Gross Income

Textbooks on the law of federal income taxation routinely make reference to Section 61(a) of the Internal Revenue Code and its definition of as “all income from whatever source derived, including (but not limited to) the following items: (1) Compensation for services, including fees, commissions, fringe benefits, and similar items; (2) Gross income derived from business; (3) Gains derived from dealings in property; (4) Interest; (5) Rents; (6) Royalties; (7) Dividends; (8) Alimony and separate maintenance payments; (9) Annuities; (10) Income from life insurance and endowment contracts; (11) Pensions; (12) Income from discharge of indebtedness; (13) Distributive share of partnership gross income; (14) Income in respect of a decedent; and (15) Income from an interest in an estate or trust.”

And, on the whole, these same textbooks take note that the is not so generous when it comes to deductions. In fact, deductions exist only as a result of “legislative grace.” Put differently, unlike gross income, there is no all-inclusive concept of exclusions or deductions from income. The reason for this apparent disparity is that Congress, through its drafting of a pervasive concept of income in the Code, brings into play its power to raise revenues for, ideally, public goods. Structurally, the Code does allow for ordinary and necessary business expenses and certain , but, in general, one should make the assumption that a desired deduction is not allowed unless granted and placed in the Code, for reasons sound or obscure, by Congress.

Several landmark Supreme Court cases reinforce the Code’s all-encompassing (egregious?) concept of income and add substance to its necessarily incomplete listing of items of income. First, in , taxpayer’s company pays not only salary and commissions but also, and directly to the Bureau of Internal Revenue (renamed in 1953 as the Internal Revenue Service), his estimated federal income taxes. Taxpayer argues he never received monies sent on his behalf to the Bureau; therefore, he shouldn’t be taxed. The Supreme Court disagrees: the payment is not a gift but rather an increase in the taxpayer’s wealth.

Second, deals with the portion of damage awards that are punitive in nature and, more generally, the definition of income in a previous landmark case, . In Glenshaw Glass, taxpayer argues that punitive damages are a windfall and accordingly not income under Macomber’s definition of income as “gain derived from labor, from capital, or from both combined.” The Court rules that sources of funds other than labor, capital, or combinations thereof also constitute ““; in brief, punitive damages fit the category of accessions to wealth and are fully taxable.

Third, in (pdf file), the taxpayer, a corporation, purchased its own bonds at a discount thereby increasing its net worth. The Court ruled that the taxpayer realized a clear economic benefit and, without an exclusion in the Code, such accessions to wealth are taxable. After the decision in Kirby Lumber Co., Section 108 was created leading to the Code’s general rule that, except for cases of bankruptcy or insolvency, discharge of indebtedness results in cancellation of debt income.

There are many other cases that document the concept of gross income but these examples should give the reader a feel for the all-embracing character of this key concept in federal income taxation.

For the interested reader, several additional resources on the concept of gross income are listed below:

Many happy returns, Roger

Adjusted Gross Income

Why adjusted gross income? Wouldn’t gross income be a good enough yardstick or reference point for determining tax in the Federal Income Tax Equation?

(Note: The Federal Income Tax Equation is defined as Tax Due or Refund = - [a category that for the most part is limited to the expenses of producing Gross Income but also includes expenses that aren't related to the production of income such as alimony and interest on education loans] = - - [the choice between the standard deduction or itemized deductions] = x - .)

The answer is that adjusted gross income (AGI) takes into account the expenses of generating gross income and avoids making the federal income tax a tax on . Indeed, one could even say that a strong logic of fairness undergirds the role of AGI in the federal tax system: in the Federal Income Tax Equation as applied to (pdf file), taxable income is based not on gross receipts but rather on what is left after business owners (or individuals engaged in profit-seeking activity) subtract the (read: reasonable and customary) business expenses of producing gross income. (Please note this article does not consider the Federal Income Tax Equation as applied to Form 1120 U.S. Corporation Income Tax Return, Form 1120S U.S. Income Tax Return for an S Corporation, or Form 1065 U.S. Return of Partnership Income.) To be taxed on gross income without allowance for advertising, car and truck expenses, depreciation, property taxes, rent, utilities, wages, and other business-related expenses as detailed on (pdf file) would destroy the prospects of a positive cash flow for most sole proprietorships, especially when they must also pay their (employers’) share of . Adjusted gross income is thus a net concept and also a benchmark for calculating .

It is also important to distinguish between deductions taken above the line and deductions taken below the line. Above the line deductions, since they are used to determine AGI, are not subject to an AGI floor or the threshold of the ; in short, they are allowed in full. On the other hand, below the line deductions (also known as itemized deductions) are only allowed to the extent they, in toto, exceed the standard deduction. Moreover, (pdf file) and (pdf file) are subject to a further restriction in that they must exceed a floor amount expressed as a percentage of AGI (in 2007, 2% of AGI for miscellaneous itemized deductions and 7.5% of AGI for medical and dental expenses). If, for example, taxpayer’s AGI is $50,000 for 2007 and he or she has medical and dental expenses of $10,000 only $6,250 of these expenses qualify for deduction after subtracting the floor amount of $3,750 (7.5% of $50,000 AGI). If our taxpayer is single it would make sense to itemize since medical and dental expenses alone, even after subtracting the AGI floor amount, exceed the standard deduction of $5,350 for single filers.

Additional resources on the topic of adjusted gross income are listed below:

Many happy returns, Roger

Assignment of Income

The assignment of income doctrine, as outlined by , is a very ambitious doctrine, a doctrine that attempts to answer two elemental questions in federal income tax law: (1) the “who” (the person or entity to be taxed) and (2) the “what,” that is, the character of the income received (i.e., or ).

In the famous Supreme Court case, , the Court held invalid the contract between the taxpayer-attorney and his wife wherein all the couple’s acquisitions (including income from his personal services as an attorney) were to be shared equally: the “fruits” from the attorney’s “tree” cannot be attributed to the wife’s “tree.” In other words, despite the legal form of the couple’s contract, the Court looked to the substance of the contract and deemed it tax avoidance. From this decision emerges the general rule that taxes on income from personal services are attributable (assignable) to the person performing the services. In this case, the obvious answers to the “who” and “what” questions are the taxpayer-attorney is taxable and the character of the income received is ordinary (compensation for services).

The assignment of income doctrine also helps to differentiate between transfers of and associated with, or attached to, that property. The basic principle is that in an effective, substantial transfer of the entire underlying property, the , not , is taxed on future income from the property. In short, the assignment of income doctrine does not apply.

However, if the property is transferred with income attached (e.g., any interest accrued on a will be taxable to the assignor in the year he or she transfers the interest-bearing security) or the assignor transfers only the right to receive income yet retains the income-producing property, the assignment of income doctrine will apply even if the form of the transfer is gratuitous (a gift). Put differently, to avoid classification as a and be effective for federal income tax purposes, the transfer must be real and effective for state law purposes and the donor must not retain excessive controls over the income-producing property transferred.

And this brings us to another important distinction: gratuitous assignments versus assignments for . The key issue in gratuitous assignments is the “who” question, that is, the person or entity taxable. In assignments of income for consideration, the pressing issue is the character of the consideration received or the “what” question, namely, the classification of consideration received as capital gain or ordinary income. As a general rule, if the assignor receives bona fide consideration for transferring a right to income, the tax burden falls on the assignee and one must look to the character of the right transferred to determine whether it will produce capital gain or ordinary income.

For example, in the Supreme Court Case , the lessee paid the lessor a lump-sum payment in order to cancel a lease. Looking to the character of the payment received in consideration for cancellation of the lease, the Court reached a conclusion contrary to the lessor-taxpayer’s claim that the payment be recognized as capital gain. Instead, the Court ruled that the character of the amount received by the lessor was in substance ordinary income since it was a substitute for rent.

For additional information on the assignment of income doctrine, please consult the following resources:

Many happy returns, Roger

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