Chapter 3 p.89
Compensation for Losses
Gross income includes “gains derived from dealings in property.” IRC §61(a)(3).
How determine property “gains”?
See IRC §§ 1001, 1011 and 1012.
Requires determination of (1) tax basis, (2) the amount realized, and (3) gain (or loss) realized.
Value is based on FMV: Reg. §20.2031-1(b).
What about the amount received for a “loss” or an “injury” as being gross income?
Clark case p.90
What tax characterization when a recovery of a prior (not tax deducted) loss occurs?
Clark case facts: Tax return preparer makes a mistake in preparing joint tax return rather than separate returns – costing taxpayers 19x+ extra taxes. Tax preparer reimburses taxpayer clients for the 19x+ amount. No refund claim is possible since the statute of limitations has run.
Held: No GI inclusion - after-tax (not taxable) reimbursement received. Tax basis recovered?
Clark case, etc. , cont.
Is this similar to the Old Colony case (or not)?
Is this really paying someone else’s taxes?
Cf., what is the treatment of an income tax refund when one’s income tax is overpaid?
Is this merely a tax basis recovery?
E.g., after excess wage withholding by the employer – not gross income upon the receipt of the refund of the excess wage tax withholding.
Cf., refund of (deductible) state taxes (although refunds at state level are difficult to obtain).
A compromise settlement amount was received in anti-trust litigation.
No qualification for an exclusion under §104 (exclusion for certain damages) since a corporate taxpayer is involved.
Compensation was received for the destruction of the “goodwill” of the business. A “return of capital,” but is tax basis zero for the goodwill? If so, inclusion in gross income? And what amount?
GLENSHAW GLASS p.96
Damages were recovered for lost profits plus punitive damages for violations of anti-trust laws. Were the punitive/exemplary damages includible in GI? Yes.
Windfalls are within the scope of §61.
Within “income from whatever source derived.” “Undeniable accessions to wealth” as constituting income. See p. 98.
Punishment factor not relevant for recipient.
Legislative history/reenactment issue, p.99
a) Damages for breach of an employment
contract. Compensation equivalent.
b) Damages for the wrongful destruction of
one’s property. Equivalent to a sale.
c) Malpractice damages received. Clark case applicable, & what was replaced? Tax-free here?
Examples, cont. p.100
d) Compensation for breach of promise to
marry. Recovery of previously incurred expenses? Damages for humiliation and emotional distress excluded. See Rev. Rul. 77-47 (p.105). But, §104(a)(2) and Murphy case (p. 110) causing gross income inclusion?
Payment for release of privacy rights (i.e,
invasion of one’s privacy). Does Raytheon suggest this is not gross income? Loss of “imputed income”? But, §104(a)(2).
Recovery of Capital
Inaja Land case p.101
7(b). Consideration received for easement (for fishing rights) in water adjacent to owned land.
The amount received was less than the total basis for the land. How allocate amount received? Exclude the entire amount and reduce tax basis by those proceeds received? Yes, here.
See Burnet v. Logan (p. 295) re “open transaction” treatment – basis recovery to occur first here. See, also Reg. §1.1001-1(a).
Damage Recoveries p. 102 §104(a)(2)
Personal injury damages – exclusion of damages from GI if a personal physical injury. §104.
What about a “tax basis recovery”?
This personal injury GI exclusion does not encompass libel and discrimination awards.
No exclusion for punitive damages (even if received in personal injury context). §104(a)(2).
No exclusion for lost profits/lost compensation reimbursements.
Deferred Payments and Structured Settlements
P.103. See §104(a)(2) re exclusion for personal injury damages - whether received as a lump sum or in “periodic payments.”
What is a “structured settlement” in this context - where an intermediary agrees to provide periodic settlement payments?
What about interest income from the deferral?
Result: Tortfeasor deduction: yes, immediately with structured settlement; even though any GI inclusion (?) for plaintiff is delayed until receipt.
Solicitor’s Opinion No. 132 (1922) p.104
No income derived from receipt of damages for (1) alienation of affection or (2) defamation.
Based on Supreme Court jurisprudence (e.g., Eisner v. Macomber). Holding personal rights were not assignable or susceptible of appraisal.
Not income for 16th Amendment purposes.
Rev. Rul. 74-77, p. 105 – Holding amounts for alienation of affection & surrender of child custody not income. No reference to the 16th Amendment. Not withdrawn after §104(a)(2).
Employment p.107 Discrimination Damages
Supreme Court cases & Rev. Rul. 93-88 (re exclusions under § 104(a)(2)):
Damages for sex based wage discrimination
(Title 7) excluded. Cf., payment for “back pay.”
Damages for racial discrimination (Title 7)
are excluded from GI.
3) Damages under ADA (disabilities act ) are excluded from GI (under §104(a)(2)).
4) ADEA (age discrimination) damages are included in GI (not a tort equivalent).
Emotional Distress Damages p. 107
What about emotional distress damages?
No exclusion under physical personal injuries.
See Trafficking Victims Protection Act of 2000 (p. 109) specifying mandatory restitution (including for psychiatric care).
IRS Notice 2012-12 (p. 109) – specifies mandatory restitution and no requirement of physical injury for GI exclusion.
Is this consistent with §104(a)(2)? No special treatment is specified in the Act (above)?
Murphy case p. 110
Tax Refund Litigation
Issue: Income tax on compensatory damages received for emotional distress and loss of reputation?
Amount not received for personal physical
injuries - & not exempt under §104(a)(2).
Award is “gross income” for §61 purposes
(whether 16th Amend. or U.S. Const., Art. 1(8)).
3) Tax on award is an excise tax and, therefore, not a “direct tax” subject to apportionment clause in U.S. constitution. continued
Murphy case p. 110
Type of proceeding: Declaratory judgment action/injunction proceeding against IRS under the Administrative Procedure Act. P. 111
Prior proceeding: Concluded award was not “income” within meaning of 16th Amendment.
USGovt. response: even if not income, not an unconstitutional “direct tax” & taxable under Article 1, §8. Appeals Court (p.112): Review of Dist. Ct. grant of summary judgment on de novo basis. continued
Murphy case p. 110
Accession to Wealth?
Need not have an “accession to wealth.”
Taxpayer did have economic gain.
Sold part of her “human capital.” p. 125.
Possible to label an item as “income” for income tax if not subject to “direct tax” treatment.
Here not a direct tax, since the equivalent of an excise tax (i.e., tax on a transaction). See, tax on carriages, Hylton case, p. 123; & p. 125-6. Therefore, no apportionment required (Art. 1, §9, Cl. 4).
Murphy case p. 128
Sequel to Murphy
Obamacare (i.e., Affordable Care Act), fn.2.
Imposition of individual mandate: IRC §5000A.
Penalty (“shared responsibility payment”) to be paid for failure to purchase health insurance (i.e., not for a receipt but for a failure to spend).
Held: Within the taxing power of U.S. Congress – and not an unconstitutional “direct tax.”
National Federation of Independent Business v. Sebelius decision (Sup. Ct., 2012).
- Employer, etc. p.129
Employer funded health insurance:
1) Employers can deduct the cost of medical insurance provided for employees. §162.
Premiums paid by employers are excluded
from the employee’s gross income. §106. This exclusion applies to medical insurance.
3) Proceeds subsequently received from employer provided insurance coverage is excluded from gross income. §105(b).
1) Self-employed can the deduct costs of medical care, including health insurance. §162(l). Proceeds are excluded - §105(b).
Individuals purchasing insurance – possible
deduction under §213(d)(1)(D) (medical expense deduction; if all med. costs over 10% of AGI). Proceeds are later excluded - §104(a)(3).
3) Self-insured (i.e., no commercial insurance); deduction (limited) is available for medical expenses when subsequently incurred. §213(a).
Policy Aspects p.130
Consider the national health policy implications of these various provisions, i.e.,
Gross income exclusions or tax deductions
for front-end premiums;
(2) exclusions for proceeds received; and
(3) other items, e.g., charitable deductions for contributions to hospitals, medical research, etc.
See the Tax Expenditure List (Income Tax course website) re health care benefit exclusion costs, etc.
Flexible Spending Arrangements p.132
1) IRC §125 – deflection of some gross income into a spending account & subsequent payment of (medical) expenses from this account.
Objective: to cover the medical expense portion (deductibles) not covered by the traditional employer based insurance coverage.
Irrevocable election to contribute each year.
12 month use-it-or-lose it rule.
Also, health savings accounts (HAS) –
IRC §223, p. 134. next slide
Health Savings Account (HAS) p. 134
IRC §223 – savings plan available when individual has only high deductible health plan coverage.
Limited deductions for contributions to an HSA, but no §213 limit if above 10% of AGI.
Investment earnings of HSA are not gross income to the owner of HSA account. §223(e). Distributions to pay for uninsured medical care costs not included in gross income. §223(f).
IRC §5000A – individual mandate – “shared responsibility payment.”
$695, as indexed. § 5000A(c)(3).
But, what collectability by IRS? See §5000A(g).
Cadillac plan tax - §4980I. “Excise Tax on High Cost Employer Sponsored Health Coverage.”
Beginning after December 31, 2019. P.L. 111-148 (2011).
Considering Medical Self-Insurance P.136
Consider the income tax effect of providing a deduction for extraordinary medical expenses.
Same economic effect occurring as allowing an exclusion from gross income equal to the amount of the deduction?
Is this objective accomplished by Code §213?
Cf., Sibla case (earlier) re exclusion from gross income for mandated withholding from wages for meal costs.
Ochs v. Commr. P.137 Medical cost self-insured
Were expenses to maintain children in a boarding school medical costs incurred to alleviate health strain on taxpayer’s spouse?
Held: non-deductible family expenses. §262.
Note the dissent: compelled to incur this cost to alleviate the wife’s medical problems and, therefore, deductible cost. Expense was for “prevention” of illness.
What about the cost of a divorce recommended by a psychiatrist?
Defining term “medical care” - §213 p.143
Code §213(d)(1)(A) – cost of diagnosis, cure, mitigation, treatment, or prevention of disease.
Cosmetic surgery? See §213(d)(9). Is a business expense deduction available as an alternative (if not deductible as medical care expense)? Is a depreciation deduction available?
Consider: anti-smoking programs (deductible, Rev. Rul. 99-28). Birth control pills?
“Quality of life” drugs: Prozac? Marijuana (where legal)? Viagra? Psychologists?
Additions to a residence – capital improvments
Deduction for (see Reg. §1.213-1(e)(1)(iii)):
Elevator in the home?
Home swimming pool?
Weight room? Sauna? Tennis court?
What if the expense for the home improvement increases the fair market value of the property?
Other items: Health club dues?
Cost of a “service dog”?
Other medical expense P.143
Transportation (ambulance?) - §213(d)(1)(B).
Lodging - §213(d)(2); not lavish and $50 per night limit (cf., hospitals in the Houston Medical Center area?).
Travel from the cold north to warm weather south environment in the winter (with a doctor’s prescription!)?
Medical insurance premiums & medicare costs? §213(d)(1)(D), (6) & (7).
Long term care premiums? §213(d)(1)(C)&(10).
Considering National Health Policy P.145
Implemented by IRS (not HHS) – tax
deductions & not appropriation funding.
No qualification for medical benefits (tax
deduction) unless having taxable income.
Further, only tax return itemizers qualify.
High deductible (only expenses exceeding
10% of AGI are deductible).
5) Tax deduction (i.e., co-insurance equivalent) benefits the highest taxed individuals the most.
Considering National Health Policy, cont.
Reviewing fundamental choices for structuring a national health care delivery system:
Government/single payment system (e.g., VA
medical benefits & most developed countries).
Employer provides health benefits (with tax
deductions), with other health care support for those not employed (i.e., Obamacare).
3) Exclusively a private individual market for insurance and health care (and, welfare hospitals, if any). Is a tax deduction adequate?
Disability Insurance (wage substitute?) P.146
What is “disability insurance”? Provided by?
Payments to replace lost wages or salary?
§106 – GI exclusion when premium paid by ER.
§105(a) – amounts received by employee for sick pay included if attributable to ER contributions.
§104(a)(3) – amounts received through individually purchased accident or health insurance for personal injuries or sickness are excluded from gross income (but not deductible premiums when originally paid).
What is “life insurance”? A payment for dying – ordinarily paid in a lump sum. Why not call this arrangement “death insurance,” rather than “life insurance”?
Code §101(a) excludes from gross income amounts received under a life insurance contract if paid upon the death of the insured.
Cf., income tax treatment of a “mutual fund” investment and the return on this investment (no actuarial factor is involved). Cf, §7702.
Life Insurance – Policy Types p.147-8
Term insurance – payment only for actuarial
risk. Small investment return during coverage period. No cash value at expiration of the term.
Whole life – often level payments and
the early year payments exceed actuarial risk cost. The savings element produces investment return which is used to reduce insurance cost (but this income return is not included in GI).
3) Other types – single-premium life; universal life; endowment; paid-up policy.
Life Insurance & Income Tax Questions, p.148
Fundamental income tax questions:
Is a gross income exclusion available (§101(a)) for both:
Pre-death interest build-up inside the policy
(e.g., whole life policy), and
Mortality gain (any loss?), if realized at
death, when policy matures.
Answer: yes. Appropriate treatment?
See next slide for options.
Life Insurance - Income Tax Treatment Options
Tax the interest component currently –
similar to a savings account. What treatment for the earnings used to purchase current lilfe insurance coverage?
Income inclusion for proceeds received in
excess of tax basis – including both accumulated earnings and mortality gain.
3) Consumption tax approach: deduction for premiums but full income inclusion when paid.
Life Insurance Taxation
No tax deduction for certain premiums paid
- §264(a)(1). Or, for interest, §264(a)(3); any exception to this treatment – see §264(d)(1)?
2) No current GI inclusion of policy earnings.
3) Policy loans to the owner of a policy are not treated as distributions - §72(e)(5)(A) & (C).
4) Life insurance policy - if terminated before death - gain derived (if any) is subject to GI inclusion (but, no GI inclusion for the benefit of insurance coverage during policy’s existence).
Group Term Life Insurance P.150
IRC §79(a) exclusion from gross income is available for the value of “group term” life insurance coverage (up to the value of $50,000 face value insurance coverage per employee).
What is a “group” for this purpose?
Note the non-discrimination requirements – IRC §79(d ) – no discrimination in favor of key employees is permitted in making this insurance benefit available.
Life Insurance Taxation
Gross income exclusion is not applicable to
any interest accrued on the policy proceeds invested after death. §101(c) & (d).
2) Various settlement options are available –
All cash proceeds receivable after death.
Deferred settlement arrangements, e.g.,
annuity or installment payments.
3) Cf., what is a “viatical settlement”? See §101(g). P.150.
Life Insurance & Policy Transfers
See Code §101(a)(2). A “transfer for consideration” limitation may apply to limit the gross income exclusion at death.
But, see the exceptions (to this transferred policy inclusion treatment) for:
1) Policy transfers with a “transferred basis,” or
2) Policy transfers to partners, partnership, or a
corporation (but not to other shareholders).
See problem 2, p. 150.
Creditor Life Insurance Problem 4 P.151
What is “credit life insurance”?
Under what circumstances is it acquired?
How long does the policy exist, and in what amount?
Who is the designated beneficiary?
Is the purchase of this life insurance “cost effective”?
Prior Deducted Losses Annual Accounting P.151
More than merely timing questions?
Burnet v. Sanford & Brooks Co., p.151
Cash basis taxpayer. Expenses exceeded income by 176x in various years; large “income” later.
Issue: Offset earlier year losses against current year gross income in determining current year income? Answer: no; each year stands on own.
P. 153: Does the 16th Amendment require “transactional accounting” (i.e., tax on net income combining all related transactions)?
Burnet v. Sanford & Brooks, cont.
Other timing options available? See p. 154
Long term contract method - (a) % of completion or (b) completed contract method)
Accrual method (how defined?).
- Net operating loss carryforward.
Should the court have looked to prior years for “characterization” of the transaction to avoid the result in this case, i.e., to recognize some type of capital investment in the project?
Burnet v. Sanford & Brooks, cont.
Should the court have mandated the filing of amended returns (per the Court of Appeals)?
Did the court have an obligation to fix the problem presented here (tax common law?) –
Or, is this exclusively within the prerogative of the U.S. Congress? What is the appropriate “separation of powers” in this context?
Taxable Year P.155
§441(b) options – annual accounting period (calendar year or fiscal year).
Mandatory calendar year if “no books kept” - §441(g).
Can an individual have a fiscal year? But, see §31(a) re wage withholding refunds on a calendar year basis.
Loss Carryovers & NOL Deduction p.155
Net operating loss (NOL) deduction enables averaging of business income (& losses) over multiple years, i.e., two years back and 20 years forward. §172. Amended returns are not filed.
For individuals those are only business losses, i.e., not investment losses or personal deductions in excess of income, etc. §172(d)(4).
Capital losses are limited - §172(d)(2).
Separate treatment applies for the carryforward of capital losses (no carryback). §1212.
§446(a) – taxpayer shall compute taxable income under the method of accounting on which the taxpayer “regularly computes his income in keeping his books.”
§446(b) – exception applies where taxpayer’s method “does not clearly reflect income.”
Methods of accounting: (1) cash method & (2) accrual method. Cf., what is the purpose of “accrual accounting”? Accrual is (usually) required where inventories are used.
Tax Benefit Rule -
Dobson case p.156
Deduction claimed in an earlier year and recovery of loss amount in a subsequent period.
Sold was stock at a loss and a loss deduction (not utilized) was claimed on the earlier return.
The transaction was treated as closed and completed – but the loss did not reduce income.
Subsequent recovery occurred after fraud suit.
Held: for taxpayer (no GI inclusion) since no earlier actual income tax benefit was obtained.
Dobson case p.156
Appellate Review Scope
What “deference” should be paid on appeal by an appellate court to U.S. Tax Court decision?
Should the scope of appellate review of Tax Court decisions be limited (e.g., because of the special expertise of U.S. Tax Court judges)?
See, however, IRC §7482(a) – Tax Court decisions to be reviewed the same as civil case decisions made in U.S. District Court. See FRCP Rule 52(a) & the clearly erroneous rule.
Tax Benefit Rule
Taxpayer claims a tax deduction in 1st year (which offsets taxable income) and then receives a recovery for the deducted item in a later year.
E.g., deduction for bad debt, taxes paid, or losses and then a recovery of the deducted item.
Inclusion in gross income in the later year? Yes.
This effectively produces transactional accounting (rather than annual accounting) for this particular item.
Next slide – Code §111.
Assume No Actual Tax Benefit Earlier p.164
Deduction is claimed in an earlier year; but, no tax benefit is actually realized in the earlier year; then later, when reversal of the earlier transaction, no gross income inclusion required since no tax benefit was realized earlier.
See §111 – an exclusionary provision – i.e., recovery of a loss deductible in the earlier year is excluded from gross income to the extent the earlier deduction produced no income tax benefit in that earlier year. Next slide
Tax Benefit Rule -
Code §111 p.164
Function of Code § 111 (the “tax benefit” rule):
To preclude current income tax when a restoration occurs in the subsequent year – if the item when available as a deduction in the earlier year did not actually reduce the taxpayer’s income tax liability.
Actually a “non-tax-benefit rule” for restoration of an item from the prior year when no tax value was available in the prior deduction?
No protection against adverse tax rate changes.
Tax Benefit Rule & GI Inclusion p.164
Example: Perry & Sullivan cases, p.164:
1) Property was transferred to charity.
2) Charitable deduction was claimed for federal income tax purposes.
3) Property was returned to the donor.
4) Inclusion in the donor’s gross income?
Yes – (Sullivan) to the extent of the lesser of (a) the earlier deduction or (b) the fair market value of the property. What if property is significantly appreciated when recovered;or,higher tax rates?
“Inconsistent Events” Rule p.166
Hillsboro and Bliss Dairy cases:
1) Repayment to bank shareholders of taxes on
shareholders previously paid by the bank corporation. No recognition required of the banks when refunds were made to shareholders.
2) Distribution of previous (corporate) expensed assets (cattle feed) in a corporate liquidation. Recovery was required to the corporation on the distribution. This is now covered by §336.
Dissent: file amended returns (if S/L not run).