#11515 - Gross Income - U.S. Income Tax Law

GROSS INCOME

1. General Rule: Inclusion

   1. Basic assumption under §61 is that income is all income from whatever source derived

   2. Other definitions:

      1. Eisner v Macomber (US 1920, p 249)—NJ company decides to issue an additional share of common stock for each share outstanding. Court has to wrestle with whether this is income, and what is income. Decides this is not income. Shareholder is not getting any anything out of the company, this is functionally just an accounting thing—twice as many shares outstanding, each worth half as much. Court here defined income as “derived from labor, capital, or from labor, or from both combined.”

      2. Commissioner v Glenshaw Glass (US 1955)—expands on Eisner definition so it includes windfalls.

         1. Taxpayer recv’d settlement in antitrust litigation settlement, which included punitive damages. Argues those are just meant to punish D and he got lucky, not income.

         2. Court says income is “all accessions to wealth, clearly realized, and over which the taxpayers have complete dominion,” unless clearly exempted.

      3. James test (cited in Collins): taxpayer receives income “when she acquires earnings, lawfully or unlawfully, w/o the consensual recognition, express or implied, or an obligation to repay and w/o restriction as to their disposition…

   3. Realization Rule (§1001): We only collect tax when there’s some kind of transaction or transfer or exchange that is a realization event.

      1. Rationale: Maybe too hard to value illiquid assets; maybe ppl don’t have cash to pay tax as stock rises in price but before they sell; just simpler. Realization rule also allows for compounding—the gains from each period stay in there and aren’t taxed until much later.

      2. What is an exchange? In Cottage Savings, Supreme Ct defined it as an exchange of something “for something materially different.”

      3. Alternatives to realization rule:

         1. Mark to market: poses valuation and administration issues. Even if only for liquid stocks, still makes gov’t income really volatile.

         2. Progressive realization: basically like mark-to-market, but only for certain taxpayers

   4. Exclusions from Income

      1. Conceptual exceptions (imputed income)

      2. Statutory Exceptions

         1. Gifts

         2. Certain fringe benefits

         3. Damages received for personal physical injuries

2. Non-Cash Income

   1. Valuation: Reg. §1.61-2(d): When income is received in the form of property or services, the value is the fair market value. If services are rendered at a stipulated price, such price will be presumed to be the FMV absent evidence to the contrary.

      1. Valuation of fringe benefits (Reg §1.61-21(b)): income includes the FMV of any fringe benefit received minus any amount paid for the benefit, minus any amount for benefits specifically excluded by the code.

   2. Property, Stocks and Stock Options (§83): Basically, you don’t pay tax until the options vest, unless you elect to pay at grant (then you don’t pay at vesting until you sell). Employer takes deduction when payee pays tax.

      1. Substantial Risk of Forfeiture (§83(c)): This is the statutory grounding for vesting. Because you don’t pay as long as there is substantial risk of forfeiture, defined as “if such person’s rights to full enjoyment of such property are conditioned upon the future performance of substantial services by any individual.” (§83(c)(1)). Similarly, transferrable only if the rights of the transferee are not subject to substantial risk of forfeiture.

         1. Regs example notes that two year work requirement is sufficient for SROF (1.83-3(c) examples)

         2. Taxes are due at the earlier point of either when the risk of forfeiture is no longer substantial or when the property becomes transferrable (where the rights in such property of any transferee are not subject to a substantial risk of forfeiture).

         3. If property is forfeited before vesting, the employee (or holder of option) pays ordinary income tax on any amount he receives upon forfeiture, minus whatever he initially paid for the property.

         4. If you sell unvested property, you pay ordinary income on whatever you receive in the sale minus the basis (§1.83-1(b)(1))

      2. Election (§83(b)): You have the choice of paying tax on the FMV of the option minus whatever you paid for it, or you otherwise would have to pay at vesting. Decision basically depends on opportunity cost of funds, projected growth in stock, and projected changes in your marginal tax bracket.

         1. Employers: Many prohibit election b/c they would rather take a larger deduction at vesting.

         2. Deductions: If taxpayer elects, and later forfeits the property, no deductions is allowed w/r/t the forfeiture. He eats the tax paid as a result of a bad bet in electing. However, you can take a loss for the amount realized upon forfeiture (usually zero) minus your basis (whatever you piad for it, which is often zero, so no deduction). Employer would then have to include as income an amount equal to the deduction it took when employee did the election (Reg 1.83-6(c), but not covered for this class).

         3. Policy: Maybe Congress wants to help out startups, maybe they want to encourage payment through equity to align managerial incentives.

         4. Capital gains: election also carries benefit of lowering basis (assuming stock rises over time), so more of the income is shifted from ordinary to capital gains (lower rates).

         5. Alves v Commissioner (9^th Cir 1984, p 224): Alves was senior employee at company, got stock and did not elect. At the time he took stock, he paid FMV for it (no discount). So he argued it wasn’t in connection w/ services, b/c he wasn’t given any deal. But the stock was basically only available to employees, public couldn’t buyit was in connection with performance. Court says it is irrelevant that there’s no discount and that employee paid FMV at time of transfer. Since he didn’t elect, he has to pay tax on difference b/w FMV at time of vesting and price he paid upon transfer.

         6. No tax on option exercise (§83(b))

         7. Valuation of stock options (83(a))-you do not reduce the FMV of stock options for tax purposes due to any vesting or other liquidity constraints.

            1. Non-ascertainable: no taxes on transfer of an option without a readily ascertainable FMV (§83(e(3)).

      3. Exclusivity requirement: (Reg §1.83-3(f)): existence of other non-employees receiving the same options could be signal that they were not received in recognition of services delivered.

      4. Property defined (Reg. §1.83-3(e)): Basically includes real property, stock options, and everything else that is not money.

   3. Services Exchange: Services traded for services counts as income (§1.61-2(d)(1)).

   4. Incentive Stock Options (§421, §422): For an incentive stock option, the grant of the option is nota taxable event, and when the employee exercises the option, the gain in value is also not taxable. Employee with ISO pays no tax until the capital gains (note lower rate) when he sells the stock (if ever). Hugely favorable to employee, but:

      1. Employers don’t like it, b/c they never get to take a deduction

      2. §422(b) provides some restrictions, including: can’t be granted to a person who owns more than 10% of the corporation, option cannot be “in the money” at time of grant; no one can receive more than $100K in ISO in a year.

   5. Cancellation of Indebtedness(§61(a)(12))

      1. US v Kirby Lumber (US 1931 p 143): Kirby Lumber issued $12 mil in debt (bonds of $10K each) and later repurchased it on secondary mkt at discount ($9K each). The difference of $1K on each bond is taxable income.

         1. Kirby result now codified at §61(a)(12), expressly including discharge of indebtedness as a type of income.

      2. Timing of tax consequence: When it becomes apparent that the loan will not be repaid, the amount not paid must be reported as income for the year in which it becomes apparent (not the year in which the loan was received).

      3. Exemptions (§108): Situations that do not require inclusion in income

         1. Chap 11 bankruptcy under court supervision

         2. The cancellation occurs while debtor is insolvent

         3. Qualified farm indebtedness

         4. Qualified principal residential indebtedness thru 2012 if cancelled in response to decline in value or taxpayer financial distress (but note, taxpayer reduces basis in home by amount of cancellation excluded).

      4. Insolvency details (108(a)(3)):

         1. The amount excluded shall not exceed the amount by which taxpayer is insolvent. So if his liabilities exceed assets by $200K and he has $600K of cancellation income, still must pay tax on $400K of the income.

      5. Reduction of Tax Attributes (§108(b))

         1. Taxpayer excluding indebtedness income for any of the 108(a) reasons must reduce other tax attributes, in this order: NOL; general business credits or AMT credits from §38 and §53(b) (NOT COVERED for this class); capital loss carryovers; basis reductions; other tax credits

            1. Basis reductions: They need to reduce the basis on assets by the amount of cancellation tax benefit, so if they ever sell the asset, they wind up paying that amount of tax back as a result of lower basishigher gain. Again, not covered.

      6. Purchase Price Adjustment (§108(e)(5)): Purchase price adjustment due to revealed facts previously unknown (e.g. seller of home reduces amount outstanding by amount by discovery of asbestos reduces property value) is not cancellation income. But the owner reduces his basis to reflect the reduced purchase price as if that were the price all along.

      7. Other details:

         1. 108(a) provides order in which the provisions kick in (so bankruptcy debt is handled first, then residential debt, etc)

         2. Only applies to indebtedness for which the taxpayer is liable (108(d) or subject to which the taxpayer holds property

         3. Cancellation of indebtedness reduces...