Thursday, September 12, 2013

The day they argued Duberstein

Commissioner v. Duberstein and its companion case, Stanton v. United States, are two of my favorite cases to talk about in class. The Supreme Court turned aside the government's theory of what constitutes a tax-free gift for income tax purposes, leaving open the possibility that a gift can be made in a business setting, even by a corporation. Congress has since changed the rules quite a bit, essentially vindicating the government's theory, but it had to -- the High Court wasn't going to refine the statute.

It never occurred to me that there might have been a tape recorder going during the oral arguments in the Supreme Court in those days -- but as I just found out, there was.  And if anyone wants to hear what was said, on one chilly, blustery Wednesday in March, 1960, it's here.  My old tax professor in law school, Wayne G. Barnett, can be heard making the IRS's pitch in the Stanton case.  As students of income tax history know, he lost.

The most colorful moments on the tapes come when Duberstein's lawyer is speaking.  He really had everyone going, until he decided to skip a lot of his prepared remarks and simply read out loud what the Sixth Circuit had written.  Not only was that a totally boring ending to his argument, but he lost his place and made everyone wait nearly a minute before he found it.  He wound up losing, too.

Friday, March 1, 2013

Happy 100th birthday, federal income tax

It's a big day for us tax mavens. It's the 100th anniversary of the effective date of the U.S. individual income tax. To celebrate the occasion, we've ordered up some custom refreshments. Many happy returns!
 
 


Wednesday, October 17, 2012

A tax on the tax on the tax

What if the IRS had won the Clark case (page 122 of our casebook)?  What if the receipt of the malpractice settlement from the Clarks' attorney had been treated as gross income to them for tax purposes?  Well then, the Clarks would have needed more money from the attorney in order to be made truly whole.  They would have needed the attorney to pay them the tax owed on the base settlement amount.  And if the attorney paid them that additional amount, that would have been gross income, too, triggering additional tax.  And if the attorney paid them that additional tax, that payment would have been more gross income, triggering more tax.

Would this result send us into an endless feedback loop?  Not really, because the tax is only a percentage of one's taxable income, and so the additional amount of tax triggered by any receipt will be smaller than the receipt itself.  The additional amounts become smaller and smaller and eventually drop to just tiny fractions of a penny; at that point we can stop counting them.

For example, assume that the taxpayer is in the 35% marginal bracket, and she receives $10,000 of gross income (with no offsetting deductions) in a transaction in which the other party agrees to pick up the tax on the $10,000 receipt.  That tax would be $3,500, and if the payor reimbursed the taxpayer for that amount, the additional $3,500 of income would trigger another $1,225 of tax -- 35% of $3,500.  The tax on that $1,225 would be $428.75, the tax on that $428.75 would be $150.06, etc.

In the end, the total payout needed to allow the taxpayer to keep $10,000 after tax would be $15,384.62, calculated as follows:

$10,000.00
$3,500.00
$1,225.00
$428.75
$150.06
$52.52
$18.38
$6.43
$2.25
$0.79
$0.28
$0.10
$0.03
$0.01
$0.0041
$0.0014
+  $0.0005
$15,384.62

Another way of looking at it is this: If this taxpayer gets $15,384.62 of additional gross income, the tax at 35% is $5,384.62 -- leaving the taxpayer with the $10,000 base payment to keep.

And so if the Clarks' receipt had been gross income, the attorney would have had to pay them more --  probably a substantial amount more -- to make them whole.  That wasn't the result in Clark, but it would be the result if, say, one's employer agreed to pay one's income taxes.  (See Reg. sec. 1.61-14.)  If your employer agreed to pay $10,000 of income tax for you, then assuming a 35% tax, she'd have to pay you an additional $5,384.62 to pay the tax on the tax, the tax on the tax on the tax, and so on.

You math majors out there are way ahead of me -- you've already figured out the formula for finding the total payout (or PT).  It is: 

PT = PB + (.35 * PT)

where PB is the base payment (the amount that the taxpayer would like to keep).  If PB is $10,000, the algebra goes like this:

PT = $10,000 + (.35 * PT)

.65 * PT = $10,000

PT = $10,000 / .65

PT = $15,384.62

Tuesday, May 22, 2012

Another Benaglia sighting

On a recent family vacation in Hawaii, we learned a little about the Father of Surfing, Duke Kahanamoku, whose athletic feats are worthy of epic poetry.  So impressed were we by his story that one of my daughters is working on a presentation about Duke for her second-and-third-grade classmates.

In researching his life further, we bought a book called Memories of Duke: The Legend Comes to Life, by Sandra Kimberley Hall and Greg Ambrose.  It's a wonderful recounting of the life of Kahanamoku, including his exploits wowing the early Honolulu tourists in the waters of Waikiki.  Among many splendid photos was this one, which brought a brought smile to our tax prof face:


"Unidentified man"?  Surely they jest.  To a true student of the U.S. income tax, he's anything but.

Wednesday, October 5, 2011

Cool, clear water

The story behind the Inaja Land case is almost as interesting as the tax issue it presents.  The City of Los Angeles gets a lot of its drinking water from runoff from the east side of the Sierra Mountains in the general vicinity of Yosemite National Park, quite a bit north and east of L.A.  The city started building an aqueduct to divert runoff water from the Owens Valley southward in the early 1900s.  Leading the effort was the city's famous (or infamous) utility commissioner, William Mulholland, after whom was named the Hollywood Hills drive on which so many show business celebrities have lived.

The loss of the water destroyed the farm economy and the ecosystem of the Owens Valley -- Owens Lake eventually went dry, for example -- but it enabled Los Angeles to become the booming metropolis it morphed into in the 20th Century.  The corruption and violence that surrounded water-related matters in the Mulholland days played an important role in the classic 1974 film "Chinatown," which is a must-see.

The first round of water diversion, which commenced with the completion of the aqueduct in 1913, was not the end of the story, however.  The headwaters of the Owens River, a natural spring, lie on the east side of a crest in the mountains called Deadman's Divide, not too far from Mammoth Mountain.  There was a lot of valuable water on the west side of the divide, sitting in bodies such as Mono Lake, Walker Lake and Grant Lake.  Los Angeles planned to get that water across the divide by means of an 11-mile-long tunnel, which would pass under Bald Mountain, come out on the east side at a place called Mono Craters, and spill into the Upper Owens.

In 1934, the Angelenos, led by Mulholland's successor, H.A. Van Norman, started blasting on both ends of the tunnel.  Here's a photo of the work camp on the west end:


Here's a view inside the tunnel while the work was in progress:

 
It was a nasty project, lasting five years, during which time about a dozen workers died.  Since the area is volcanic (as the name Mono Craters suggests), and there had been eruptions only around 600 years before, the construction crews encountered dangerous gases, unstable geological conditions, and lots of water.  The excavation and construction made quite a mess, and the mess floated downstream through the lands below, including the trout fishing club that had been established in 1928 by a group of Los Angeles outdoorsmen through their corporation, Inaja Land Company.  (Inaja Land had bought it from a Los Angeles furniture store family named the Barker Brothers, who had previously acquired it from locals in the Owens Valley community of Bishop.)  The Inaja folks threatened to sue the city, the case settled, and the rest is tax history.

Inaja Land Company is still there today, and apparently, the routing of all that extra water through its stretch of the Owens didn't hurt the trout much.  According to the full Tax Court opinion in case, the club restocked the stream with fish, constructed a diversion ditch, and made some other improvements that helped cope with the greater flows.  Nowadays a visit to the ranch, still a private club with just a couple of dozen members, tends to produce rave reviews among fly fishers.

Thursday, September 29, 2011

Stock dividends and other accounting mysteries

Eisner v. Macomber, that ancient Supreme Court case on realization of gross income for income tax purposes, gives us a chance to dabble in some corporate accounting matters.  It’s not necessary to understand the accounting completely in order to grasp the holding and rationale of the case –  Mrs. Macomber had no gross income because she owned the same thing after her receipt of the stock dividend as she did before.  But if the accounting intrigues you, as it did the Court to some extent, here’s a look at it.

The stock dividend is a maneuver that lowers the price per share of a company’s  stock by diluting the existing shares with new shares.  The transaction is recorded on the issuing corporation’s  balance sheet – one of its financial statements – but it has little economic significance.  No real assets leave the corporation, and the shareholders’ relationships with each other do not change.  The market senses the presence of the new shares, and adjusts accordingly; the price per share decreases, but since the shareholders have received new shares, the value of their holdings doesn’t change.

To understand the corporation’s accounting for the transaction, an introduction to  the balance sheet is helpful.  A balance sheet is a crude snapshot of the financial condition of a person or enterprise  at a given moment in time.  It’s divided into two sides – Assets and Liabilities.   The bottom line on one side will always match the bottom line on the other side -- hence, the name “balance sheet.”

The liabilities side is divided into two portions, Debt and Equity:

Assets
Liabilities


Debt



Equity

Total Assets

Total Liabilities (Debt + Equity)


On the Liabilities side, the  Debt plus the Equity equal the Total Liabilities.  And the Total Liabilities always equal the Total Assets (the bottom line on the other side).

The  Equity portion of the Liabilities side of the balance sheet (also known as “net  worth”) represents who owns the corporation – namely, the shareholders.  Let’s say that two people form a corporation,  each contributing $10,000 cash to get it started.  Each receives 1,000 shares for his or her investment, or $10 per share.  The balance sheet just after the corporation is formed would look like this:

Assets
Liabilities
Cash
$20,000
Debt
-0-


Equity: 2,000 shares, stated value $10 per share
$20,000
Total Assets
$20,000
Total Liabilities
$20,000

Now let’s assume that the corporation borrows $30,000 from a bank.  The resulting balance sheet would look like this:

Assets
Liabilities
Cash
$50,000
Debt: Bank
$30,000


Equity: 2,000 shares, stated value $10 per share
$20,000
Total Assets
$50,000
Total Liabilities (Debt + Equity)
$50,000

Next, let’s assume that the corporation uses half of its $50,000 cash to buy machinery and equipment:

Assets
Liabilities
Cash
$25,000
Debt: Bank
$30,000
Machinery and equipment
$25,000
Equity: 2,000 shares, stated value $10 per share
$20,000
Total Assets
$50,000
Total Liabilities (Debt + Equity)
$50,000

Note that the machinery and equipment are entered on the books at their historical cost, which is the same basic standard that’s used for determining basis for income tax purposes.  The value that an asset has on the balance sheet is called its “book value.” 

Next, let’s assume that the corporation has a successful year, bringing in a great deal of additional cash.  Its machinery and equipment wears out a little, which is reflected by a lowering of its “book  value,” but the increase in cash shows that it had a profitable year.  Here’s the asset side of the balance sheet at the end of the year: