#12329 - Gross Income - Taxation

Gross Income

1. What is Income

1. Compensation for Services is Income. Section 61 requires that compensation paid for services be included in income, regardless of the form of the compensation. Thus, the FMV of stock, notes, or other property transferred to a person in exchange for that person’s services will be regarded as income. Royalties and other contingent-based compensation is also income.

2. Fringe Benefits: Background. Fringe benefits are “in kind benefits transferred to an employee.” They may be in addition to compensation or they may be essential to the performance of the employee’s job. Many fringe benefits are excluded from the income tax and excluded from the definition of “wages” for purposes of the federal employment taxes. In recent years, fringe benefits, including health and pension benefits, have accounted for an increasing percentage of employee compensation. They are also one of the largest tax expenditures.

3. Receipts Other Than Cash. Generally, the receipt of “property” would be taxable to the same extent as cash, but there are some exceptions. This may be because (1) the public would not accept treating the item as income or (2) valuation is difficult and excessive valuation would lead to inefficiencies.

4. Incidence of Tax or Tax Exemption. It is important to realize that a tax or tax exemption can burden or benefit a party other than the party nominally affected. State and local bonds are an example. The tax exemption on income from state and local bonds may primarily benefit the state and local governments that issue bonds, rather than the bondholder, because the state and local governments will be able to pay lower interest rates than they would otherwise have to pay to be competitive (N.B., however, that unless all purchasers of state and local bonds are in the top bracket, the state and local governments will not be able to capture the entire tax benefit). Similarly, the employer may be able to capture much of the benefit from the exemption of taxation on the employee’s fringe benefits, because the employer can provide fringe benefits worth 60% of the cash that the employee would otherwise demand and the employee will be indifferent.

5. Problems with Tax Exemption for Fringe Benefits: Equity, Efficiency, and Complexity. Equity. The tax exemption for fringe benefits creates problems of horizontal equity because there may be circumstances where similarly situated employees are taxed differently based on the percentage of their compensation that is in cash and the percentage that is in the form of tax-exempt fringe benefits. Efficiency. The tax exemption for fringe benefits may create problems of efficiency because the tax treatment of fringe benefits causes employers to offer wage and benefit packages that are very different from those that would obtain without the tax benefits. There may be deadweight loss—which occurs when an employee chooses a benefit that is worth less to him than its cost to the employer, but more than the after-tax benefit he would receive from receiving the cash value of the benefit. Complexity. The taxation of fringe benefits results in complexity because (1) it is difficult to distinguish in kind compensation from the provision of goods or services related to the employee’s work that also provides the employee with an incidental benefit; and (2) Congress has proven unwilling to accept the proposition that all noncash compensation designed to reward the employee for services rendered should be subject to income tax.

6. Taxed versus Tax-Exempt Fringe Benefits. Section 61 provides authority to tax fringe benefits paid as compensation. Section 83 also provides authority to tax “property transferred in connection with performance of services.” However, other provisions of the Code specifically exempt certain items from income. Section 132 excludes eight categories of work-related fringe benefits. And Section 119 excludes certain work-related meals and lodging.

In general, Section 132 attempts to distinguish between “working condition benefits”—which, although they benefit the employee, are provided to for a substantial non-compensatory business purpose—from “in kind compensation.”

Section 132 provides that the following items (among others) are excluded from gross income (and from payroll taxation):

(1) no-additional-cost service, a service that is the same type ordinarily sold to the public which is provided by the employer or another business with whom the employer has a written reciprocal agreement and which results in “no substantial cost (including foregone revenue)” to the employer;

(2) qualified employee discounts, discounts on merchandise (not including real property or personal property of a kind commonly held for investment) not exceeding the employer’s gross profit percentage, or discounts on services where the discount does not exceed 20% of the ordinary selling price

(3) working condition fringe, property or services that would be deductible as ordinary and necessary business expenses (under Section 162) if the employee had paid for them

(4) de minimis fringe, for property with such little value, taking into account the frequency with which similar fringe benefits (otherwise excludable as fringe benefits) are provided, as to make accounting for the benefits unreasonable or administratively impractical.

7. Valuation of Fringe Benefits. When a fringe benefit is included in income, its value is generally the FMV.

8. Dependent Care Fringe. Section 129 provides an exclusion for an employee for up to $5,000 in employer-provided dependent care services.

9. Surrogate Taxation. An alternative to the §132 approach would be to disallow the employer’s deduction for providing fringe benefits that appear to actually be compensation. This approach would not work with respect to the employees of tax-exempt employers, however.

10. Expense-Paid Trips. The Gotcher Court concluded that an expense-paid trip would not be taxable to an employee unless (1) there was an economic benefit to the employee and (2) that primarily benefited the employee (i.e., there was “no legitimate corporate purpose.” Section 274(m)(3) governs the expense-paid trips that pay for the spouse or dependent’s travel. Under §274(m)(3), the travel expenses of a spouse or dependent of a taxpayer or an officer of the taxpayer can be deducted unless such person is also an employee of the taxpayer, there is a bona fide business purpose, and the expenses would otherwise have been deductible.

11. Section 119: Meals and Lodging. Section 119(a) provides that an employee may exclude from income the value of any meals furnished to him by his employer for the convenience of the employer, but only if the meals are furnished on the business premises of the employer. An employee may also exclude from income the value of lodging furnished to him if he is required to accept such lodging on the business premises of his employer as a condition of his employment. Adams adopted a “functional rather than a spatial test,” reasoning that a private residence was on the “business premises” of the employer if the taxpayer was required to perform business activities at the residence during working hours.

According to the regulations, there must be a “substantial non-compensatory purpose” to demonstrate that meals are provided “for the convenience of the employer. Generally a requirement that an employee be “on call” after business hours establishes that the lodging or meals are for the convenience of the employer. Another way to establish that meals are for the convenience of the employer is to adopt a policy that precludes employees from eating away from the employer’s business premise during reasonable meal hours.

Section 119 also excludes meals and lodging provided to the employee’s spouse or dependents.

12. Imputed Income. The benefits derived from labor on one’s own behalf or the benefits from the ownership of property are commonly referred to as “imputed income.” Economists generally regard imputed income as income that should be taxed, but these benefits usually are not taxed. The exclusion of imputed income results in similarly situated taxpayers being treated differently, and results in inefficiencies by causing taxpayers to make economic choices different from those that they would have made in a no-tax world. However, there are administrability concerns, public opinion concerns, and conceptual concerns (where do you stop? Almost any non-business activity could be seen as creating imputed income of some sort).

13. Gifts: The Duberstein Case. Gifts are generally excludable from income. In Duberstein, the government argued that “gifts should be defined as transfers of property made for personal as distinguished from business reasons.” Duberstein declined to adopt this test, instead adopting a test that turns on whether the donor’s intent manifested “a detached and disinterested generosity,” considered in light of the totality of the circumstances.

Concurring, Justice Frankfurter argued that the Court should adopt a clearer test, such that “things of value given to employees by their employers upon the termination of employment, and payments entangled in a business relation and occasioned by the performance of some service” would be presumptively taxable.

Because the Duberstein test requires an inquiry into the donor’s motivation, it is not easy to administer. In Harris, for example, the court held that an individual could not be convicted of criminal tax evasion for failing to report gift income unless the individual knew that the donor’s intent was...