Kaiser - Individual Income Taxation slides

Minnesota State Bar Association CLE
Tax Law for the Non-Specialist

Individual Income Taxation

February 8, 2012

By: Kevin Kaiser

Agenda
• Taxation of individuals and families

• Tax policy considerations

• Gross income

• Exclusions and deductions from gross income

• Trade or business activities

• Tax planning and tax shelters

• Attorney tax considerations

Basic Issues
• Who is the taxpayer?

• What items of income will be includable in gross income?

• When should income be recognized?

• What items of expense will be allowable as deductions?

• When should a deduction be allowable?

• What is the character of recognized income or deductions
(capital or ordinary)?

The Taxpayer
• From inception the income tax laws have been designed
with the view that every individual should file their own
return

• Tax theorists and policy makers debate whether the
income of a nuclear family should be combined on a family
tax return

• Current tax law reflects a hybrid system of tax reporting
focused on the individual while also treating the family as
the taxable unit

The Taxpayer
• Selected tax laws that take account of family relationships
to treat the nuclear family as the 'taxpayer' :
 Personal and dependent exemptions
 Child and dependent care credits
 Medical care expenses
 Earned Income Tax Credit
 Head of household Status
 Joint tax return filing
 Restrictions on the deductions of losses resulting from
transactions with family members

Basic Design Principles of the Income Tax
• Horizontal Equity
 Those with equal ability to pay should pay equal taxes

• Vertical Equity
 Those with greater ability to pay should pay more (progressivity)

• Efficiency
 Taxes should not distort behavior
 Taxes should never operate in a way that leaves one person
better off at the expense of someone else

• Simplicity (transparency)

Basic Formula - Individual Taxpayer’s Taxable Income and Tax Liability

Gross Income (Section 61 – “all income from whatever source derived”)
- Less deductions provided by statute
------------------------------------------------------------
Adjusted Gross Income (AGI)
- Itemized or Standard Deduction
- Personal Exemptions
------------------------------------------------------------
Taxable Income
x Tax Rates (10% to 35% for ordinary income; 15% to 28% capital gain)
------------------------------------------------------------
Tentative Tax Liability
- Tax Credits
------------------------------------------------------------
Final Tax Liability (or Tax Refund)
=====================================

Gross Income
• Reg. Sec. 1.61-1(a) “Gross income includes income realized in any form, whether
in money, property, or services”

• Commissioner v. Glenshaw Glass Co. (1955), the U.S. Supreme Court defined
“income,” as used in section 61 of the Internal Revenue Code, as “undeniable
accessions to wealth, clearly realized, and over which the taxpayers have
complete dominion”

• Congress applied no limitations as to the source of taxable receipts
 Gross income includes “worldwide” income (i.e., earnings within the U.S.
and outside the U.S.)
 Gross income includes all earnings in whatever form including money,
property or services
 Gross income includes proceeds from illegal activities (e.g., embezzlement)

Gross income means all income from whatever source derived, including:
• Compensation for services
• Gross income derived from business
• Gains from dealings in property
• Interest
• Rents
• Royalties
• Dividends
• Alimony, and separate maintenance payments
• Annuities
• Income from life insurance and endowment contracts
• Pensions
• Income from discharge from indebtedness
• Distributive share of partnership gross income
• Income in respect of a decedent
• Income from interest in an estate or trust
(Excerpt from IRC Section 61(a))

Gross Income
• Generally, income must be “realized” before an amount becomes
subject to recognition

• Generally, individual taxpayers calculate their taxable income using
the “cash receipts” method of accounting

• The Realization Doctrine provides an administrable rule that, for
the most part, avoids the liquidity and valuation problems that
would arise under a pure accretion model of taxation

Gross Income
• Mark-to-market and accrual method of accounting are elective for certain
investments and transactions, however, mandatory for others:
 Mark-to-market method of accounting is required by statute for certain
types of investments described in Section 1256, “Contracts Marked to
Market”
 Regulated futures contract
 Foreign currency contract

• Interest income generally must be taken into account using the accrual method
of accounting (e.g., original issue discount (OID))

• Securities and commodities traders can elect to account for their trading gains
and losses using the mark-to-market method of accounting (§ 475(f))

Gross Income
• Gross income includes “unearned” income from whatever source:
 Punitive damages
 Treble damages under the antitrust laws
 Qui tam compensation from False Claims Act or Whistleblower
recoveries
 Economic benefit derived from expense paid by another
person
 Treasure trove (e.g., catching a record breaking home run
baseball)
 Contest winnings (lottery, game show, drawings)

Exclusions For Adjusted Gross Income
Taxpayers can deduct certain items in figuring adjusted gross income:
• Loans (obligation to repay so no accession to wealth)
• Return of capital permitted tax free
• Life insurance death benefits
• Gifts, bequests and inheritances (§ 102)
• Compensation for personal physical injury or sickness (§ 104)
 Does not include amounts received for nonphysical injuries
• Costs involving discrimination suits (e.g., contingent fees) (§ 62(a)(20)
• Interest on State and local bonds (§ 103)
• Exclusion for gain on principal residence (§ 121)
• Certain fringe benefits (§ 132)
• Discharge of indebtedness income (§ 108) [under limited circumstances]

Trade or Business
• Generally, in order to qualify as a “trade or business” for income tax purposes,
the taxpayer must be involved in the activity on a continuous and regular basis,
and the taxpayer's primary purpose for engaging in the activity must be for
income or profit

• Income and expenses of a trade or business operated as a sole proprietorship
are reported on an IRS Form 1040, Schedule C “Profit or Loss From Business”

Trade or Business - Recent controversies testing the trade or business classification:
• Day-Traders in securities
 Trading in securities (as a business) vs. Investing in securities
 Issue - Characterization of expenses
 Trade or business expense (§ 162) – Schedule C deduction
 Production of income expense (§ 212) – misc itemized deduction
 Accounting method – mark-to-market election (§ 475(f))

• Gambling/Gaming
 E.g., poker tournament play
 Business vs. recreation (personal)
 Tax treatment of losses and related expenses
 Schedule C or misc itemized deduction

Passive Activity Loss Rules
• PAL rules require individual taxpayers to classify their income, losses and credits as being
generated by “passive activities,” "nonpassive activities,” or portfolio investments

 PAL Rule: Passive activity losses may only be used to offset passive activity income

• Material participation
 A passive activity is generally defined as any trade or business activity in which the
taxpayer does not materially participate
 A taxpayer’s participation will be considered material if it is regular, continuous and
substantial
 A material participation safe-harbor is the annual 500 hours of taxpayer activity test
 A passive investor will not be a material participant in an activity
 Certain activities such as rental real estate are per se passive
 Exception for 'active' participation in a rental real estate activity. Up to $25,000
of rental losses allowed. ($25K allowance phased out for incomes over $100K.)

Hobby Loss Rules
• Losses incurred in carrying on personal hobbies are not deductible

• Section 183(d) creates the rebuttable presumption that an activity
was engaged in for profit, with respect to a given year, if the
activity was profitable for three years in the five-year period
ending with the year in question

• If section 183 applies and activity is classified as a hobby loss
activity, then deductions only allowable to the extent of income
from the activity

Capital vs. Ordinary Gains and Losses
• Capital gain or loss
 Investment income ('unearned')
 Risk based return
 Must result from a realization event
 Note – capital losses only deductible to the extent of capital gains.
($3,000 per year net capital loss allowance for individuals)

• Ordinary income or loss
 Income earned in exchange for personal services (i.e., compensation)
 Time based return (interest income, OID, market discount)
 Amortizable or regular and predictable income stream

• Policy Question – Should capital gains be subject to a lower tax rate?

Information returns
• IRS Form 1099 Information Returns
 Form 1099-INT
 Form 1099-DIV
 Form 1099-B (including basis information)
 Form 1099-C
 Form 1099-MISC

• Schedule K-1
 Partnership, Schedule K-1
 S-corporation, Schedule K-1
 Trust, Schedule K-1

• Form W-2
 Form W-2, Wage and Tax Statement
 Form W-2G, Certain Gambling Winnings

Deductions From Adjusted Gross Income
• Selected Itemized deductions
 Interest (§ 163)
 Trade or business related interest expense
 Investment interest expense (§ 163(d))
 Qualified residence interest expense (§ 163(h)(3))

 Taxes (§ 164)
 Cannot deduct federal income, gift, estate, or Social Security taxes
 Foreign income taxes can be deducted or claimed as credits

 Casualty losses (§ 165 (c)(3), (h))
 Deductible to the extent they exceed $100 per event and 10% of
AGI in aggregate

• Itemized deductions
 Medical expenses (§ 213)
 Deduction permitted to the extent that aggregate medical costs
exceed 7.5% of AGI

 Charitable contribution (§ 170)
 Deduction allowed in an amount up to 50% of AGI
 Deduction equal to amount of cash or FMV of property donation
 No deduction if taxpayer will receive significant economic benefit
(e.g., private school tuition)
 No political or lobbying expenses

• Itemized deductions
 Miscellaneous itemized deductions (§ 67)
 Deductible to the extent the expenses exceed 2% of AGI

 Examples of miscellaneous itemized deductions
 Unreimbursed business expenses
 Investment expenses (production of income expenses
under § 212)
 Tax preparation fees
 Estate planning
 Safety deposit box
 Union dues

Determination of Taxable Income and Tax Liability
• Gross income less allowable deductions

• Apply tax rates to appropriate income categories
 Ordinary income
 Net capital gain income

• "Kiddie Tax"
 Include child's unearned income on parent's return, or subject child's
unearned income to parent's tax rates (§ 1(g))

• Alternative Minimum Tax
 Must compute AltMin tax every year and compare to regular tax liability

Tax Credits
• Generally, more valuable than deductions. Credits provide a
dollar-for-dollar reduction in tax liability. Sample tax credits:
 Taxes withheld (§ 31)
 Dependent care (§ 21)
 Earned income tax credit (§ 32)
 Education credits (§ 25A)
 Adoption credit (§ 23)
 Foreign tax credit (§ 901)
 Business related credits (§ 38, aggregates bus credits)

Tax Planning and Tax Shelters
• “Any one may so arrange his affairs that his taxes shall be as low
as possible; he is not bound to choose that pattern which will
best pay the Treasury; there is not even a patriotic duty to
increase one’s taxes,” Helvering v. Gregory (CA-2, 1934)

• Generally, tax planning and ‘tax avoidance’ are permissible and
value added activities and objectives that taxpayers and their
advisors routinely engage

• Tax evasion is illegal

• Taxing authorities have recently adopted a multi-layered approach to
combating abusive tax planning

• Courts have applied various judicial doctrines to challenge transactions :
 Sham transaction
 Business purpose
 Substance over form
 Economic substance (recently codified as § 7701(o))
 Generally, the economic substance doctrine includes the other doctrines

• Interpretive Treasury regulations include broad anti-avoidance provisions

• Congress has increased the penalties targeted at abusive tax planning
conduct by both taxpayers and their advisors

• Planning generally involves managing the timing of income and deductions,
eliminating the recognition of income, or subjecting the recognition of
income to preferential capital gains rates. Examples:
 Investment in municipal bonds

 Investing in and holding a growth stock that appreciates for many years

 Selling a stock with a unrealized loss before year end

 Using the nonrecognition or tax deferral rules, such as the Section 1031
exchange

Attorney Specific Tax Issues and Considerations
• Tax treatment of settlements and judgments
 Tax treatment of contingent attorney fees
 Settlement agreement of damages allocation
 Origin of the claim doctrine
 Form 1099 reporting

• Client costs incurred in contingent fees cases
 Gross fee contract


Q&A

Contact Information
Kevin W. Kaiser
Lindquist & Vennum PLLP
4200 IDS Center
80 South Seventh Street
Minneapolis, MN 55402

Phone: (612) 371-2467
E-mail: kkaiser@lindquist.com


ANY TAX ADVICE CONTAINED IN THIS COMMUNICATION IS NOT INTENDED OR
WRITTEN TO BE USED, AND CANNOT BE USED FOR THE PURPOSE OF (i)
AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii)
PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY
MATTERS ADDRESSED HEREIN.

The information contained herein is general in nature and based on authorities
that are subject to change. Applicability to specific situations is to be determined
through consultation with your tax advisor.

Kaiser - Individual Income Taxation slides

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