Presentation:
Federal Income Taxation
Chapter 1 Overview
Professors Wells
August 24, 2015
Introduction to Federal Taxation
p.1
Federal Income Tax is a law school subject, but it is much more, it is
about the social compact. Other quotes on taxes:
“Taxes are what we pay for civilized society.” Justice Oliver Wendell Holmes, Compania General de
Tabacos de Filipinas v. Collector of Internal Revenue, 275 U.S. 87, 100 (1927) (dissenting).
“Basic tax, as everyone knows, is the only genuinely funny subject in law school.” --Martin D. Ginsburg
“[T]axation, in reality, is life. If you know the position a person takes on taxes, you can tell their whole
philosophy. The tax code, once you get to know it, embodies all the essence of life: greed, politics, power,
goodness, charity.” --Sheldon S. Cohen
“America's tax laws are similar to the writings of Karl Marx and the writings of Sigmund Freud in that
many of the people who loudly proclaim opinions about these documents have never read a word of
them.”--Jeffery L. Yablon
“One of the problems with trying to have a rational discussion about taxes is that so many people want
to believe what's convenient rather than what's accurate. Believing, after all, requires so much less
effort than thinking.” --Allan Sloan
“Tax issues are fun. Getting to love them may take a bit of effort, but the same is true for Beethoven's
string quartets, and think of how much pleasure they give if one does make the effort.”--Peter L. Faber
“People want just taxes more than they want lower taxes.” --Will Rogers
2 Congress “plans” much more tax revenue
p.3
Congress “plans” no discretionary spending growth
57% Increase
67% Increase
*CBO: Budget and Economic Outlook: Fiscal Years 2015 to 2025 (January 2015)
3 Tax Policy Concerns
p. 3
1.  Financing Government Expenditures
2.  Promoting Economic Stability and Growth
3.  Equity (Fairness)
4.  Redistributing Income or Wealth
5.  Neutrality
6.  Create Special Incentives or Disincentives for Certain Activities
4 Tax Subsidies
p. 3
Tax subsidies involve using the tax system to redistribute money.
-  Tax transfers (e.g., refundable credits, energy credits, first
time homebuyer credits)
-  Social spending, e.g., charitable deduction
What are “upside-down” subsidies?
5 Sources of Federal Revenue GDP
CBO (February 2014)
p.10
Distribution'of'BeforeBTax'Income'and'Taxes,'by'Income'Group,'2009'and'2010*
Average'Income'(2010'Dollars)
Lowest+Quintile
Second+Quintile
Middle+Quintile
Fourth+Quintile
Highest+Quintile
2009
++++++++23,800
++++++++44,000
++++++++65,200
++++++++95,100
+++++227,100
2010
++++++++24,100
++++++++44,200
++++++++65,400
++++++++95,500
+++++239,100
All+Quintiles
++++++++89,800
++++++++92,200
Share'of'Income'(Percent)
Change+ All+Federal+
(Percent)
Taxes
*
0.4
L0.2
3.8
L0.4
9.1
L0.7
17.6
1.1
68.8
Share'of'Federal'Taxes'(2010)
Individual+
Social+ Corporate+
Income+ Insurance+
Income+
Taxes
Taxes
Taxes
L6.2
5.6
1.7
L2.9
9.8
3.1
2.9
15.4
5.5
13.3
23.9
9.5
92.9
45.1
78.8
Change+
(Percent)
1.2
0.5
0.3
0.4
5.3
2009
5.1
9.8
14.6
21.1
50.8
2010
5.1
9.6
14.2
20.4
51.9
Excise+
Taxes
13.4
15.4
18.7
20.6
31.5
2.7
100.0
100.0
n.a.
100.0
100.0
100.0
100.0
100.0
0.5
1.8
3.5
16
14.9
10.1
12.5
13.3
14.6
9.9
12.5
14.9
L0.3
L0.2
*
1.6
15.5
11.9
17.2
24.2
15.4
13.8
24.6
39.0
17.8
11.5
11.5
4.2
8.4
7.1
13.7
49.5
12.0
7.1
7.5
4.9
+
+
81st+to+90th+Percentiles
91st+to+95th+Percentiles
96th+to+99th+Percentiles
Top+1+Percent
+++++134,000
+++++178,400
+++++276,700
++1,237,300
+++++134,600
+++++181,600
+++++286,400
++1,434,900
*Chart+Taken+From+CBO+Report+on+Distribution+of+Household+Income+and+Federal+Taxes+2009+and+2010+(February+2014)
Is the tax burden “fair?”
Is society happier with higher or lower taxes? See Johnston, “Taxes, Happiness & Heliocentrism”
“People want just taxes more than they want lower taxes.” -Will Rogers. Is Will
Rogers right?
6 Top Marginal Tax Rates, 1909-2012
p. 10
7 Distributional Effects: Ability to Pay
p.11
Should the rich pay more proportionately?
Utility
Lost Utility
Taxes
Lost Utility
Taxes
Income
8 Tax Incidence Theory
Tax Incidence: Describes the person that bears the ultimate burden
of a tax.
Hypothetical: Are retail sales taxes borne economically by the
customer or by the retailer? Depends on whether prices can be
increased.
Hypothetical: Exemption for state and local interest. Municipal
bond rates are lower to reflect in part the tax preference given to
the investor. So, the investor tax savings is “shared” with states
and municipalities via lower interest rates.
Assumption: Income taxes (particularly on wages, salaries, and
service income is typically not shifted but stays with the individual.
9 Capital Gain and Dividend
p.29
1)
A tax rate preference for much of our history has existed for
certain “capital gains.” See §1(h).
2)
Thus, we need to categorize whether income is from a sale or
exchange of a capital asset or if it is “ordinary income.” We will
cover this character question in Chapters 19-21.
10 Average versus Marginal Rates
p.31-32
1.  Average Tax Rates. This is the percentage tax rate the taxpayer
pays on their entire income
2.  Marginal tax rates. This is the incremental tax rate the taxpayer
pays on the next incremental amount of income. Marginal rates
are what influence tax planning and investment decisions.
3.  Types of Income Taxes.
A.  Progressive Income Tax: Tax rates increase as income
increases.
B.  Regressive Income Tax: Tax rates decrease as income
increases.
C.  Proportional Income Tax: Tax rates remain constant.
11 WHAT IS INCOME?
P.554
How is the concept of “income” defined?
Consider the Haig-Simons definition: Y = C + ΔW
“Accession to wealth” consisting of
1) Consumption (during the measurement period), plus
2)  Change in net worth (during the measurement period).
12 Tax Terminology
1)
Taxable Income: This is the “base” on which we calculate the
tax due. How we get there:
Step One:
Start with Gross
Income defined in §61
Step Two:
Deductions (set forth in §62) are subtracted from
Gross Income to arrive at Adjusted
Gross
Income.
Step Three:
Deductions (personal exemptions plus either standard
deduction or itemized deductions) are subtracted to
arrive at
Step Four:
Taxable Income as defined in §63.
Taxes are computed on Taxable Income per §1 to
derive tentative tax due. Credits (see §21 through §54)
and minimum tax computations to derive final Tax
Payable.
13 Timing Issues
1)
2)
3)
Tax Accounting Methods
A.  Cash Method.
Exception: Capital Expenditures
B.  Accrual Method
C.  Regardless of method, the tax period is typically an
annual accounting period. Issue: transactional
consistency versus annual reporting.
Timing of Income Recognition: governed by when income is
realized and when it must be recognized. A realized gain is
generally recognized for tax purposes. When is a gain realized?
When is a realized gain not recognized?
Timing of Deductions (Cost recovery, depreciation, basis).
14 Whose Income Is It?
(Chapter 17 & 18)
1)
Assignment of Income Issues. To preserve a progressive tax
system, we must have the right taxpayer report their income
and not have it deflected to others at lower rates.
2)
Deflecting income to business entities (corporations/
partnerships), trusts, or to family members to be reported as the
income of others is a Chapter 7 issue.
15 Survey Over Areas
Things Lawyers Do Implicate Tax Issues.
1)
What is income? Chapters 1-8.
u Contexts: Payments in settlement of cases, compensationtype arrangements, transactional issues, dealing in
encumbered real estate, debt discharge issues, family
wealth planning, marital settlements. In other words,
things that lawyers document.
2)
What is deductible for tax purposes? Chapters 9-16.
u  Payments in a variety of contexts (personal, business,
investment).
3)
Whose income is it anyway? Chapters 17-18. Deflecting income
to business others. Who is taxed in what situations?
4)
Type of Income or Deduction (Capital Gains & Losses versus or
16 Ordinary Income & Expenses)
New BigLaw Associates to Spend First Month in B-School
WSJ Law Blog, Trendy New Perk (or Punishment?) for Law Firm Junior Lawyers
Debevoise & Plimpton’s presiding partner Michael Blair announced internally that the 675lawyer firm has arranged for a group of 23 incoming associates to participate in a program
developed by Fullbridge, a year-old company co-founded by two Harvard MBA graduates.
The associates from its New York and London offices arriving at the firm September 12 will
participate in the program full-time over their first four weeks at the firm, Mr. Blair said in an
email to the firm. The program will be a pilot this year, he noted.
The Fullbridge program, which combines an online format with individualized coaching and
group projects, aims to teach the junior lawyers financial and accounting concepts, including
how to read balance sheets and analyze financial statements, as well as how to spot and
resolve business problems in case studies.
They’ll also learn practical skills which many law schools don’t teach, such as creating powerpoint presentations and computer spreadsheets. Those skills can come in handy when junior
lawyers are calculating damages or compiling facts for investigations or litigation, Debevoise
says.
Skadden, Arps, Slate, Meagher & Flom in January rolled out a training program for its
associates though Fullbridge, according to Carol Sprague, the law firm’s director of associate
and alumni relations and attorney recruiting. Fullbridge will run a second program for all 100
or so of Skadden’s fall associates in its U.S. offices, she said. The fall Fullbridge program will
take place over the course of four weeks.
17 TIME VALUE OF MONEY
Pay Tax Today or Tomorrow?
p.254
What is the importance of the “time value of money” concept?
Dollars that are invested will give a return over time. It follows
then that a dollar received early is worth more than a dollar
received later. The earlier dollar will grow to be worth more than
a dollar received later.
It follows also that dollars received at different times do not have
the same real meaning (even if there were no inflation). They are
like apples and oranges. Dollars received or paid at different times
cannot be compared or netted as if they were the same.
How is this done?
18 TIME VALUE OF MONEY
Pay Tax Today or Tomorrow?
p.255
Dollars received or paid at different times can not be compared
or netted as if they were the same.
•  One must first “translate” the earlier dollar into what it
would be worth later.
•  Alternatively, one must translate the later dollar into its
equivalent at the earlier time. Dollars payable at different
times are translated into either a “future value” or a
“present value” before they are compared. Financial
analysis only insists on translation to a single time. Dollars
received earlier than the point of comparison must be
translated forward by taking into account the compound
growth that is available; dollars received later than the point
of comparison must be translated back by “discounting.”
19 TIME VALUE OF MONEY
Future Value Concepts
p.256
Example: $100 dollars at Year Zero with a 10% interest market
rate has the following equivalent values depending on the date
(assuming no taxes for the moment)
$110
Year 1
$121
$133
Year 2
Year 3
$100
Year 0
Conclusion: If I can defer paying a $100 tax until Year 3, I will pay
the $100 and have an extra $32 to keep. In real terms, I have used
the government’s money to earn $32 to apply against my tax bill.
20 TIME VALUE OF MONEY
Future Value Concepts
$110
Year 1
$121
$133
Year 2
Year 3
p.256
$100
Year 0
Although the above picture shows the principle graphically, we can
also express this concept mathmatically as follows:
P * (1+r)
n
where r is the interest rate and n is the periods
100 * (1+10%)
100 * (1.1)
3
3
100 * (1.331) = 133.1
21 TIME VALUE OF MONEY
Present Value Concepts
p.256
“Discounting” or present value calculations are just the inverse of
compound growth calculations.
•  The present value of a future value is the amount that will
grow to equal this future value amount at given compound
growth rates. The present value answers the question of how
much must I put into an account if I need to have the future
value by the end of n periods.
•  If, for instance, I need $133 in 3 years and get 10% tax
exempt in my best investment, I can calculate that I must put
$100 aside now: $100 will grow to equal $133 by the end of three
years. So $133 in three years is like $100 now.
22 TIME VALUE OF MONEY
Present Value Concepts
p.256
I can demonstrate that $100 is the present value equivalent of $133
from Year 3 pictorially as follows:
$110
Year 1
$121
$133
Year 2
Year 3
$100
Year 0
Or, I can express the same idea mathmatically for a future value of A
as follows:
PV=
A
since 133
= 133 =
n
3
3
(1+r)
(1+10%)
(1.1)
133
=
1.331
100
23 TIME VALUE OF MONEY
p.256
How Financial Concepts Turn the World Around
Why does any of this matter?
Prove to me that it makes any real difference?
Okay, stay with me on this and let’s look at a simple example.
24 TIME VALUE OF MONEY
p.256
How Financial Concepts Turn the World Around
An investor is given a choice of the following three investments
expressed in red numbers that provide cash flow in black
numbers.
Year 0
Year 1
Year 2
Year 3
A
($100)
$0
$20
$0
B
($100)
$40
$40
$40
C
($30)
$55
$20
$20
Year 4
Year 5
$110
($70)
Which investment has the highest accounting profit?
25 TIME VALUE OF MONEY
p.256
How Financial Concepts Turn the World Around
An investor is given a choice of the following three investments.
Year 0
Year 1
Year 2
Year 3
A
($100)
$0
$20
$0
B
($100)
$40
$40
$40
C
($30)
$55
$20
$20
Year 4
Year 5
$110
($70)
Which investment has the highest accounting profit?
Answer:
A= $30 profits
B= $20 profits
C=($5) loss
26 TIME VALUE OF MONEY
p.256
How Financial Concepts Turn the World Around
An investor is given a choice of the following three investments.
Year 0
Year 1
Year 2
Year 3
A
($100)
$0
$20
$0
B
($100)
$40
$40
$40
C
($30)
$55
$20
$20
Year 4
Year 5
$110
($70)
What choice has the highest net present value assuming a 5%
discount rate?
27 TIME VALUE OF MONEY
p.256
How Financial Concepts Turn the World Around
An investor is given a choice of the following three investments.
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
A ($100)
$0
$20
$0
$110
B ($100)
$40
$40
$40
C
($30)
$55
$20
$20
($70)
What is the net present value of each investment assuming a 5%
hurdle rate? Answer:
NPV @ 5% Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
A
$4.33 ($100)
$0
$20
$0
B
$8.93 ($100)
$40
$40
$40
C
$0.21
$55
$20
$20
($30)
$110
($70)
28 TIME VALUE OF MONEY
p.256
How Financial Concepts Turn the World Around
An investor is given a choice of the following three investments.
Year 0
Year 1
Year 2
Year 3
A
($100)
$0
$20
$0
B
($100)
$40
$40
$40
C
($30)
$55
$20
$20
Year 4
Year 5
$110
($70)
What is the result assuming a 10% hurdle rate
29 TIME VALUE OF MONEY
p.256
How Financial Concepts Turn the World Around
An investor is given a choice of the following three investments.
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
A
($100)
$0
$20
$0
$110
B ($100)
$40
$40
$40
C
($30)
$55
$20
$20
($70)
What is the result assuming a 10% hurdle rate?
Answer:
NPV @
10% Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
A
($15.17) ($100)
$0
$20
$0
$110
B
($0.53) ($100)
$40
$40
$40
C
$3.75 ($30)
$55
$20
$20 ($70)
30 Relevancy of Time Value of Money Tax Law p.257
Implication: Timing matters greatly to the issue of the effective tax
rate. Effective tax rates measure the difference between the aftertax rate of return on and rate of return if there were no income tax.
The benefit of deferring a tax or accelerating a deduction can greatly
impact a businesses “effective tax rate.” We are not striving to make
you financial planners in this class. We will leave that to the
business school, but lawyers need to understand what makes
deferral a financial benefit.
Tax lawyers must be sensitive to time value of money issues to
understand whether a case is being decided correctly or wrongly.
Without knowing these concepts and without a grasp of the HaigSimon ideal, you are at sea without a compass.
Tax laws that can achieve tax deferral for clients provide an
enormous value to their clients.
31 Relevancy of Time Value of Money Tax Law p.260
Let’s think about it another way:
Suppose I told you that I could provide you the equivalent of a
tax-free profit regardless of your investment. Does that sound
too good to be true?
32 Cary Brown Thesis
(Tax Deferral and Yield Exemption)
p. 260
An immediate deduction for the cost of a capital asset, which is often
called expensing, can produce the same results as exempting the
income produced by the asset under certain conditions, including the
assumption that tax rates remain the same. Under that assumption,
the equivalence between exemption and expensing holds because the
tax savings from the deduction, if reinvested in comparable assets,
will fully fund future tax liabilities on income produced by the
investment
See E. Cary Brown, Business Income Taxation and Investment
Incentives, in INCOME, EMPLOYMENT AND PUBLIC POLICY:
ESSAYS IN HONOR OF ALVIN H. HANSEN 300, 309-10 (1948),
reprinted in THE AMERICAN ECONOMICS ASSOCIATION,
READINGS IN THE ECONOMICS OF TAXATION 525 (Richard
A. Musgrave & Carl S. Shoup eds., 1959).
33 Cary Brown Thesis
(Tax Deferral and Yield Exemption)
p. 260
Cary Brown Thesis Proven
-------------------------------------------------------------------------------------------------------(B)
(A)
Soft Money
Capitalized
Expensed or
Investment
Excluded
-------------------------------------------------------------------------------------------------------1. Income at $100
2. Tax on row 1 at 33 percent
3. Investable amount (row 1 - row 2)
4. Investment (row 3) triples
5. Basis
6. Taxable amount
7. Tax at one-third of row 6
8. End result (row 4 - row 7)
$100
-$40
$60
$180
$60
$120
Tax exempt
$180
$100
$0
$100
$300
$0
$300
-$120
$180
34 Cary Brown Thesis
Soft Money Investing
p.260
What is the value of deferring tax on $1,000 for 5 years?
Assume the tax rate is 40% and that the investment will grow 10% per
year for 5 years when the tax deferral is ended.
35 Cary Brown Thesis
Soft Money Investing
p.260
What is the value of deferring tax on $1,000 for 5 years?
Answer: The ability to earn a return on the government’s tax money
will pay for the tax on profits for the taxpayer’s original investment.
Year 0 Growth
Year 1 Growth
Year 2 Growth
Year 3 Growth
Year 4 Growth
Year 5
(a) Post-Tax
600
1.10
660
1.10
726
1.10
799
1.10
878
1.10
967
(b) Soft Money
400
1.10
440
1.10
484
1.10
532
1.10
586
1.10
644
1000
1.10
1100
1.10
1210
1.10
1331
1.10
1464
1.10
1611
(a+b) Total
Proof: 1611 x 40% = 644.4
36 Cary Brown Thesis
Soft Money Investing
p.260
The ability to deduct an investment immediately or to do the
equivalent by the taxation on income in order to make an
investment with this pre-tax amount is called "soft money
investing.“ This concept is routine to tax economics but is not
commonly evident in statutory or judicial decision-making. The
effect of “soft money investing” is that taxpayers are given tax-free
treatment on the return related to their after-tax equivalent
amount.
Many people would object to giving tax-free income to certain
types of investment activities, but failing to recognize that tax
deferral creates the equivalent of that result is a fundamental
conceptual mistake that will get you into trouble.
37 Soft Money Investments:
Retirement Income Plans (§401(k) Plans)
p. 260
Employee gets benefit of income exclusion for
(1) employer’s contribution to plan, and
(2) employee’s contribution to plan
Employer gets immediate deduction for contribution to the plan.
Tax “whipsaw” effect?
No gross income for income build-up during accumulation/
investment phase
Tax Expenditure impact of Defined Contrbution & Benefit Plans,
Self-Employed Plans and IRAs was is $146.4 billion (see p. 536)
38 IRS Responsibilities
p.16
Administrative law is pronounced by the Internal Revenue Service
(part of the U.S. Treasury Dept.) through regulations and other
pronouncements.
Acquiescence by IRS to Tax Court decisions
IRS Revenue Rulings (Rev. Rul.)
IRS Revenue Procedures (Rev. Proc.)
IRS Notices
IRS Private Letter Rulings (PLRs)
Technical Advice Memoranda (TAM)
Closing Agreements
IRS Determination Letters
IRS is responsible for the enforcement of tax laws, including tax
reporting, collection and litigation
39 Self-Assessment System
(Annual Returns)
p.17
1.  The income tax is a “voluntary” self-assessment regime. It is the
taxpayer’s obligation to submit the information, prove the
amount that is due, and to properly pay their tax.
2.  The IRS is there to help the taxpayer understand their obligation
and to verify that the taxpayer did comply with their obligations.
40 Tax Controversies
p.19-20
IRS has broad investigatory authority (See §§7601-7612). The IRS
can prepare a taxpayer return if one was not filed (See §6020(b)) and
can assert tax deficiencies (see §6201-6204). The IRS has broad
authority to collect taxes that are assessed (see §6303, §6321, §6331,
§6335).
Resolution of disputes is first handled through the IRS
administrative appeals process and then ultimately by the U.S.
Courts, including the United States Tax Court (an Article 1, not
Article 3, court).
A.  U.S. Tax Court petition after a “90 day letter” received
from IRS. Must file within 90 days of the date of the “90
day letter.”
B.  Refund litigation:
U.S. District Court
U.S. Court of Federal Claims
41 Forum shopping opportunities?
Statute Of Limitations
p.20
Generally, the IRS has three years to assert a deficiency from the
due date of a timely filed tax return, and the taxpayer has three
years to file a claim for refund, but the statute of limitations is tolled
upon issuance of a statutory notice of deficiency (“90 day letter”).
Taxpayers cannot bring suit for a claim for refund until after six
months and must do so within two years of the disallowance of the
refund claim.
42 Penalties for Noncompliance
p.21
Penalties Apply for Failure to File or Pay the Right Amount of Tax
1.  Negligence (reckless & intentional): 20% penalty regardless of
amount of underpayment.
2.  Substantial Understatement: 20% penalty for underpayment that
is greater than $5,000 or 10% of the proper tax amount.
A.  Exception #1: Reasonable Cause. Taxpayer is not subject to a
penalty if they have “substantial authority” for a position.
B.  Exception #2: Adequate disclosure of the position on return
plus a “reasonable basis.”
3.  Failure to file penalty. 5% per month up to 25% of deficiency.
4.  Interest for late payment.
5.  Civil Fraud: 75% penalty.
6.  Criminal Tax Evasion: Not more than $100,000 and 5 years in
prison
43 Opinion Practice
p.21
Opinion Levels
1.  “Reasonable Basis” (15% to 30% chance of success)
2.  “Substantial Authority” (30% to 50% chance of success)
3.  “More Likely Than Not” (more than 50%)
4.  “Should” Prevail (more than 70%)
Tax opinions are regulated by the IRS in Circular 230 that sets forth
criteria for professional quality and care in the opinion.
44 History of U.S. Taxation
p.22
U.S. Constitution Art.1, Sec. 8, Cl. 1: The Congress shall have Power To lay and collect Taxes, DuBes, Imposts and Excises, to pay the Debts and provide for the common Defence and general Welfare of the United States; but all DuBes, Imposts and Excises shall be uniform throughout the United States; Art. 1, Sec. 9, Cl. 4: No CapitaBon, or other direct, Tax shall be laid, unless in ProporBon to the Census or enumeraBon herein before directed to be taken. 45 Federal Taxes – History Before the 16th Amendment
p.23
Carriage tax not a “direct tax”
Civil War Period: Income Tax of 1862 with 1864 Amendments
1894 - personal income tax
Unconstitutionally imposed tax Pollock v. Farmers Loan & Trust - p. 23
Held: a tax on unapportioned real property rental income was
unconstitutional
46 Federal Taxes –16th Amendment
p.23
U.S. Constitution -
16th Amendment:
Congress shall have power to lay and collect taxes on
incomes, from whatever source derived, without
apportionment among the several states, and without
regard to any census or enumeration.
47 Federal Taxation
Is A Statutory Based Set of Laws
p.24
1.  Primary source of law - The Internal Revenue Code (Title 26
of the United States Code) (assuming authority under U.S.
Constitution).
2.
Administrative Guidance (Treasury regulations, Revenue
Rulings, Revenue Procedures, Private Letter Rulings).
3.
Judicial Decisions.
4.
Legislative History: Committee Reports (Senate Finance,
House Ways & Means Committee, Conference Report, and
the staff of the Joint Committee on Taxation
48