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** Old Colony Trust Company v. Commissioner, (1929)
2. Facts: Mr. Wood was president of a corporation. Old Colony is his
executor. The corporation paid all income taxes on Mr. Wood's salary
directly to the government so that his resulting salary would have no
deductions for income taxes.
3. Procedural Posture: The Board of Tax Appeals found that the
corporation's payment of the tax was income to Mr. Wood. The decision
was granted review by the Supreme Court.
4. Issue: "Whether a taxpayer, having induced a third party to pay his
income tax or having acquiesced in such payment as made in discharge of
an obligation to him, may avoid the making of a return thereof and the
5. Holding: No. The payment of income tax by an employer is a gain
derived by the employee from his labor and is in consideration of the
services rendered by the employee, and is therefore taxable against the
employee as income.
6. Reasoning: The Supreme Court reasoned that the discharge by the
company of the employee's obligation was a direct gain to the employee,
regardless of the form of payment and the fact that it went directly to
the government. Because the payment of his income taxes was in
consideration for his continued employment, the payments constituted
income to the employee. The Court rejected the argument that it was a
tax on a tax as not being before them.
7. Notes: A. Third-party payments - Old Colony established the
proposition that gross income includes economic benefit to a taxpayer
resulting from the payment of an obligation to a third party. Any other
approach would make it too simple to avoid taxation by restructuring
cash payments to third parties. Also taxable as income are: payments of
fines to government, etc.
B. Tax on a Tax - In Old Colony, the
government only included in the gross income of the taxpayer the first
layer or tax paid on behalf of the taxpayer. This only took into account
the difference in tax owed based on the after tax compensation of the
taxpayer and that actually paid by the company (the tax would have been
more had the full salary been paid). However, a proper calculation would
have included a "pyramiding" of the tax, and thus been assessed against
the before-tax compensation. Ex: Taxes are $33,000 on an after-tax
income of $100,000, but only $22,000 on a before-tax income of $100,000.
C. Other forms of benefit - In Armantrout v. Comm., disbursements from a
school trust fund set up for the employee's kids were part of gross
income to the employee. In U.S. v. Gotcher, the taxpayer went on a 12
day trip to Germany to visit the VW plant. VW paid 75% and Gotcher's
employer, the other 25%. The court held that the trip expenses were not
income because they were for the "primary purpose" of the "legitimate
business purpose of the party paying the expenses." [This can be squared
with Old Colony if one views the Old Colony payment as compensation to
continue employment, and the VW payment as travel expenses of a
potential business partner.] Similarly, the "convenience of the
employer" test developed in Benaglia applies to expenses paid for by the
employer but imposed on the employee (manager of a hotel got room and
board tax free because the employer required him to be there). See also
McDonnel v. Comm. (holding that taxpayer assigned to discuss business
with customers on a vacation to Hawaii was not liable for tax on the
value of the trip because it was primarily a working trip, not a
vacation, even if they enjoyed it).
** Revenue Ruling 79-24 (Non-Cash Benefits), (1979)
2. Facts: Situation 1: In return for legal services, a painter paints
the lawyer's house.
Situation 2: An artist paid 6 months rent with a painting.
3. Statutes/Regulations: I.R.C. 61(a) and Regs. 1.61-2(d)
4. Issue: Are bartered services included in gross income?
5. Holding: Yes. If services are paid for other than in money, the fair
market value of the property or services taken in payment must be
included as income.
6. Notes: A. Other examples: Dean v. Comm., shareholder realized
dividend income from rent-free use of house owned by corporation; Strong
v. Comm., lessor of a cattle breeding herd realized rental income when
calves born were added to the herd which remained in lessee's
possession. B. Barter Exchange Clubs - even where the services are not
contemporaneous, and instead "trade units" or credit is given (like
money), the value received is still included in the year of receipt as
** Rooney v. Commissioner, (1987)
2. Facts: An accounting partnership regularly conducted business by
receiving goods and services from their clients as payment for their
services. This method was called "cross-accounting". Four of their
clients became delinquent in their accounts, and so the accountants
chose to patronize their businesses, receiving goods and services in
lieu of cash as partial payment of the client's delinquent accounts.
However, when reporting this income, the partnership "discounted" the
value of the goods and services, claiming that although they were
charged retail prices for the goods and services, the actual value to
them was much less because they were "forced" to take payment in kind to
avoid not being able to collect at all from the clients, who were on the
brink of going out of business. The partners never told the clients that
they were discounting.
3. Statutes/Regulations: IRC 61(a) and Regs 1.61-2(d).
4. Issue: May an accounting partnership discount the value of goods or
services received according to the partner's subjective valuation of the
goods or services when computing income?
5. Holding: No. The proper measure for the value of compensation made in
other than cash terms is the objectively determined fair market value of
those goods or services.
6. Reasoning: The court reasoned that if any subjective valuation was
used, then the tax system would be unworkable because the IRS can not be
concerned with the subjective state of mind of the taxpayer.
Furthermore, they rejected the argument that the partners were under
economic duress because, although the partners claim they would not have
paid as much for the services, other customers regularly paid that much.
7. Notes: A. Fair Market Value is defined in the Estate Tax Regs as "the
price at which the property would change hands between a willing buyer
and a willing seller, neither being under any compulsion to buy or sell
and both having a reasonable knowledge of relevant facts." Regs.
20.2031-1(b). However, in Turner v. Comm., the tax court held the value
of non-transferable steamship tickets won by the taxpayer at 2/3 their
value because they would not have purchased them for themselves. B.
Bargains - a taxpayer is required to pay tax only on the actual "price"
value of the services he obtains, even if they are less than the market
value. For example, in Pellar v. Comm., a taxpayer who received
intentionally discounted services from a contractor because of a
preferential business relationship did not recognize gross income on the
difference between the discount price and the regular price the
contractor charged. [Pellar can be reconciled with Rooney only if the
test is whether the service provider charged less for his services, or
the taxpayer discounted the value of the services independently. In the
former, the market differential is not includable as income, while the
latter is.] However, when the service provider intends the discount to
be compensation to the taxpayer in return for the taxpayer's goods or
services, then the market differential value is includable as income to
** U.S. v. Drescher, (1950)
2. Facts: Drescher was an employee of Bausch and Lomb who was given
voluntary retirement before he reached 65. He was given, in "recognition
of prior services rendered" a non-transferable annuity that would begin
to pay when he reached 65 in 1958 (or to his designated beneficiary if
he died), for which the company paid a premium of $5,000, and deducted
as compensation to Drescher. The policy had no cash surrender value. It
was only a guaranteed future income stream for himself or his
3. Statutes/Regulations: I.R.C. 61(a) includes "compensation for
personal service, of whatever kind and in whatever form paid."
4. Issue: What is the includable income value of the annuity in the
present tax year? Is it the price of the premium paid by the company
($5,000), or is it zero because the annuity gives the taxpayer no
5. Holding: The present value of an annuity which is non-transferable is
equal to the cost to the taxpayer of acquiring identical rights.
6. Reasoning: The court reasoned that the value lie somewhere between
the premium price paid and zero. Even though the taxpayer might die
before the annuity started paying, he had some present rights to a
future income stream which he could designate to a beneficiary.
Furthermore, the taxpayer could realize present cash payment from a
third party who he could designate as a trustee to hold the future
payments in trust for him. However, this would probably be worth less
than the premium paid by the company based on the risk of the taxpayer
dying before the annuity began paying, and thus the payments going to
the beneficiary. However, the burden of proof was on Drescher to show
that the present value was less than $5,000.
7. Dissent: The dissent reasoned that the value was the amount paid by
the company because it represented the present value of the future
payments, and was consideration for the contract between the taxpayer
and the company. The dollar amount of the policy premium represented
what the market expected the present value of the aggregate payments
over Drescher's life to be, which was greater than $5,000.
8. Notes: A. As a result of the Gov't victory in Drescher, he would be
required to pay taxes currently on the present value of the policy
($5,000), plus future taxes on any payments greater than $5,000 if he
lived long enough. Drescher would have gotten the same value in present
terms if the company had given him a cash bonus large enough so that
after taxes he would be left with $5,000. An annuity is deferred
I. Imputed Income (Excerpt from Marsh, The Taxation of Imputed Income)
A. Definition - "a flow of satisfaction from durable goods owned and
used by the taxpayer, or from goods and services arising out of the
personal exertions of the taxpayer on his own behalf."
1. By definition, it is a species of non-cash or income in kind which
arises outside of the normal market.
a. Imputed rent - net value of the services rendered by a house to its
owner which he otherwise would have had to pay a landlord.
b. Imputed interest - use of durable goods
c. Imputed wages - value of services rendered for oneself, such as
mowing the lawn, housework, subsistence farming.
B. Imputed income, like all income, increases a taxpayer's buying power.
Thus, this drives decisions to do work yourself and avoid the tax on the
extra money you would have had to make to hire out the same work.
1. Taxing imputed income would broaden the tax base, but might not be
able to be assessed properly.
2. Also, high administrative costs would probably outweigh the value of
the tax collected because people don't normally do a wide variety of
highly valuable things for themselves.
3. However, imputed income from residential rent, or cars, etc., might
be more easily measurable.
1. Rental Value: In some European countries imputed rent is taxable as
income. In the U.S. it is generally believed that imputed rent is not
2. Farm products consumed by Farmer: Reg. 1.61-4(a) states that "crop
shares" which are the landowner's cut of crops grown by a third party on
his land are taxable income. However, homegrown food for one's own use
is not under Morris v. Comm..
3. Payments to Oneself: commissions paid by a partner in a firm to the
firm itself, of which he shared in the profits, were held to be non-
taxable to the extent they could be traced to him directly.
I. Employee Benefits as Income
A. Many fringe benefits are valuable to the employee, and have been
1. Discounts on company goods and services leads to potential
discrimination in benefits among employers because some employers have
more desirable goods than others.
2. Also, benefits to higher-paid employees are normally given as a way
to avoid income tax liability.
B. The Deficit Reduction Act of 1984 sought to exclude only certain
benefits to widen the tax base in a fair manner.
1. No-additional-cost services - Sec.132(b) where the employer provides
a service to the employee for a discount, it is excludable if the
employer incurs no additional cost by providing it, including foregone
a. Example: employee can use excess capacity of employer while not being
used by customers (airline stewardess flying free to any destination
with extra seats).
b. Must be the same type of service sold to the public in the ordinary
course of business in which that employee works. (Thus, an employee of a
conglomerate can not use company owned hotel rooms if she is only a
c. Must be something that the employee would not have purchased for
himself at market price (otherwise it is lost revenue).
d. Can be provided by a third party employer as long as there are
reciprocal benefits to that company's employees. Sec.132(i).
2. Qualified Employee Discount - Sec.132(c) the amount of the exclusion
is subject to a limitation based on the employer's gross profit
percentage, normally a max. of 20% (otherwise the employer would be
3. Working Condition Fringe - Sec.132(d) excludable if the property or
services would have been deductible by the employee individually as an
ordinary and necessary business expense, but instead was provided by the
a. Ex: company car used for business purposes (not personal use).
b. Ex: employer pays for subscription to magazines, or professional
4. De Minimis Fringes - Sec.132(e) otherwise includable income that is
so small that the cost of accounting for it would be impractical.
a. Ex: occasional personal use of company resources (copier, car, meals,
5. Qualified Transportation Fringe- Sec.132(f) employer provided
parking, transit passes, etc. are excluded to a maximum limitation.
6. Qualified Moving Expense Reimbursement Sec.132(f) only reasonable
costs and expenses of the actual move are excluded, not house-hunting
7. Non-discrimination - Sec.132(i) Each of these exclusions is available
to highly compensated groups (officers) only to the extent substantially
the same benefits are offered to others.
a. Nondiscrimination is only applicable to no-additional-cost and
employee discount fringes, not working condition or de minimis fringes.
C. Sec.119 Meals or lodging furnished by the employer
1. Cost of meals and lodging is excludable if it is "for the convenience
of the employer," even if the employee is thereby convenienced, and it
is provided for a "substantial non-compensatory reason".
2. Sec.119 only covers meals or groceries furnished in kind, not cash
provided as a meal allowance.
3. Sec.119 also covers meals furnished to the employee's dependents
because of difficulties in separating the value of those services from
the value to the employee.
4. Sec.119 the meals and lodging must be provided on the employer's
"business premises" - but simply being close and "on call" is
D. Other Fringe Benefits
1. Life Insurance - Sec.79 excludable up to $50,000 group-term life, and
subject to the non-discrimination rule for key employees.
2. Health Benefits - Sec.105 and Sec.106 "Sick pay" is not excludable,
a. Medical payments tied to the type of injury suffered, not relating to
the period the employee is absent from work are excludable.
b. Still subject to non-discrimination.
3. Qualified Educational Benefits Sec.127 - excludes up to $5,250/yr.
paid by employer or discounts to university employees.
4. Dependent Care Sec.129 excludable for children under 13 as long as
there is a non-discriminatory written plan.
5. Group legal services Sec.120 qualified exclusion up to $70 in legal
6. Cafeteria plans - Sec.125 the choice between taxable and non-taxable
benefits will make an otherwise excludable benefit includable.
E. TAXABLE Benefits - anything not specifically excluded under statute
becomes includable under Sec.61(a).
1. Most exclusions are not based on sound tax policy reasons, but rather
other policy objectives, and therefore distort consumer choices.
a. Why should a person who is lucky enough to enjoy a tax-free benefit
pay no tax when another consumer is forced to pay for the same service
with after-tax dollars?
** Commissioner v. Duberstein, (1960)
2. Facts: Situation 1: Duberstein was the president of a metal company.
He frequently conducted business with, and gave business leads to, a Mr.
Berman, who was the president of another metal company. Duberstein knew
Berman "personally". Because of the helpful business leads that
Duberstein provided, Berman gave Duberstein a Cadillac. Berman claimed a
business deduction for the Cadillac, but Duberstein did not include it
Situation 2: Stanton was the comptroller of a church corporation. After
tendering his resignation amidst some ill-feeling, the church
corporation resolved to give him a "gratuity" of $20,000 "in
appreciation of services rendered...provided that the [church
corporation] be released from all rights and claims to pension and
3. Statute/Regulations: Sec.102 on gifts (actually, its predecessor).
4. Issue: May a transaction between persons who are involved in a
business relationship be categorized as a gift?
5. Holding: Yes. Whether a transaction between persons who are involved
in a business relationship may be categorized as a gift, and thus
excludable as income, is a question of fact to be determined on a case-
by-case basis, and not a matter of law.
6. Reasoning: The majority followed the dissenting opinion in Bogardus
v. Commissioner, that the "intention" of the transferor (objectively
determined) is what is controlling as to whether a transfer is a gift.
They rejected the Government's proposed test that if business were
involved then it could not be a gift as a matter of law. Since intention
is a question of fact, the Court stated that a workable test of law
could not be fashioned, but that consideration of all the circumstances
must be taken into account. Thus, whether a business "gift" is taxable
should be left to the trier of fact's experience. The gift should be
made with "detached or disinterested generosity".
7. Notes: A. The Gift Tax statute definition of a gift is not the same
as the income tax definition.
B. Generally, employer payments to
employees "in appreciation" after they have left are taxable as income,
and are not considered gifts. Section 102(c) requires all transfers to
employees fro employers to be included as income. However, it seems to
only apply to a current employer/employee relationship, and not "in
appreciation" gifts like that in Duberstein. Likewise, it does not seem
to apply to independent contractors.
C. Death Benefits - although they
have had a history of inconsistency between the District Courts and the
Tax Court, Sec.101(b) now excludes from gross income amounts up to
$5,000 paid by an employer to the beneficiaries of a deceased employee,
but only if the employee's right to receive the amounts was forfeitable
while he was alive. This exclusion applies regardless of whether it can
be considered a gift. D. A business "gift", if deductible by the donor,
would be excluded entirely from the tax base if it were excludable by
the donee. Thus, Section 274(b)(1) denies business deductions in excess
of $25 per person per year. Theoretically, this taxes the wrong person,
but keeps the gift in the tax base. Combined with death benefits, a
company can give $5,025 to a surviving spouse under Sec.Sec.102 and 101.
E. Tips are included in gross income under Regs 1.61-2. This includes
chips given to craps dealers. The IRS, in Sec.6053, has taken the
general rule that 8% of gross receipts are includable in income as tips,
based on random surveys of tipping behavior among patrons. Strike
benefits are normally taxable unless clearly based only on need and not
tied to picketing requirements. Public appeals for money can be taxable
even if there is no legal obligation to pay because it is assumed that
the paying party is not simply giving out of "disinterested generosity."
A person is entitled to treat transfers from a lover as gifts unless
they are specific payments for specific sex acts. Generally, bequests
are excludable under Sec.102, however, if they are used for compensation
to a taxpayer who has provided a service to the deceased, they are
** Irwin v. Gavit, (1925)
2. Facts: Testator left the residue of his estate in trust to be divided
into parts. Some income from the estate was to be paid to the testator's
son in law, in equal quarterly payments, for his life, or until
testator's granddaughter reached 21, whichever was sooner.
3. Statutes/Regulations: The lower court found that the payments
received from the estate were acquired by bequest and thus were not
taxable under statute. The modern statute is Sec.102.
4. Issue: Is the income from an estate includable as income even though
the bequest is made of the income of the estate and not the estate
5. Holding: Yes.
6. Reasoning: The court reasoned that the broad language in the statute
that stated that income from whatever source derived included income
from an estate, because it was not specifically excluded by statute. The
court stated that it was artificial to hold that the income from the
estate was a gift separate from an interest in the estate itself. It was
already settled that the estate was excludable, but the income from the
estate was not excludable. Thus, since the income of the estate could
not be separated from the estate, it could not be classified as a gift
on its own to get around the provisions for inclusion of income on a
7. Notes: Under Irwin and Sec.102(b), if a $100,000 gift is made in
trust to A to live off the income for life, and then the whole amount
over to B, then B excludes the entire $100,000 from income, but A
includes the income on the trust during his life.
I. Life Insurance Death Benefits (Sec.101).
A. Life insurance is defined by Section 7702. It must have the element
of insurance risk.
1. Ex: If a life insurance policy is granted only if the person buys an
annuity whose premium is equal to the face value of the life insurance
policy, then there is no insurance risk, and the proceeds are taxable
against the beneficiary.
2. Sec.7702 covers the situation where there is a current cash surrender
value and interest being made on the policy. The interest earned on the
savings portion of the policy is taxable.
B. Installment Payments
1. If the only amount that the beneficiary can receive is the face
amount of the policy, then the full amount of the proceeds is excludable
under Sec.101(a) regardless of the method of payment of the proceeds.
2. However, if the beneficiary leaves the proceeds with the insurance
company under an option to pay the face amount in installments, the
insurer will pay interest which is includable as income to the
3. Generally the present value of the policy at the death of the
testator is excludable.
C. Commercial Transactions
1. If a creditor insures the life of a debtor to secure repayment of the
a loan, the creditor only receives the amount of the debt. Thus, the
amount received is not "by reason of the death of the insured" and so
Sec.101(a) does not exclude the receipt.
2. If the taxpayer receiving the proceeds had bought the policy from
another, then any gain resulting (excess of proceeds over purchase price
plus later paid premiums) is includable under 102(a)(2) even though the
entire proceeds would have been fully exempt if the policy had been
taken out by the taxpayer himself.
D. Employee Death Benefits
1. 101(b) excludes $5,000 of post-death payment to the surviving spouse
by an employer, even though such payments are usually deferred
2. 101(b) does not apply to amounts which the employee had a non-
forfeitable right prior to death, such as accrued vacation pay, or any
guaranteed deferred compensation.
3. 101(b) does apply to payments pursuant to a contract expressly
providing for the payment of a benefit if the employee dies during the
period of employment.
I. Prizes (Section 74)
A. Prizes are generally includable as income to the payee.
1. Prizes are excludable only if:
a. the recipient was selected without any action on his part to "enter"
the contest (such as Nobel Prize);
b. the recipient is not required to render substantial future services
as a condition of the prize; and
c. the prize is transferred directly to the government or a non-profit
organization designated by the recipient. (direct donation).
2. Scholarships are not governed by Sec.74, but rather Sec.117.
B. Valuation of Taxable Prizes
1. Reg. 1.74-1(a)(2) requires that non-cash prizes be included as income
at their fair market value.
2. However, the courts might take into account the subjective value to
the individual recipient based on the probability that the recipient
would have made an expenditure to buy the prize for themselves.
C. Employee Achievement Awards
1. Sec.74(c) excludes employee achievement awards to the extent that the
award does not exceed the amount allowable as a business deduction to
2. Sec.274(j) requires that the award be personal property, awarded for
length of service or safety, be part of a "presentation", and not look
like disguised compensation, probably $400 or less.
I. Scholarships (Section 117).
A. In general, scholarships and tuition reduction for degree candidates
are excluded from gross income to the extent that they do not represent
any form of compensation, but are "disinterested" scholarships with no
1. The scholarship can only be used for tuition, fees, books and "course
related expenses", not room and board. The amount of the scholarship is
excludable only to the extent that the student has incurred these costs.
2. This applies to all levels of education from primary through
graduate, including accredited trade schools, but not correspondence
schools or on the job training or the like.
3. Amounts received for teaching, research or other services are
includable as income to the extent they represent compensation, if they
are a condition of the scholarship or tuition reduction.
4. Educational loan forgiveness is includable if it requires the
recipient to restrict his services (stay with a company, practice in
only rural areas, etc.)
B. Employer Provided Education Benefits - Where an employer pays,
directly or indirectly, education costs of its employees, Sec.117(a) is
not applicable, and thus the income is includable if not qualifying as a
tax-free fringe benefit under Sec.132.
C. If someone other than the student wins a scholarship intended to be
for the benefit of the student, it becomes taxable as a prize under
D. Policy Issues - the exemption of scholarships probably should be
analogous to the gift to a student from the family to pay for education.
Intra-family gifts are non-taxable to the student, so should
scholarships be non-taxable.
** Commissioner v. Glenshaw Glass, (1955)
2. Facts: Situation 1: Glenshaw Glass was involved in a long and
protracted anti-trust suit against a machinery manufacturer. It was
eventually settled for $800,000, of which, $324,000 was allocated as
payment of punitive damages. Glenshaw did not report this amount as
income, and the Commissioner claimed it was a deficiency. Situation 2:
William Goldman Theaters sued Loew's for antitrust violations. Their
actual damages were $125,000, which they reported as income, but they
did not report the other 2/3 of the treble damages awarded.
3. Statute/Regulation: Sec.61(a)'s predecessor: income derived from any
source whatever. Both the Tax Court and the Court of Appeal held in
favor of the taxpayer.
4. Issue: Are punitive damages awarded by a court, or settlements in
excess of actual damages includable as income?
5. Holding: Yes.
6. Reasoning: The court reasoned that there were no constitutional
barriers to the imposition of a tax on punitive damages. Furthermore,
the broad language of the statute defining gross income evidenced
Congress' desire to exercise their taxing power fully. Punitive damages
represent "undeniable accessions to wealth, clearly realized, and over
which the taxpayers have complete dominion." For the same reason that
the actual damage recoveries are taxable, the extra amount extracted for
punishment is also taxable.
7. Notes: A. In General American Investors Co., Inc. v. U.S., the
company recovered moneys from a director employee who had been guilty of
insider trading. The Supreme Court held that this was includable as
taxable income. B. In Haverly v. U.S., an elementary school principle
received unsolicited copies of books from various publishers. The
principle gave the books to a local library, and then claimed a
charitable deduction on them. The court held that the value of the books
constituted income, although they seemed to indicate that if he had not
taken a deduction for them, then it would have been a more difficult
case. C. The finder of a treasure trove of lost money is taxable to the
extent of its value in U.S. currency in the present tax year.
** North Am. Oil Cons. v. Burnet, (1932)
2. Facts: The Government owned the property that the company possessed.
The Gov't sought to oust the company from possession, and so set up a
receivership to take the company's profits for 1916. The company paid
the receivership the profits, and a suit proceeded for possession. In
1917, the District Court entered a decree for the company, awarding them
the profits previously paid to the receivership. The Gov't took an
appeal, which was ultimately affirmed in 1922.
3. Statutes/Regulations: Sec. 13(c) of the Revenue Act of 1916.
4. Issue: At what time do profits which are subject to litigation become
includable as income to the taxpayer?
5. Holding: Litigated profits become income of the taxpayer when they
first become entitled to them under a claim of right (a judgment),
regardless of whether the case is subsequently appealed.
6. Reasoning: The court reasoned that the company did not have
constructive receipt of the profits in 1916 when it paid them over to
the receivership because they had no claim of right to them. The outcome
of the pending case was uncertain. However, upon the first judgment in
their favor, they had constructive and actual receipt of the money,
regardless of any pending appeal. Even though the outcome of the appeal
was uncertain, in 1917 they were given a judgment for the money and so
had to make a return for it. Had the appeal gone the other way, they
would then have been able to claim a deduction against their 1922
7. Notes: A. Amounts received under a claim of right and without
restriction as to their disposition constitute income in the year of
receipt, even though the taxpayer may ultimately be required to restore
an equivalent amount in a subsequent judgment. [This differs from loans
which are not taxable because it does not involve "true" debt where the
receiver is under an unconditional obligation to make repayment.]
B. The receipt is includable as income even if "set aside" in a special
account with the intention of not using it until final judgment (Comm.
v. Alamitos Land Co.), or even if a bond is filed as security for
repayment in a final judgment (Comm. v. Brooklyn Union Gas Co.), but not
if the receipt is deposited under conditions preventing it from being
under the dominion of the taxpayer, such as a payment into the court
clerk pending final judgment (Rev. Rul. 69-642).
** James v. United States, (1961)
2. Facts: James admitted to embezzling funds from his employer. He did
not include the embezzled funds on his tax return.
3. Statute/Regulation: Section 61(a).
4. Issue: Are embezzled funds includable as income to the embezzler in
the tax year embezzled?
5. Holding: Yes.
6. Reasoning: The majority, overturning a previous ruling concerning
taxation of embezzled funds (Wilcox), reasoned that section 61(a)
language which included all income from whatever source derived,
included embezzled funds in the same way that it included all other
illegal income such as extortion (Rutkin). The embezzler, they reasoned,
had received income which he could exercise dominion over and realize
present economic benefit from, even though he may be required to repay
it at a later date. The embezzler should not be able to avoid taxes when
the honest man has to pay. If the embezzler were required to pay back
the debt, then he could claim a deduction. The embezzled funds could not
be termed a "loan" because they did not arise out of a "consensual
recognition" between he two parties to repay the debt. However, the
court reversed this particular defendant's conviction because he could
have not acted willfully if he had been relying on Wilcox to relieve him
from obligation to pay taxes on the embezzlement.
7. Dissent: The dissent reasoned that an embezzler does not gain any
claim of right to the money he embezzles until the statute of
limitations runs. The embezzler has effectively "borrowed" the money
without the consent of the owner, and so he should be treated like a
borrower of legal debt.
8. Notes: B. Under RICO, a racketeer or drug dealer forfeits the title
to any property he gains to the government as of the day he gains it.
Thus, technically he never had a claim of right. However, he is still
required to pay income tax on the gains, even though he can not claim a
deduction for the forfeiture. C. Even if an embezzler subsequently turns
himself in and negotiates repayment to the victim, his illegal income is
still taxable under the rule in James because it was not consensual at
the time of creation. [There was a finite time where the embezzler had
dominion over the money with the opportunity to use it.] However, a
taxpayer who fully intends to repay a debt, who reasonably expects to be
able repay the debt, and who has reasonably expected the lender to
consent to the debt is not required to include the amount of the debt as
income even if the lender then refuses to consent. Gilbert v. Comm.. D.
The Government's claim to taxes on illegal income often conflicts with
the rightful owner's interest in recovering the full amount of
embezzled, especially where the embezzler's assets are few. However, the
rightful owner may be able to recover the full amount ahead of the Gov't
tax lien, or even recover the taxes directly from the Gov't after the
embezzler has paid. This conflict is worst when the embezzler is
declared bankrupt because Congress has given tax liens have a high
priority under the Bankruptcy Act.
** Comm. v. Indianapolis Power & Light Co., (1990)
2. Facts: IPL is the power company. They require certain customers to
provide a security deposit approximately equal to twice their estimated
monthly bill. These funds can be refunded to the customer with interest
upon the showing of satisfactory credit, or they can be applied to the
customer's bill at the option of the customer. IPL did not claim these
deposits as gross income, even though they commingled the deposits with
their general funds. However, they counted them as liabilities in their
3. Statute/Regulation: 61(a).
4. Issue: Are security deposits made to a utility company considered
5. Holding: No.
6. Reasoning: The court reasoned that the security deposits did not
represent advanced payments. They rejected the Government's argument
that since the IPL gained economic benefit from the deposits that they
were income. They reasoned that since the disposition of the funds lay
with the customer, and not IPL, then IPL did not exercise the requisite
amount of control over them to be income. The fact that IPL gained an
economic benefit, meaning the chance to earn more money on the deposits,
was not determinative, because it is assumed that in the case of a loan
that the borrower gains some economic benefit greater than the interest
he pays. The distinguishing factor that made these deposits like loans
was that IPL could not, at its own choice, apply the money to the
payment of electricity. Thus, these were not advanced payments. Like a
loan, the customer (lender) retained control over the manner in which
they could be applied or refunded. Thus, it was never certain that IPL
would keep any part of the deposit. However, the court realized that
this could pose problems for private transactions where the company was
not closely regulated.
7. Notes: A. The tax courts have expanded the scope of IPL to apply to
the cases where the deposit was non-interest-bearing (Oak Ind., Inc. v.
Comm.), and even where it was only applicable as a rebate against future
charges (Kansas City Southern Ind., Inc. v. Comm.).
1. Eisner v. Macomber, (1920)
2. Facts: The taxpayer owned 2,200 shares of stock in a company. The
company declared a 50% stock dividend in 1916, so the taxpayer received
an additional 1,100 shares of which 198.77 shares represented the
surplus of the company earned between 1913 and 1916. The shares that
represented the surplus had a par value of $19,877 and the Commissioner
treated the par value of these shares as income to the taxpayer. The
taxpayer asserted that the stock dividend was not income under the 16th
amendment. The District court found for the taxpayer.
3. Statutes/Regulations: The sixteenth amendment, and articles of the
Constitution. Definition of income under the Revenue Act of 1916.
4. Issue: Is the payment of a stock dividend, as opposed to a cash or in
kind dividend, to a stockholder of a company includable as income to the
5. Holding: No.
6. Reasoning: The Court understood a stock dividend to be a method of
recapitalizing surplus, and spreading that capital among the
stockholders in proportion to the shares that they held. Thus, the
shareholder's capital investment had grown and was worth more if it were
to be sold, but he still owned the same proportion of the company as he
did previously. A stock dividend takes nothing from the property of the
company and adds nothing to that of the shareholder. The sixteenth
amendment gave Congress the power to tax "income", and in the common
meaning of the word, "income" did not include unrealized gains that were
still the property of the company. Using Towne v. Esiner's definition of
income being a "gain derived from capital" under the Revenue act of
1913, the Court analogized "capital" as being separate from "income" in
the way that a tree is separate from its fruit. The Government argued
that it was nevertheless a "gain" to the stockholder because it could be
sold for more. However, the Court stated that the taxpayer had not sold
yet, and that his investment was still exposed to the business risks
that could wipe it out. The taxpayer does not realize increased worth in
property unless he receives "something of exchangeable value proceeding
from the property." A stock dividend is different from a cash dividend
which is subsequently reinvested because cash dividends actually
transfer the company's property to the stockholder. A stock dividend
7. Dissent: Holmes argued that the meaning of the 16th amendment was to
put to rest any questions as to what might be direct taxes. Thus,
"income" should be interpreted in that light. Brandeis argued that a
corporation should not be differentiated from a partnership. A
partnerships' profits are taxable to the partners even if they have not
yet been distributed.
** Cottage Savings & Loan v. Comm., (1991).
2. Facts: Cottage is an S&L who owned several long-term, low-interest
mortgages which depreciated in value in the 1970's when interest rates
surged. To avoid possible closure by the Federal Home Loan Bank Board if
they had sold their devalued mortgages outright and taken a loss on
their books, they instead exchanged 90% interests in 252 of their
mortgages for 90% interests in 305 of other S&L's mortgages with an
equivalent fair market value at the time of exchange. However, the face
value of the mortgage interests that Cottage exchanged was approximately
two million dollars higher than the face value of the mortgage interests
they received. Thus, Cottage took a business deduction on the loss,
while still retaining mortgage interests.
3. Statutes/Regulations: Section 1001(a) and Regs 1.1001 on the
definition of "realization" of gain from the disposition of property.
4. Issue: Is there a realization of a gain or loss from the exchange of
interests in mortgages where the mortgages are made to different
obligors and secured by different homes?
5. Holding: Yes. An exchange of property gives rise to a realization
event so long as the exchanged properties are "materially different" -
that is, so long as the embody legally distinct entitlements.
6. Reasoning: The Court recognized that taxes were only assessed against
realized gains as an administrative convenience. Otherwise, it would be
difficult to value any increase or decrease in the yearly value of
property. However, when property is sold or otherwise disposed of, it is
straightforward to determine the valuation. The Court deferred to the
Commissioner in requiring a "material difference" of the property
exchanged in order to constitute "disposition" under the Regs 1.1001.
However, the Court defined "material difference" as being legally
distinct entitlements. The Court rejected the Gov't argument that there
the test for "material difference" should depend on the market and the
relevant regulatory agency's subjective consideration of the materiality
of the difference. The Court stated that the valuation problem required
no more than determining the difference in legal entitlements between
the two properties.
7. Dissent: The dissent, although agreeing that realization required a
"material difference" in the properties, concluded that under these
facts, there was not a difference in substance, but only in form.
Superficially they were different, but the lack of attention that the
parties paid to the differences was evidence that they considered the
properties to be materially the same.
8. Notes: A. The impact of the Eisner v. Macomber realization
requirement is that tax on capital investment is deferred until the
profit can be separated from the capital. This creates a tax advantage
for long-term investments that do not pay yearly dividends over those
that do. On a $100 investment at 8%, the difference is almost 10% after
tax profit if the interest is recapitalized in the investment rather
than paid to the taxpayer yearly and then reinvested. B. Eisner may have
been too broad in declaring the Revenue Act of 1916 as unconstitutional
to the extent that it taxes stock dividends. Subsequent Supreme Court
cases have limited its holding to only provide for a realization
requirement. In recent years however, Congress has enacted some
provisions that tax some gains on an accrual rather than a realization
basis. C. Regs 1.1001 applies to both gains and losses. Thus, if the
Commissioner would have won, it is likely that there would have been
lost revenue from taxpayers who had gained by exchanges of similar
properties. Some sections provide for the moving of capital between
different real estate properties without recognizing gain. Similarly, an
exchange of the stock of a corporation for another in a reorganization
or acquisition may be tax-deferred. D. In the case of stock dividends
that increase the stockholder's proportional interest in the company,
such as when stockholders are given a choice between cash or stock
dividends (and some choose cash, thus decreasing their proportional
share with respect to those who chose stock), the increase in
proportional interest is taxable. E. Section 109 excludes income derived
by a lessor of real property on termination of a lease attributable to
buildings or other improvements constructed by the lessee. However,
Section 1017 provides that the lessor's basis for the property shall not
be increased or decreased by the lessee's improvements. Thus, if the
lessor sells the property, his gains or losses will be realized on the
low basis, or if he re-leases the property for a higher value because of
the improvements, his low basis provides reduced depreciation
reductions. F. Section 475 requires securities dealers to "mark-to-
market" their securities and report accrued gains or losses as taxable,
even though no realization has occurred from sale.
I. Gifts and Basis
1. Section 1015 provides that if the fair market value of the gift is
greater than the donor's basis at the time of the gift, then the donor's
basis becomes the donee's basis, and the accrual is not taxed at the
time of the gift.
2. However, if the fair market value is less than the donor's basis at
the time of the gift, then the donee's basis for determining losses
becomes the fair market value at the time of the gift, rather than the
donee's basis. This prevents a donor from shifting an unrealized loss to
B. Gift Tax
1. Generally, any gift taxes paid on the appreciation in the property at
the time of the gift become add to the basis of the donor. Section
2. The result is that the overall tax consequence is the same whether
the donor sells the property and gives the proceeds, or the donee sells
the property and pays tax on the gain.
C. Special Rules for some gifts.
1. Section 84 provides that the donor is taxed on the appreciation of
property made as gifts to a political organization.
2. The political organization's basis then becomes the fair market value
at the time of the gift.
D. Part Gift and Part Sale
1. If a gift is made where the donee pays the donor more than his basis
for the property, but less than the fair market value, then the donor's
is taxed on the gain he makes, and the donee's basis becomes his cost
under Regs 1.1001-1(e) and 1.1015-4.
a. Ex: in Diedrich v. Comm., the taxpayer gave stock to his children,
but they had to pay the gift tax. Thus, the taxpayer was taxed on the
difference between his basis and the amount of gift tax relief he
2. If the gift is made to a charity, however, the basis of the two
parties is adjusted according to the proportion of the amount of the
sale and contribution.
II. Transfers at Death
A. Generally, if the decedent's assets have appreciated, at his death,
the inheritor's basis is "stepped up" to equal the fair market value at
the time of death. Section 1014.
1. Any appreciation in the decedent's property will never be taxed.
2. Any depreciation in the decedent's property will never be deductible.
3. Thus, a taxpayer should sell all depreciated property before death,
while holding any appreciated property.
** Clark v. Commissioner, (1939)
2. Facts: Clark was paid $19,941 by his tax counsel in 1934 to
compensate him for his tax loss based on bad advice. The amount
represents the difference between the taxes he would have paid if he and
his wife had filed separately, and the amount he did pay based on his
tax counsel's advise to file jointly.
3. Statutes/Regulations: The predecessor of 61(a).
4. Issue: Is compensation for losses of capital includable as income?
5. Holding: No.
6. Reasoning: The court reasoned that the compensation for loss was not
includable because it was not "derived from capital, from labor or from
both combined." They rejected the gov't argument that the amount
constituted taxes paid by a third party on the taxpayer's behalf. Clark
paid his own taxes, and the compensation represented a return of capital
to him. It was not income to him as long as he did not take a deduction
for the loss previously.
7. Notes: A. Damages for libel and slander and personal injury are
analogized to Clark as a return of "human capital." B. Whether punitive
damages for personal injury are excludable under 104(a)(2) is not clear.
C. Even if the compensatory damages are non-taxable, any interest
received with respect to the compensatory damages is taxable.
** Raytheon Production Corp. v. Commissioner, (1944)
2. Facts: Raytheon developed and patented a rectifier tube and licensed
several radio manufacturers, building a large business of good will. RCA
developed a competing tube and licensed it to many of the same
manufacturers, including Raytheon, with a clause 9 that stated that the
licensee would only buy from RCA. Over the next few years, Raytheon's
market share declined significantly due to RCA's licensees being
contractually bound to buy only from RCA. By the end of 1927, RCA's
conspiracy and monopolistic practices had completely destroyed
Raytheon's business and its good will at a time when it had a present
value in excess of $3,000,000. Raytheon sued RCA for anti-trust
violations. RCA countersued for non-payment of licensing fees. RCA got a
judgment against Raytheon for $410,000 for non-payment of fees, and then
Raytheon and RCA settled the anti-trust suit for the same amount,
$410,000, including rights to some 20 patents. RCA refused to make an
allocation of how much of the settlement was for the patent rights and
how much was for damage to Raytheon's good will. Raytheon estimated the
value of the patents at $60,000, and so made a return claiming only the
$60,000 as income and excluding the remaining $350,000.
3. Statutes/Regulations: Predecessor to 61(a)
4. Issue: Whether an amount received by a taxpayer in a settlement of a
suit for damages under the Federal Anti-Trust Laws is a non-taxable
return of capital.
5. Holding: A settlement of a suit to recover damages for the
destruction of business and good will is a return of capital to the
extent that it does not exceed the taxpayer's basis in that business.
6. Reasoning: The court reasoned that the general rule was that
recoveries that represent reimbursement for lost profits are income.
They developed a test for taxability of the recovery based on "[i]n lieu
of what were the damages awarded?" However, they reasoned that the
evidence of profitability here was introduced only to show the value of
the business and good will. But because they were being compensated for
loss of capital, the capital could have appreciated since Raytheon had
made the investment. Any compensation in excess of Raytheon's cost would
be income. In this case, since the business and good will had been
entirely destroyed, the amount in excess of Raytheon's cost was readily
7. Notes: A. Determining whether a payment is for lost profits or for
damage to property may be difficult where a suit seeks damages on
account of both, or where it is settled without an accounting as to the
amount attributable to each. In Sager Glove Corp. v. Commissioner,
payments in settlement of an antitrust action were taxable as ordinary
income, not excludable as a return of capital, because the amount of the
settlement was nearly the same as what the taxpayer had claimed in the
suit to be lost profits. Liquidated damages provided for non-performance
of a contract are treated as ordinary income, not a recovery of capital.
B. When the property has not been totally destroyed, and the taxpayer
receives a judgment, Inaja Land Co. v. Commissioner indicates that at
least where the damaged portion of the property is not divisible from
the undamaged portion, the recovery is entirely a return of capital up
to the amount of the basis. Thus, the first "x" number of dollars goes
to the basis (return of capital), and only the excess is taxable.
** Threlkeld v. Commissioner, (1986)
2. Facts: Threlkeld was paid $21,500 in damages in 1980 as part of a
settlement agreement for a malicious prosecution suit. Because of the
malicious prosecution, Threlkeld's professional reputation was damaged
and he lost income.
3. Statutes/Regulations: 104(a)(2) providing that damages for "personal
injuries or sickness" are excludable and 1.104-1(c) defining "damages
received" as being based on tort or tort-type rights.
4. Issue: Whether damages received as part of a settlement for a
malicious prosecution suit which represented damages to a natural person
taxpayer's professional reputation are excludable under section 104.
5. Holding: "Exclusion under section 104 will be appropriate if
compensatory damages are received on account of any invasion of the
rights that an individual is granted by virtue of being a [natural]
person in the sight of the law."
6. Reasoning: The court considered its previously overruled decision in
Roemer v. Commissioner, where the Tax Court of Appeal ruled that there
is no proper distinction between the damages to a person's personal
reputation and the person's business or professional reputation when
excluding damage awards under section 104. That court stated "The
nonpersonal consequences of a personal injury, such as a loss of future
income, are often the most persuasive means of proving the extent of the
injury that was suffered." However, "[t]he personal nature of an injury
should not be defined by its effect." In the case of a professional
person, the amount of income lost is an accurate measure of the personal
injury. The court then used common law tort principles to determine that
tortcious prosecution was a "personal injury" of a tort or tort-type
nature under the Regs.
7. Dissent: The dissent reasoned that allowing damages which were
measured by the loss of professional income to be excluded as a personal
injury under section 104 would be to stretch it too far.
** United States v. Burke, (1992)
2. Facts: Burke was awarded damages from a settlement of a Title VII
action for sexual discrimination in salaries against the TVA. The
settlement amount represented back pay and was based on the length of
service of the employees. The TVA withheld ordinary income tax from the
amount of the settlement, and Burke sought to get a refund of that tax
under section 104(a)(2). The District Court found for the gov't and the
Court of Appeal for the Sixth Circuit reversed.
3. Statutes/Regulations: Section 104 and Regs 1.104.
4. Issue: Whether a payment received in a settlement of a backpay claim
under Title VII of the Civil Rights Act of 1964 is excludable from the
recipient's gross income under section 104(a)(2) of the IRC as "damages
received... on account of personal injuries."
5. Holding: No.
6. Reasoning: The court stated that in order to come within the section
104(a)(2) income exclusion, the legal basis for the recovery of backpay
must be a tort