Federal Income Tax 2016

1
ILLEGAL INCOME

GILBERT v. COMMISSIONER (2d Cir. 1977)

FACTS: TP took $1.9M w/o permission from his co. to finance a merger. Lawyers told him to give the co. a
promissory note that hed pay it back and pledge his own property as security. Company fails to perfect its
security interest, so it ends up behind the IRS in priority on TPs property. QP is whether TP should be
taxed as a thief or borrower.
LAWS
o THIEVES: if you steal money and keep it, you have income from the theft, same if you steal and
promise to pay it back in that year. If you steal and ACTUALLY repay in same year, no income
from the theft.
HOLDING: This is not a typical embezzlement case; TP not taxed as thief b/c he was not self-interested in
embezzlement and b/c he meant to pay it back. Consensual recognition of the debt with intent to repay so no
embezzlement occurred (and no GI)
STRENG: look to intent of borrower. If he has to repay this amt several years later, he can claim a deduction
JAMES v. US (1961)(p.183 in Gilbert)
HELD: Embezzled funds DO constitute GI. No intent to repay existed at time of embezzlement. TP has
obligation to include on his return even if he is liable for returning the funds.
Gilbert the taxpayer wanted a merger with a Company named Celotex, so he and his
associates buy up shares of Celotex on margin. After a decline in the market, lender made a
margin call and Gilbert had no way to pay the margin call. In turn, he embezzles 2MM from the
E.L Bruce Company to meet the margin call. Commissioner wants to tax Gilbert on realized
income in the amount of 2MM from his embezzlement. Shortly after, Gilbert takes his actions to
the Board and outside council, and subsequently Gilbert claims it was a loan due t the obvious
obligation of Gilbert to pay it back evidenced by his assignment of assets exceeding the value of
the debt to Bruce. Lower court found Gilbert received taxable income. Upper court found Gilberts
intentions were to pay back the embezzled funds, and his actions (the assignment of assets and
note payable upon demand by Bruce), evidence that intention. Thus, Gilbert received no
accretion to wealth despite the nonconsensual nature of this loan. Court fashioned a 4
Point test as an exception to the James Test: (1) Where a taxpayer withdraws funds
from a corporation which he fully intends to repay and (2) which he expects with
reasonable certainty he will be able to repay (3) where he believes that his
withdrawals will be approved by the corporation, and (4) where he makes a prompt
assignment of assets sufficient to secure the amount owed, he does not realize
income on the withdrawals under the James test.

Federal Income Tax 2016

INTEREST ON STATE & LOCAL BONDS:

GOALS OF GOOD TAX POLICY:
Equity is the tax system fair?
Horizontal Equity people who are equals should bear the same tax burden
(because they have equal ability to pay)
Vertical Equity people with more $ should pay more taxes
Horizontal Equity is thought of as a subset of Vertical Equity
Once you have people w/ same ability to pay that is a vertical equity issue
TAX-EXEMPT BONDS (pg. 186-191) (Code 103)
1. 103: exempts interest on state, municipal, and other such bonds for TP who holds them/gets the interest
from them.
2. It is the locality that benefitsthe interest rates are lower on tax-exempt bonds, and the difference in
interest is a subsidy to the locality from the federal government.
3. Limits on tax-exempt bonds:
(a) Private activity bonds 141(e) & 142 cf. School bonds
(b) Registration Requirement
(c) Arbitrage bonds - 148
4. This starts to break down because not everyone is taxed at the same rate:
(a) Localities have to increase interest rates to attract TPs at a lower rate; cant issue different bonds for
different tax brackets
(b) Above doesnt change cost to government, but does reduce subsidydifference goes to TP in
highest tax brackets.

Tax arbitrage is an equity issue people with more income and assets would be able to take greater
advantage of the system.
Interest on State and Local Bonds: Many restrictions on issuers, but anyone can buy

them.
Tax Arbitrage: Buying tax exempt bonds on credit at one rate, and reinvesting interest at
another rate, reaping a deduction of interest on the borrowed funds to fund the bonds, and then
receiving tax free interest on the exempt bonds. E.g: *Assume 33% Tax Rate, meaning every 10K
sheltered produces 3.3K in gainX Borrows 100K at 10 Percent, or 10K annually. Buy 100K in
bonds at 9% interest, costing 1K to make the investment after debt service. But, 10K interest is
deductible, so debt service actually costs 6.7K, producing 2.3K in non-taxable gain.

Federal Income Tax 2016

GAIN ON A SALE OF A HOME (pg. 191- 193) (Code 121)

121 provides for an exclusion of gain realized on the sale of a principal residence
(A) REQUIREMENTS:
(1) principal residence;
(2) used for two of last five years;
(3) limit to $250,00 gain, unless married;
(4) then $500,000 exclusion (on joint return)
(B) EXCLUSION AVAILABLE ONLY ONCE EVERY TWO YEARS
Eliminates necessity of proving ones basis
Gain on Sale of a Home: IRS Code SS121 (Pg. 124)
Single Exemption on $250K
Joint Exemption on $500K
Two Basic Requirements: Tax Payers (1) Principle Residence (2) for 2 of last 5 years.

MULTIPLETRANSACTIONS:

TaxpayerAownsatownhousetharheusesashisprincipleplaceofresidencefor2fullyears,1998and
1999.
In2000hebuysahouseandusesashisprincipleresidence.
AsellstheTHin2002andexcludesgainrealizedonitssaleundersection121.
Athensellsthehousein2003
o Cantgetexclusionunder121again(needtwoyearperiod).
o Eventhoughhemeets121(a)withrespecttobothproperties,hedoesmeet121(b)(3)(A)for
anotheryear
Under121(c)(2)(B)=thelimitationiscalledoffifthesameorexchangewasbyreasonofachangein
employment,healthorunforeseencircumstancesyougetaproratedexclusion.
121(c)(1) (allows for (b)(3) to not apply)

*Formula for Pro-Rata Exclusion: Months since 121 Last Applied / 24 x $250K(or
$500K if couple) = Pro Rata Exclusion.

Susans bonds
buys $10,000 of taxable bonds
bonds pay 5% annually
receives interest of $500 per year
has marginal tax rate of 40%
after tax income of $300
$200 of tax

Source of income
Economic income
Taxable income

adele
$1,000,000 of taxable
bonds paying 10%
$100,000
$100,000

Buys $10,000 of tax exmept bonds

Bonds pay 4% annually
Receives interest of $400 per year
Has a marginal tax rate of 40%
After tax income of $400
$100 of punitive tax
bernardo
$1,000,000 of tax-exempt
bonds paying 8%
$80,000
$0

Carlos
Wages

Federal Income Tax 2016

Tax
$28,000
After tax income
$72,000

4
$0
$80,000

$72,000

SPECIAL RATE FOR DIVIDENDS (pg. 193-194) (Code 1(h)(11))

61(a)(7) specifies inclusion of dividends in GI but at capital gains rate (15%)
1(h)(11)(A): At end of this year, code section expires and becomes ordinary income