a valuable object has income equal
to the value of the object. The regulations make the point explicitly in section
1.61-14 ( is income). The additional question raised by Cesarini is when does
the finder have the income?Incometiming of
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Principles of Income Taxation
Ch. I
On the one hand, why didn't Cesarini have income when the piano was
purchased, since at that time the money first came into his possession? On the
other hand, would Cesarini have had income if he discovered that the piano
was worth much more than he paid for it? Does the person who buys a
painting at a flea market for $5 and later discovers that it is an original Van
Gogh have income before the painting is sold? The answers to these questions
put a gloss on the concept of realization.
There is another, somewhat awkward question raised by Cesarini. How
did the Internal Revenue Service ever find out about the money in Cesarini's
piano? One does not need to give people the third degree to discover that most
have found money on the street, or in the coin return boxes of pay telephones,
and never thought to report that money as income on their tax returns.
Moreover, even after reading Cesarini, many otherwise respectable persons
continue to ignore found money in reporting their income. It is unlikely that
any of them expect the IRS to find them out.
The question about Cesarini's money can be answered in a number of
ways. As a technical matter, one can say that the IRS found out about
Cesarini's money because Cesarini told the IRS about it first.
There are two ways that a tax issue can reach the courts. The IRS can
assert that a taxpayer owes additional taxes ("assert a deficiency"). Rather than
pay the taxes, the taxpayer disputes the IRS's position and brings the case to
court. Alternatively, the taxpayer can pay a tax (either on the original return
filed by the taxpayer or in response to a deficiency claimed by the IRS) and
then sue for a refund.
Look again at the reported decision. The taxpayer was suing for a
refund in Cesarini. Apparently the taxpayer noted the found money on his
original tax return, and then decided to bring the issue to court. If the taxpayer
never told the IRS about the money, it is likely that the IRS would never have
found out about it.
1.
Treasure trove, the self-assessment system, and the ethics of
tax practice.
Was it foolish for the taxpayer to bring the issue to the IRS's attention in
the first place? To answer that, note first that the IRS is rather peculiar when
compared to other debt collectors. Unlike the telephone company or the
electric company, which send their customers bills to be paid, the Federal
government waits for taxpayers to tell it when money is owed, and how much.
This sself-assessment system is not the only way a tax system can be
run. Real property taxation in the United States operates by having an assessor
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55
for the governmental unit first value the property. The owner then either pays
the tax or disputes the valuation.
Because we rely on the self-assessment system, the level of honesty of
taxpayers in assessing themselves plays an important role in the income tax
collection process. If taxpayers as a matter of course failed to report all their
income on their tax returns, the tax collection process would be substantially
sabotaged. who advise taxpayers must balance their obligations as advocates
for their clients with their duty as officers of the court.
How does the issue arise? Suppose a client calls up counsel to tell of
his or her good fortune in finding $5,000 in cash in a recently purchased piano.
At the end of the conversation, the client casually says: "By the way, I am right
in thinking that when you get a lucky break like this, you don't have to report it
on your tax return?"
Many tax lawyers would prefer to deal with such questions with a
pregnant silence. However, if an insensitive client presses, the lawyer must
advise that, in fact, finding treasure trove does constitute taxable income. Then
the client may ask: "But, do I really have to report it on my tax return?"
Many approaches might spring to mind in responding to this question,
including a consideration of the likelihood of discovery, penalties upon
discovery, and so forth. But, in fact, the lawyer has only one proper option in
answering a question where the answer is so clear. The lawyer must advise
that, indeed, the income does have to be reported.
This conclusion is reflected in a specific opinion of the American Bar
Association. In Formal Opinion 85-352, reproduced in the Appendix, the ABA
Standing Committee on Ethics and Professional Responsibility addressed the
standards to be used in advising clients on positions to be taken in tax returns,
and reached the following conclusion:
A lawyer may advise reporting a position on a tax return so long as the
lawyer believes in good faith that the position is warranted in existing law or
can be supported by a good faith argument for an extension, modification, or
reversal of existing law and there is some realistic possibility of success if the
matter is litigated.
Where, as here, there does not appear to be a "realistic possibility of success if
the matter is litigated," the lawyer cannot advise the client to take the position
on the return.
The lawyer's ethical obligations in tax practice are not always clear. We
will return to this issue below.
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To some extent, Congress has become warier of taxpayers' selfassessment. This makes the lawyer's ethical position easier to maintain,
because the lawyer can point to more serious penalties for misreporting income
than once would have been the case, and can suggest more reasons that the
taxpayer's failure to report will not go undetected by the IRS.
1.
To the extent taxes are collected when transactions take place, for
example, withholding taxes on wages, the possibility of hiding the
transaction from the IRS is sharply reduced. Moreover, in such a case,
the taxpayer may well want to report the transaction to the extent the
withholding on the transaction was greater than the taxpayer's actual tax
liability. Thus, the withholding of taxes on wages means that a large
percent of tax collections are made before anyone files an income tax
return.
2.
The filing of information with the IRS on a transaction substantially
increases the likelihood that the IRS will know about it even if the
taxpayer fails to report it on his or her tax return. Thus, interest and
dividends, for example, which are reported to the IRS, are less likely to
be ignored by taxpayers than if the IRS knew nothing about them.
3.
Increasing penalties on taxpayers who fail to report transactions on their
returns encourages proper compliance with the tax law.
Another problem in applying the tax law to a person who finds a nickel
on the streets is some concept of the level of fineness to which the IRS expects
taxpayers to go in reporting their tax liabilities. At times it is clear that, as a
matter of administrative convenience, the IRS will concede that certain types of
income are to be ignored, in part because they are too small and are difficult to
value. For example, while it first tried to rule otherwise, the IRS now holds
that book reviewers who receive books, unsolicited, for review, generally have
no income on receipt of those books.20 The effect of administrative needs on
the tax law will be considered again below.
2.
Forum shopping in tax litigation.
There is one final issue that should be noted about the way tax cases get
to court. We said before that a tax case can be brought in response to a
deficiency asserted by the IRS or in a suit for a refund claimed by the taxpayer.
There is an important consequence of the different ways chosen to get into
court.
20See Haverly v. United States,; reproduced in Chapter VII, which discusses Revenue
Ruling 70-498;.
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If the taxpayer goes to court in response to a deficiency claimed by the
IRS, the taxpayer must sue in the Tax Court, a specialized court that, as its
name implies, hears only tax cases. The decisions of the Tax Court are
appealed to the Court of Appeals of the Circuit in which the taxpayer resides.
If the taxpayer goes to court after paying a disputed tax, the taxpayer
must bring suit in its local District Court or in the Claims Court. A District
Court decision is appealed to the appropriate Court of Appeals. A Claims
Court decision is appealed to the Federal Circuit; after that, the losing side's
only recourse is to the United States Supreme Court.
Thus, the decision whether to pay the disputed tax will affect the trial
court in which the issue will be heard. Moreover, if the taxpayer decides to pay
the tax and sue for a refund, the taxpayer will have a choice not only of two
trial courts, but also of two courts to make a final decision in the case
(assuming that the case will not reach the Supreme Court). Since one or
another of the courts may already have taken a position on the issue in
question, the ability to forum shop can be quite valuable to the taxpayer.
To return to Jones, Jones has income at the time the property is sold to
Smith. Jones' income is $30,000, the difference between what Jones received
from Smith, $50,000, and what Jones paid for the land, $20,000.
Since we are dealing with the tax system, which is based on statutory
rules, we can find that answer in the Internal Revenue Code itself. Section
1001 tells us that gain from the sale of property is the difference between the
amount realized from a sale and the taxpayer's "basis" in the property. Among
other things, Section 1012 says that "basis" is the cost of an item to the
taxpayer. Section 1012 hints that there is more to "basis" than what we have
just said, but that is a matter we will be pursuing below.
E.
An Aside on the Sources of Tax Law
In your prior law school career, you have probably spent most of your
time deriving the law from cases you have read. You may have noticed that the
above discussion looked at other sources besides cases in order to determine
what the law is.
Of first importance in tax practice is the statute, the Internal Revenue
Code. There would be no tax law absent a statute, and so the source of the
Government's power in this area is the statute. A tax lawyer quickly learns to
look to the statute first in trying to resolve a tax issue. If the answer can be
found in the statute, it is not likely that any further research need be done. In
deciding what was Congress's meaning when it passed a particular provision,
significant assistance can be found in the contemporaneous reports of the
Congressional committees that deal with tax issues. Occasionally, illuminating
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Principles of Income Taxation
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statements will be made by Members of Congress on the floor of the House or
Senate.21
A second source of tax rules are the regulations promulgated by the
Internal Revenue Service. Since the IRS is the taxpayer's adversary in tax
matters, it may surprise you that the courts will consider seriously the
interpretations of one party to the litigation before it.
But the IRS, as an administrative agency, must promulgate appropriate
regulations, and it takes that obligation seriously. It does not lightly include a
position in the Regulations, but does so only in compliance with its general
mandate to enforce the law. Since the IRS's power to promulgate regulations is
itself part of the law, either from its general powers under section 7805, or from
more specific grants of rulemaking power (see, for example, sections 132(k),
469(k), and 1502), the courts generally accept the regulations as authoritative
interpretations of the law.
Another category of administrative pronouncements are . These rulings
give the IRS's position on specific factual circumstances that were brought to
its attention. They are published weekly in the IRS's Internal Revenue Bulletin,
and then collected semiannually in Cumulative Bulletins. In some cases, the
courts will dismiss a Revenue Ruling as nothing more than a statement of one
litigant to a controversy.22 However, most practitioners will rely on most
rulings as authoritative statements of the law. As a practical matter, one can
expect to ignore such statements at one's peril, since they are subject to
significant internal review at the IRS and thus constitute well thought out
positions of the Service. The IRS will generally challenge taxpayers who
disregard a published IRS ruling, thus providing an additional incentive for
taxpayers not to ignore them.
Another source for the IRS's position on an issue is the mass of "p" that
the IRS issues. In an interesting (and nowhere required) aspect of the tax
process, the IRS issues to taxpayers a ruling on how it will treat a transaction
that the taxpayer proposes entering into. If the taxpayer has properly
represented the facts of the transaction to the IRS, the IRS will feel bound to
any favorable ruling that it issues, even if it thereafter changes its mind on the
21While the sources mentioned in the text are legally significant, they are occasionally
viewed with some cynicism by those who observe the legislative process up close. Political
infighting and lobbying go into the drafting of a tax statute, and those who are unable to win a
clear victory in the drafting of the statute itself may content themselves with a supportive
statement in a committee report or a colloquy on the floor of Congress, if they can get it.
22See the discussion of Revenue Rulings 85-125 and 81-204 in note 7 of Cottage
Savings Assn. v. Commissioner, in Chapter III.
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proper treatment of that particular transaction. The taxpayer, on the other hand,
is free to challenge the IRS's position (although it is obligated to attach a copy
of the IRS's ruling to its tax return).
Since 1976, when the public became concerned with the private nature
of this process, the IRS has been obligated to release to the public anonymous
versions of these private rulings under section 6110. These are reproduced by
commercial publishers and can be found on legal databases such as LEXIS and
WESTLAW. Although the statute is clear that these private rulings are not
precedential in nature, section 6110(j)(3), it is not clear to what extent the IRS
can easily change a longstanding administrative policy that is reflected in those
private rulings.
F.
A Word of Encouragement and a Quick Preview
Most basic tax casebooks are organized in a manner that may seem a bit
more straightforward then this one. First you cover what is income, then
deductions, then accounting issues (the timing of income), with capital gains
and the question of who is the taxpayer thrown in before or after accounting.
After quietly accepting that approach for a number of years, I
discovered that my own course had developed a different structure. The
problem with trying to follow income to its end, then deductions, etc., is that
important (and, at times, difficult) issues are constantly skipped over in order to
"get to the end of the section." Introducing those important issues early on has
a number of benefits for the student, I believe. It gives the student more time to
absorb and understand them, and it also allows the student to see how they are
applied throughout the course. As a result, you will now learn about basis, debt
and the time value of money, before you learn anything about fringe benefits,
like-kind exchanges and deductions.
The structure of this casebook should not blind you to fact that,
ultimately, you need to develop a coherent understanding of the basic issues:
what is income, what is a deduction, and when is income or a deduction
recognized. In a sense, this chapter has introduced you to those issues already.
You are hopefully beginning to apply a theoretical approach to the issue of
income and deduction (as embodied in Simons' definition of income) while
nurturing a nascent appreciation for the practical problems that serve to
motivate the accounting issues we will discuss in more detail later (this through
the development of the concept of realization). You should ultimately come to
understand that the particular rules you will learn later on in the course stem
from these first principles, as filtered through Congress's desire, on occasion, to
use the tax law for purposes that have nothing to do with the measurement of
income and the collection of taxes. I hope that the devious path we take
through the Code's complexities will ultimately get you further into the forest
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Principles of Income Taxation
Ch. I
than you might have gotten otherwise, and, most importantly, with a fuller
understanding of the meaning behind each little tree.
However, in order to help the more practically-minded keep a handle on
the significance of the items in our tax system, let me include here the most
practical of aids to understanding the tax law: a form of tax return. This is not a
real Form 1040--I have modified it in order to eliminate some issues that are
peripheral to our course while combining various "schedules" that real tax
forms have into one, unified "form."
Needless to say, there will be items on this form that are not yet
meaningful to you. However, hopefully this "form" will assist you to
understand the structure of the tax system as we plow our way through it.
Ch. I
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61
U. S. Individual Income Tax Return
For calendar 1995, or other tax year beginning
, 1994, ending
, 19
Name, Address and Social Security Number:________________________
Filing Status
___Single
___Married filing joint return
___Married filing separate return
___Head of household
___Qualifying widow(er) with dependent child
Exemptions
___Yourself
___Spouse
___Dependents
___Total number of exemptions:
Income
Wages .....................................................................................
................................................................................................_______
Interest (excluding tax-exempt interest) .................................
................................................................................................_______
Dividends................................................................................
................................................................................................_______
Taxable refunds of state and local taxes .................................
................................................................................................_______
Alimony ..................................................................................
................................................................................................_______
Business income or (loss) (business
gross income minus business deductions) ..............................
................................................................................................_______
Capital gain or (loss)...............................................................
................................................................................................_______
Taxable pension distributions .................................................
................................................................................................_______
Income or (loss) from rental properties...................................
................................................................................................_______
Income or (loss) from partnerships,
estates, trusts, etc. ...................................................................
................................................................................................_______
Unemployment compensation ................................................
................................................................................................_______
Other Income ..........................................................................
................................................................................................_______
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Adjustments to Income
IRA (and other retirement plan) deductions ...........................
................................................................................................_______
One-half of self-employment tax ............................................
................................................................................................_______
Alimony paid ..........................................................................
................................................................................................_______
Adjusted Gross Income (AGI)
Subtract total adjustments to income
from total income....................................................................
................................................................................................_______
Tax Computation
The larger of your standard deduction or the sum
of the following "itemized" deductions:
Medical expenses in excess of 7.5% of AGI...............
....................................................................................._______
State and local income and property taxes paid ..........
....................................................................................._______
Home mortgage and investment interest .....................
....................................................................................._______
Charitable contributions ..............................................
....................................................................................._______
Casualty and theft losses in excess of 10% of AGI.....
....................................................................................._______
Moving expenses.........................................................
....................................................................................._______
Job expenses and other expenses, in excess of
2% of AGI...................................................................
....................................................................................._______
NOTE: If AGI is in excess of $100,000, itemized
deductions must be reduced according to a formula.
$2,300 times the number of personal exemptions ..................
................................................................................................_______
NOTE: If AGI is in excess of $75,000, this number
may be reduced according to a formula.
Taxable income
Subtract deductions and personal exemption
amount, above, from AGI.......................................................
................................................................................................_______
Ch. I
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Tax
May be computed from tables in section 1 .............................
................................................................................................_______
Credits
Income tax withheld ...............................................................
................................................................................................_______
Child care credit......................................................................
................................................................................................_______
Earned income credit ..............................................................
................................................................................................_______
Estimated tax payments ..........................................................
................................................................................................_______
Refund or amount owed
Compare tax owed to credits ..................................................
................................................................................................_______
63
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NOTE
If this form seems confusing, you may find it helpful to see that the
form reflects many of the basic structures in the Code. For one thing, income
and deductions must always be related to a particular time period--that is why
the first line in the form specifies the time period (normally, but not always, a
calendar year) over which the taxpayer's tax calculation is to be made.
Second, the entity calculating the tax must be specified--we think of our
tax system as an individual income tax but, in fact, many married couples file
joint tax returns. We will be returning to questions relating to the family v. the
individual later on in the course.
The basic tax calculation starts with a determination of income received.
Not all receipts are income--in some cases, the Code itself excludes certain
items (see the reference to "tax-exempt interest" on the "interest" line of the
form). In many ways, it hardly matters whether an item is excluded from gross
income or deducted from gross income.
From gross income, certain deductions are taken. On the form, many of
the deductions are buried in the lines dealing with business income, income or
(loss) from rental properties, and income or (loss) from partnerships, etc. In
making the calculations for those lines, the taxpayer would take account of
appropriate business deductions.
In addition, certain other deductions are allowed as "adjustments to
income" on the form. There are three reasons for distinguishing business
deductions and these "adjustments" from the deductions that are listed on the
form under "Tax Computation". First, as the form indicates, the other
("itemized") deductions can be used only to the extent they exceed the
"standard deduction." The standard deduction is a fixed amount specified in
the statute for different categories of taxpayers.
Second, as indicated in the form, itemized deductions are reduced for
taxpayers with over $100,000 of AGI. Third, by distinguishing different
categories of deductions, the Code comes up with an intermediate figure in the
calculation--"Adjusted Gross Income"--which it makes use of for certain other
purposes in tax calculations. (Many of these uses are reflected in the form.)
There is no need for you to absorb all this detail right now. The hope is
that this overview will help you to see that there is an overriding structure to
which you can attach the information you are given in this course. There will
be time enough to put all the meat on these bones.