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The concept of “income” is never really defined in the Internal Revenue Code. The closest that Congress comes to defining income is found in IRC Section 61, which is largely unchanged from its predecessor, the original Section 22(a) definition of income in the Revenue Act of 1913:


 * Sec. 22(a). “Gross income” includes gains, profits, and income derived from salaries, wages or compensation for personal service (including personal service as an officer or employee of a State, or any political subdivision thereof, or any agency or instrumentality of any one or more of the foregoing), of whatever kind and in whatever form paid, or from professions, vocations, trades, businesses, commerce, or sales, or dealings in property, whether real or personal, growing out of the ownership or use of or interest in such property; also from interest, rent, dividends, securities, or the transaction of any business carried on for gain or profit, or gains or profits and income derived from any source whatsoever.

As a result, it has been left for the Courts to define, along with the assistance of scholars of economics, law, and other fields.

Eisner v. Macomber
One of the earliest attempts to define income occurred in the case of Eisner v. Macomber, in which the U.S. Supreme Court addressed the taxability of a proportionate stock dividend. This case provided the Court with a forum to try to interpret exactly what Congress intended to include in the sparse Section 22 definition of “income.” This was not the first time the Court had addressed the issue: the case had been argued in the previous term of the court, and was being reargued with additional oral and written briefs.

The Court stated that it needed to examine the boundaries of the definition of income for several reasons.
 * First, the Revenue Act of 1916 expressly stated that a “stock dividend shall be considered income, to the amount of the cash value.” However, in a previous case, Towne v. Eisner, the Court had ruled that a stock dividend made in 1914 against surplus earned prior to January 1, 1913 was not taxable under the Act of October 3, 1913, which provided that net income included “dividends.” The district court in that case had noted that: “It is manifest that the stock dividend in question cannot be reached by the Income Tax Act, and could not, even though Congress expressly declared it to be taxable as income, unless it is in fact income.” It had held, however, that the stock dividend was the equivalent of income. The Supreme Court in Towne v. Eisner then reversed the lower court, finding that the dividend was not income because the “proportional interest of each shareholder remains the same … and the stockholder is no richer than they were before.”

As a result, the Court decided in Eisner v. Macomber to address the larger constitutional question of whether or not a stock dividend was gross income within the meaning of “income” as used in the Sixteenth Amendment. As noted by the Court:


 * In order, therefore, that the clauses cited from Article 1 of the Constitution may have proper force and effect, save only as modified by the Amendment, and that the latter also may have proper effect it becomes essential to distinguish between what is and what is not “income” as the term is there used; and to apply the distinction, as cases arise, according to truth and substance, without regard to form. Congress cannot by any definition it may adopt conclude the matter, since it cannot by legislation alter the Constitution, from which it derives its power to legislate, and within whose limitations alone that power can be lawfully exercised.

As a starting point, the Court defined income succinctly by reference to the dictionary and to two earlier cases as follows: “Income may be defined as the gain derived from capital, from labor, or from both combined, provided it be understood to include profit gained through a sale or conversion of capital assets.” The Court then went into a lengthy and somewhat convoluted discussion as to how this definition applies to a stock dividend. In the end, the Court decided that the stock dividend was not taxable because it was merely a book adjustment and not “severable” from the underlying stock. In other words, income would not be realized until the stock dividend was sold, that is, severed from the underlying original security investment.

Refinements in the Definition of Income
A number of commentators contended that the Court in Eisner v. Macomber had gone too far in overturning a statute taxing stock dividends (the 1916 Act) that many perceived as being fair and equitable. Henry Simons, a noted tax scholar of the time, in his treatise, observed the following:


 * Actually, an utterly trivial issue was made the occasion for injecting into our fundamental law a mass of rhetorical confusion which no orderly mind can contemplate respectfully, and for giving constitutional status to nave and ridiculous notions about the nature of income and the rationale for income taxes.

Despite this criticism, a number of decisions subsequent to Eisner v. Macomber relied on this simplistic definition of income. This in turn led to the question of whether or not this formulation was an “exclusive” definition of income, with any income not clearly covered by its terms deemed to be nontaxable.

In Hawkins v. Commissioner, the IRS sought to tax compensatory damages received by the taxpayer by way of settlement of a suit for injury to personal reputation and health caused by defamatory statements constituting libel or slander. While noting that “there may be cases in which taxable income will be judicially found although outside the precise scope of the description already given,” the Court found that such damages would not be taxable. The court noted that the injury was “wholly personal and nonpecuniary,” and that the remedy simply attempts to make the individual whole. Thus, even though the payment was “severable” and lead to a demonstrable increase in net wealth, the Court nonetheless concluded that the payment was not income.

Other commentators noted that if “severability” is a touchstone for the definition of income, it followed that a number of sales or exchanges of property that did not involve immediate realization through severance would not be taxable. Realizing that the “one size fits all” definition of income in Eisner v. Macomber was too broad, the U.S. Supreme Court reconsidered the idea of severability in Helvering v. Bruun. In this case, the Court addressed the question of whether or not a lessor recognizes income from the receipt of a leasehold improvement made by a lessee during the lease when the improvement reverts to the lessor at the end of the lease. In ruling that the value of the improvement was taxable, the Court noted that every gain need not be realized in cash to be taxable. There was a clear increase in the taxpayer’s wealth, and this increase did not have to be severed to measure such increase for tax purposes.

In subsequent cases, the Court distanced itself further from the overly-simplistic Eisner v. Macomber definition of income and its dependence on the concept of severability. For example, in Commissioner v. Glenshaw Glass Company, the Court ruled that punitive damages recovered under a violation of anti-trust laws were included in gross income, and that the language of Section 22 (now IRC Section 61) clearly intended that Congress exert “the full measure of its taxing power.” And in referencing its previous definition of income in Eisner v. Macomber, the Court noted that “in distinguishing gain from capital, the definition had served a useful purpose. But it was not meant to provide a touchstone to all future gross income questions.”

Current Statutory Definition of Income
The current IRC Section 61 definition of income is virtually unchanged from the 1913 definition, with the exception of a more comprehensive list of “automatic” categories of gross income. The current provision reads as follows:

 61 (a). General definition. Except as otherwise provided in this subtitle, gross income means 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 interest in an estate or trust.

(b)Cross references.
 * For items specifically included in gross income, see Part II (Sec. 71 and following). For items specifically excluded from gross income, see Part III (Sec. 101 and following).20

Exclusions. This language clearly suggests that any doubt about a particular item of income is resolved in favor of including that item in gross income: an item of income is presumed to be taxable unless it is specifically exempted "except as otherwise provided in this subtitle", i.e. Subtitle A (Income Taxes) of the Code. These statutory exceptions are collectively identified as "exclusions", and are enumerated in Sections 101 through 140 of the Code (Part III of Subchapter B, Computation of Taxable Income). For example, lottery winnings are taxable because there is no statutory provision allowing for the exclusion of such an item. On the other hand, interest income from a city of Chicago bond is not taxable because IRC Section 103 provides exclusion for interest on state and local bonds.21

Source. The phrase “from whatever sources derived” also indicates that income can be in many forms and from many different sources. One of the frustrating aspects of attempting to define income is this lack of specific guidance in the Code for doing so. Although IRC Section 61 lists 15 common sources of income, the phrase “including, but not limited to” indicates that this list is not all-inclusive. As a result, reference must be made to administrative and judicial guidance for defining the parameters of the term “income.”

Attempting to define income in one succinct sentence such as the Supreme Court did in Eisner v. Macomber creates problems, as noted by the Court in Commissioner v. Wilcox:


 * In fact, no single, conclusive criterion has yet been found to determine in all situations what is a sufficient gain to support the imposition of an income tax. No more can be said in general than that all relevant facts and circumstances must be considered.

Judicial Parameters: the principles of "Realization" and "Wherewithal to Pay"
Over the years the Courts and the Treasury have established certain judicial parameters to the definition of income, i.e. when income is "recognized".

Realization. The taxable income concept of income recognition is similar to the financial accounting concept of income, in that both require that an amount be "realized" in a verifiable market transaction. However, taxable income applies this "realization" concept more strictly. For example, it ignores price level adjustments, because any inflationary or deflationary effects have not been realized in a verifiable market transaction. The IRS would have an impossible audit task if the accounting records veer away from their historical roots.

Constructive receipt. Tax realization does not require an actual receipt of the income. Under the "constructive receipt doctrine", income must be reported when it can be reduced to the taxpayer’s possession ; a taxpayer may not delay recognition by avoiding receipt of the income.

The Regulations elaborate upon this doctrine as follows:


 * Income, although not actually reduced to a taxpayer’s possession, is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.

Under this doctrine, a taxpayer is taxed on interest income as it is earned, even though the taxpayer chooses not to withdraw the interest during the year. On the other hand, a damage deposit received by a lessor is generally not taxed at receipt, since there is a legal obligation to repay the deposit if no damage exists at the end of the rental period.

Wherewithal to pay. This concept -- closely allied to constructive receipt -- is based on the premise that a tax should be imposed when a taxpayer is best able to pay and the government is best able to collect. (This concept may be applied both to the detriment and to the benefit of the taxpayer.) It is a central tenet in much of the Code, and its application overrides any financial accounting or basis election of the taxpayer.

Code examples. Classic examples are found in the nontaxable exchange provisions of IRC §§ 1031 and 1033, as well as in the statutes permitting the tax-free formation of corporations (IRC § 351) and partnerships (IRC § 721). In all these cases, gain is not taxable unless the taxpayer receives nonsimilar property (commonly referred to as boot) in the exchange which represents a wherewithal to pay tax.

Judicial decisions
A number of important judicial decisions have been based on the realization and wherewithal to pay concepts. The first of these, Eisner v. Macomber, includes a reference to the essence of the realization principle: a realization event based on the severance of income and subsequent receipt by the taxpayer:


 * Here we have the essential matter: not a gain accruing to capital, not a growth or increment of value in investment; but a gain, a profit, something of exchangeable value, proceeding from the property, severed from the capital however invested or employed, and coming in, being “derived”—that is, received or drawn by the recipient (the taxpayer) for his separate use, benefit and disposal;—that is income derive from property. Nothing else answers the description.

Stock Dividends: Eisner v. Macomber
One of the first tests of the realization principle was set forth in Eisner v. Macomber, which addressed the question of whether or not a stock dividend is taxable. In this case, the defendant received a 50% stock dividend on her 2,200 shares of stock in Standard Oil Company of California, increasing her total holdings to 3,300 shares. This case addressed a simple question: should a true proportionate stock dividend be taxed as gross income? In other words, did the shareholder realize income because of the distribution of additional stock?
 * The IRS contended that the taxpayer recognized income, because the transaction was no different than if the taxpayer had been paid a cash dividend and then reinvested the amount in more stock. And it noted that the Revenue Act of 1916 specifically stated that a stock dividend should be taxable as income.
 * The taxpayer contended that stock ownership represents ownership in a “common fund of assets,” and that interest in the corporate assets did not change as a result of the stock dividend.

Opinion of the court. The U.S. Supreme Court sided with the taxpayer, noting that the asset and the income are inseparable in this case. In this respect, the Court quoted the famous “fruit and tree” analogy of capital and income, with the capital “… being likened to the tree or the land” and the income “to the fruit or the crop.” The Court stated that the dividend was nothing more than a book adjustment, and that it was impossible to sever the income from the property. This concept of severability would become central to a number of cases decided after this one.

The Court also noted the lack of a wherewithal to pay on behalf of the taxpayer. This was stated as follows:


 * Yet, without selling, the shareholder, unless possessed of other resources, has not the wherewithal to pay an income tax upon the dividend stock. Nothing could more clearly show that to tax a stock dividend is to tax a capital increase, and not income, that this demonstration than in the nature of things it requires conversion of capital in order to pay the tax.

Dissent. In his dissent, Justice Brandeis noted that the two methods of paying dividends (cash or additional stock) are just a matter of management choice, and that if the dividend had been paid in bonds or preferred stock it would have been taxable. He further noted that realization is not required for income recognition in other parts of the tax law; for example, partners in a partnership are taxed on their shares of income even though such income may not be distributed. Additionally, income from foreign corporations must be reported when earned, even though not distributed. In short, Justice Brandeis stated that it should be a clear case to invalidate an act of Congress, in this case the Revenue Act of 1916 provision that taxed stock dividends.

Much of the Eisner v. Macomber decision is based on an extended constitutional analysis of what constitutes “income” within the meaning of the Sixteenth Amendment. This analysis was thought by many to be confusing, unnecessary and irrelevant. Ironically, the court in an 1890 case, Gibbons v. Mahon, seemingly resolved the issue of stock dividends logically and succinctly without the extended constitutional discussion:


 * A stock dividend really takes nothing from the property of the corporation, and adds nothing to the interests of the shareholders. Its property is not diminished, and their interests are not increased. … [T]he proportional interest of each shareholder remains the same. The only change is in the evidence which represents that interest, the new shares and the original shares representing the same proportional interest that the original shares represented before the issue of new ones.

Leasehold Improvements: Helvering v. Bruun
The concept of severability was a central issue in the case of Helvering v. Bruun, decided twenty years after Eisner v. Macomber. This time, the Court addressed the issue in an entirely different context. The tax question was a fairly simple one; does a lessor recognize income from the receipt of a leasehold improvement made by the lessee during the lease, if such improvement reverts to the lessor at the end of the lease under the lease agreement?
 * The IRS contended that there was a clear enhancement in value of the asset, and such enhancement should be reported as income.
 * he taxpayer used the Macomber decision to argue that the improvement was inseverable from the property, and that gain should be recognized only when the underlying property was sold, i.e., when the lessor has a wherewithal to pay.

Actually, in 1917 the IRS had issued a ruling stating that income should be reported in such a situation at the termination of a lease; but the 9th Circuit subsequently said that income should be recognized when the improvement was completed. The IRS responded by amending the Treasury Regulations to follow this decision and stated that the lessor could depreciate the improvement. But in 1935 the Court of Appeals for the Second Circuit ruled that such improvements were nontaxable, and the conflicting decisions led the Supreme Court to agree to hear the case.

Perhaps stung by previous criticism of the Macomber decision, the Court reconsidered the idea of severability and noted that the Macomber argument was not relevant to this case. Specifically, the Court stated that the idea of severability was used as a descriptor in Macomber only to show that “in the case of a stock dividend, the stockholder’s interest in the corporate assets after receipt of the dividend was the same as and inseverable from that which he owned before the dividend was declared.” In ruling for the Service, the Court noted that every gain need not be realized in cash to be taxable; otherwise, no income would arise from an exchange of property. Otherwise, the Court stated, “no income could arise from the exchange of property; whereas such gain has always been recognized as realized taxable gain.” There was a clear increase in the taxpayer’s wealth, and this increase did not have to be severed to measure such increase for tax purposes.

In the opinion, the Court mentions the fact that the lease was terminated due to the lessee’s default on rent and taxes. The Court did not address this issue, but it could be argued that some of the value of the improvement should be applied to that default, which meant that the income would be reported as a substitute for rental income in any case. Obviously, the amount involved was nowhere near the value of the improvement, and since the Court ruled that the improvement was taxable anyway, the issue was moot.

In response to this decision, some lessors began to either extend the lease period and/or reduce rental payments in hopes of enticing lessees to renew their leases. This would delay the recognition of income on the improvement. Because of these potential problems and concerns about wherewithal to pay issues, Congress enacted IRC Section 109 in 1954, which excludes the value of such improvements from income. However, the basis in the improvements is $0, so that in effect the gain is merely postponed until the property is eventually sold by the lessor. And of course, any improvements made in lieu of paying rent would be taxed as rent, and this would in turn establish a depreciable basis in the improvement for the lessor.

Other Judicial Decisions Involving Realization
In Tucker v. Commissioner, a teacher in New York state engaged in an illegal strike, and under the Taylor Act, was penalized one day’s pay for each day on strike. This strike penalty was withheld from the paycheck of the teacher. The Tax Court ruled that the amount withheld as a penalty was income, because it extinguished an obligation owed to the state; furthermore, since the payment was classified as a penalty, it was not deductible. The same principle applies to a discharge of indebtedness in general, such as a garnishment of wages.

In Commissioner v. Kowalski, amounts advanced to a New Jersey state trooper as a meal allowance were held to be taxable. The taxpayer contended that the payments met the IRC Section 119 conditions for meals exclusion, in that they were (1) for the convenience of the employer and (2) furnished on the business premises (“the road”). The Court ruled that the meal allowance amounts were taxable because the taxpayer was not required to spend the amounts on food and the payments represented a clear accession to wealth over which the taxpayer had complete dominion. Further, the payments were not subject to exclusion from income because IRC Section 119 does not cover cash reimbursements for meals.

Judicial Parameters: The Cash Equivalent Doctrine
Income can take many forms. For example, income may be received in the form of cash, property, or services. In order to prevent cash-basis taxpayers from arranging to receive noncash property or services in return for services rendered, the cash equivalent concept has been a central part of the tax law for years. A cash-basis taxpayer who receives property or services as payment must report the fair market value of such property or services as income. This doctrine is equally applicable to an exchange of services between two taxpayers.

Third-Party Payments: Old Colony Trust Company v. Commissioner
The tax question in Old Colony Trust Company v. Commissioner43 was a fairly simple one; should a company officer be taxed on a payment made by his employer to pay the federal and state income tax due on his salary? In other words, the corporation paid not only the salary but the federal and state income tax due on that salary as well. The IRS argued that the payment represented additional compensation to the employee, even though it was not directly received by the employee. The taxpayer tried several defenses including: (1) the payment was a gift, (2) it was not received by the taxpayer anyway, and (3) to tax the amount would be to pay an illegal tax on another tax.

The U.S. Supreme Court ruled that the payment was taxable compensation received in consideration of services performed. The Court also pointed out the absurdity of the “tax on tax” argument. Although this decision may seem to be an easy one in hindsight, this case is cited in hundreds of subsequent cases because of three basic principles established by the Court, as illustrated by the following excerpts:1.The form of payment makes no difference (“The form of the payment is expressly declared to make no difference.”44)2.Discharge of an obligation by a third party is the same as receipt (“The discharge by a third person of an obligation to him is equivalent to receipt by the person taxed.”45)3.A voluntary payment does not make the payment a gift (“The payment for services, even though entirely voluntary, was nevertheless compensation within the statute.”46)These principles have been applied to a variety of cases. For example, if a former spouse pays both the alimony and the income tax due on the alimony, both amounts are taxable to the recipient.47 Also, lessors must include as income the lessee’s payment of such items as taxes and mortgages.48

Expense Reimbursements: McCann v. United States
McCann v. United States49 involves issues of both income inclusion and expense deductibility. The payment in question involves employer reimbursement of expenses for trips to Las Vegas and Mexico City, purportedly for “seminars” offered by the employer. The trips in question were awarded to insurance agents based on the amount of their nets sales for the preceding year.

If the payments were deemed to be for legitimate business expenses they would be considered analogous to reimbursements by an employer to an employee and would not be considered to be income. On the other hand, if the payments were primarily for a personal vacation for the employee, then they would be deemed reimbursement of purely personal expenditures by the employee and thus treated as gross income for federal tax purposes.

The Court of Appeals for the Federal Circuit examined the seminar program closely and concluded that the agent was not required to attend the seminar at all. Nonattendance had no effect on his or her promotional opportunities within the company, and that only a couple of hours of the three days of the seminar was actually devoted to business discussions. The company literature emphasized the “pleasurable” aspects of the convention, with only casual mention of the brief business seminar. As a result, the court viewed the reimbursement as a reward for services rendered by the employee, and thus taxable.50 Furthermore, the expenses would not be deductible since they were inherently personal in nature.

Judicial Parameters: The Claim of Right Doctrine
The claim-of-right doctrine is a judicially-based concept that holds that an amount is includable in income at the latest when it is received, provided that the taxpayer has an unrestricted right to the funds. This is so even if the amounts are received in error or the right to such income is contested and subsequent events require repayment. This doctrine reflects the basic principle that each tax year stands on its own.

Litigation Proceeds: North American Oil Consolidated v. Burnet
The claim of right doctrine is a judicially-based principle generally traced to the U.S. Supreme Court decision in North American Oil Consolidated v. Burnet,51 in which the taxpayer and the U.S. government were in litigation over income generated by certain oil fields. The government sued for possession of the land in 1916 and was successful in having a court-appointed receiver take over the land and hold all income. In 1917, a district court ruled in favor of the taxpayer and had the receiver turn over all income to the taxpayer. The government appealed, but the lower court decision was affirmed by the Court of Appeals for the Ninth Circuit in 1920 and a subsequent appeal to the U.S. Supreme Court was dismissed in 1922.

The question in the North American Oil Consolidated case was when should the taxpayer report the income: 1916, 1917, 1920, or 1922? The court ruled that the income was reportable in 1917, the first year that the taxpayer had a claim of right over the income and had in fact received the income. Until that time, it was not possible for the taxpayer to have constructive receipt over the funds.52

Income Received in Error: United States v. Lewis
In United States v. Lewis,53 a taxpayer received a bonus of $22,000 in error in 1944, and had to return $11,000 of the total to his employer in 1946. The Supreme Court ruled that the taxpayer could not simply file an amended return and recalculate the 1944 tax, since the taxpayer had an unrestricted claim of right over the funds at the end of 1944 and each tax year stands on its own. The Court noted the government’s position that the taxpayer would be entitled to take a deduction on his 1946 return when the funds were returned. This same principle has been extended to embezzlement proceeds, for example; such amounts are taxable when embezzled.54

Practice Tip:

IRC Section 1341 may provide some tax relief if the taxpayer’s marginal tax rate in the year of deduction is less than the year the income was originally reported in error. Specifically, if the amount involved exceeds $3,000, a taxpayer may elect to take a credit in the repayment year for the marginal tax paid on the income in question in the earlier year. In the Lewis case, the taxpayer could take a credit in 1946 for the marginal tax paid erroneously in 1944. This would avoid inequities if the taxpayer was in a higher tax bracket in 1944.

Deposits vs. Advance Payment of Income: Commissioner v. Indianapolis Power and Light
In Commissioner v. Indianapolis Power and Light55 a utility company required new customers to make cash deposits prior to receiving service, and such deposits were eventually returned or credited to future bills once the customer had proven his or her creditworthiness. The tax question to be answered was whether the deposits were security deposits or advance payments for services. The Service took the position that the deposits were advance payments and constituted taxable income to the utility upon receipt. After examining the facts of the case, the Court ruled for the taxpayer, noting that the intent was to treat the amounts as deposits and that there was a strong possibility that the money would be returned to the customers, as it was acquired subject to an express obligation to repay, either at the time service was terminated or when the customer established good credit pursuant to the utility’s terms. Therefore, the Court held that the dominion the taxpayer held over the funds was insufficient to qualify them as taxable income.

Judicial Parameters: Assignment of Income
Assignment of income is an expression often used to describe an attempt by a taxpayer to have income earned by the taxpayer paid to another individual so that it will be taxed to that person. Generally, income from services must be reported by the taxpayer who performed the services, and such income cannot be assigned to another taxpayer.56 On the other hand, income from property is generally taxed to the owner of the property.

In 1986, Congress took three actions to limit the abilities of parents to shift income-producing assets to their children by (1) limiting the standard deduction for a dependent, (2) eliminating a personal exemption deduction for someone being claimed as a dependent by someone else, and (3) instituting the allocable parental tax.60

In determining who must report an amount of income, it is important to determine who has earned the income. In this respect, the classic quote regarding the assignment of income doctrine was by Justice Holmes of the U.S. Supreme Court in the case of Lucas v. Earle(discussed below),61 where Justice Holmes noted that such an attempt is an arrangement by which “the fruits are attributed to a different tree from that on which they grew.”62 In other words, once an amount of income “ripens” for a taxpayer, it cannot be assigned to a different tree. Two cases illustrate the application of these principles.

Assignment of Services Income: Lucas v. Earle
In Lucas v. Earle, an attorney set up a law partnership with his wife under a valid California contract of joint tenancy and split the earnings 50-50. At the time there was no option to file a married-filing jointly tax return, so this saved taxes on the two individual tax returns. The Court noted that the taxpayer was “the only party to the contracts by which the salary and fees were earned,”64 and ruled that the fruit cannot be assigned to a different tree. Thus, all of the income of the law practice was taxed to Mr. Earle.

What if Ms. Earle had worked during the years that Mr. Earle was in law school and had paid all of his education costs? Would Mr. Earle have grounds for assigning some of the income to her as repayment for her working years? In one case, the court allowed Randy Hundley, a catcher with the Chicago Cubs, to assign a portion of his signing bonus earnings to his dad who had coached him for many hours and taught him the finer points of the game. The two had entered into a contingency contract whereby Mr. Hundley senior would receive 50% of any signing bonus as compensation for teaching services and representing his son.65

Assignment of Property Income: Helvering v. Horst
The case of Helvering v. Horst66 also involved an assignment of income, this time between father and son. The taxpayer made a gift of detachable coupon bonds to his son shortly before the due dates of the coupons. Interest was paid to the owner of the coupons. The Court ruled that the taxpayer should be taxed on the interest income, and not his son, since he enjoyed the “… fruition of the economic gain.”67 The court noted that the taxpayer received the same satisfaction as if he had spent the money himself, and noted that “… the power to dispose of income is the equivalent of ownership … ”68 Naturally, the Court referred to the “fruit and tree” analogy as well.

The key to determining who is taxed on the income from property is to determine who retains ownership of the underlying property. For bonds, interest accrues on a daily basis, while dividends become income only once declared. 69

Judicial Parameters: Windfall Gains
Earlier it was mentioned that cases subsequent to Eisner v. Macomber shifted away from simplistic definitions of income, and instead showed a trend towards accepting the assumption that Congress had intended to exert fully the power to tax income as provided in the Sixteenth Amendment. Thus, the IRC Section 61 phrase stating that gross income includes “all income from whatever source derived” is viewed broadly in terms of scope.70 The following two decisions that address damages and compensatory gifts illustrate the broad sweep of IRC Section 61.

Compensatory and Punitive Damages: Commissioner v. Glenshaw Glass Company
In Commissioner v. Glenshaw Glass Company,71 the Court addressed the question of the taxability of punitive damages paid under a lawsuit involving violations of the federal antitrust laws. The taxpayer had demanded exemplary damages for fraud and treble damages for injury to its business for alleged violations by Hartford-Empire Company of the federal antitrust laws. Hartford paid Glenshaw approximately $800,000 in a settlement of all the pending litigation in December of 1947.

The IRS simply argued that such damages were taxable because they represented a clear accession to wealth and are not excludable, and that Congress intended for IRC Section 61 to exert the full taxing power of the Constitution. The taxpayer in the case used a “legislative reenactment” defense, noting that the U.S. Tax Court had recently ruled that such damages were nontaxable and that Congress’s failure to mention such damages when they revisited Section 22 (now IRC Section 61) after this decision meant that it was “content” with this decision. In other words, by not acting to counteract the Tax Court decision, Congress was in effect “legislatively reenacting” current law that does not specifically state that such payments are taxable.

The Court agreed with the IRS, noting that Section 22 (now IRC Section 61) was designed by Congress to “exert the full measure of its taxing power.”72 In referencing several cases, the Court stated that a liberal construction of the statute was necessary, and that all gains are taxed unless exempted by Congress. The Court also noted that there was no question that the original damages were taxable (the original violation, or one-third of the total). The Court also noted that Macomber was not applicable since in that case, involving stock dividends, there was no accession to wealth.

The Glenshaw Glass Company decision is based on the IRC Section 61 principle that all income is taxable unless specifically exempted by the courts. But what about other damage awards? Interestingly, prior case law had conflicting decisions on gender, sex, and race discrimination awards; the first two were taxable, and the latter was not.73 The different verdicts were due to the fact that in each case, the Courts examined the underlying wording of the antidiscrimination statute involved, and the Civil Rights Act was the only one that mentioned “tort” remedies. Because of these inconsistent decisions, Congress decided to tax all damages as part of the 1996 Act; the only exceptions are those damages received due to personal physical injury or sickness. Punitive damages are also taxable, unless based on a civil action related to wrongful death.74

Treasure Troves: Cesarini v. United States
A “treasury trove” is another type of possible windfall gain. For example, a taxpayer discovers buried treasure in her back yard; is this taxable income? How does the realization principle apply to this situation? In Cesarini v. United States,75 the taxpayers found $4,467 cash inside a used piano which they had purchased at an auction. The piano was originally purchased by the taxpayers for $15, and was to be used by their daughter for piano lessons. The cash was found when the piano was being cleaned, and it was not possible to determine who had placed the cash there. The taxpayers exchanged the cash for newer currency at the bank.

The taxpayers contended that the treasure trove was not includable as income under IRC Section 61, and that even if the amount was treated as being realized, the IRS was barred from taxing such an amount because the statute of limitations had expired on the 1957 purchase date of the piano (seven years earlier). The IRS contended that the amount was income, based on a 1953 ruling in which the Service noted that “[t]he finder of treasure trove is in receipt of taxable income, for Federal income tax purposes, to the extent of its value in United States currency, for the taxable year in which it is reduced to undisputed possession.”76 2 Identical language was subsequently incorporated into the tax regulations.77

The Federal District Court ruled for the Service, citing the broad all-inclusive language of Congress in exerting the full measure of its taxing power under the Sixteenth Amendment. While the courts are not required to follow IRS rulings, the Court in this case made the following observation concerning the proper interpretation of the ruling:

While it is generally true that revenue rulings may be disregarded by the courts if in conflict with the code and the regulations, or with other judicial decisions, plaintiffs in the instant case have been unable to point to any inconsistency between the gross income sections of the code, the interpretation of them by the regulations and the courts, and the revenue ruling which they herein attack as inapplicable. On the other hand, the United States has shown a consistency in letter and spirit between the ruling and the code, regulations, and court decisions.78

In Cesarini, the treasure trove was in the form of cash, so there could be little doubt about a gain being “realized.” But what if the treasure trove was in the form of property? Generally, the fair market value of the property would be taxed as income, even though the property had not been converted to cash. For example, in Revenue Ruling 53-61,79 the Service ruled that the finder of buried treasure must include its value, as measured in U.S. currency, in income as soon as the treasure was reduced to the taxpayer’s possession.

What if a baseball fan catches a valuable homerun ball at a game, and immediately gives the ball to the hitter? Has income being realized? This question was posed to the IRS in 1998, when Mark McGuire was in the process of breaking the home run record of Roger Maris. Commissioner Risotti issued a News Release80 providing that if the ball was returned immediately, there would be no income tax liability. Further, Commissioner Risotti stated that “[s]ometimes pieces of the tax code can be as hard to understand as the infield fly rule. All I know is that the fan who gives back the home run ball deserves a round of applause, not a big tax bill.” Interestingly, the release also noted that the tax results “may be different” if the fan decides to sell the ball. Does this imply that no income is realized until the ball is sold? That question was not answered in the information release.

Qui Tam Action Settlement Awards: Roco v. Commissioner
In Roco v. Commissioner,81 the taxpayer sued the New York University Medical Center (NYUMC) in a qui tam action under the False Claims Act, alleging that it had submitted fraudulent information to the federal government resulting in a substantial overpayment of federal funds to the medical center. In settlement, NYUMC paid $15,500,000 to the federal government, which paid the taxpayer $1,566,087 as a qui tam payment.

The IRS contended that such payments were income, arguing that the qui tam payment was the equivalent of a reward for the taxpayer’s efforts in helping the United States obtain repayment of the overcharges by NYUMC. The Service also noted that rewards are generally includable in gross income under Treasury Regulation Section 1.61-2(a). The taxpayer argued that no tax authorities conclude that such payments to a “relator” in a qui tam case are includable in the relator’s income, and if such amount were taxable it would discourage individuals from bringing actions under the law.

The Court agreed with the IRS, noting that such payments were the equivalent of rewards and were thus includable in gross income. The Court also noted that qui tam payments, just like punitive damages, were not intended to compensate the recipient for actual damages. The Court concluded that the payment was a clear accession to wealth and was not excludable under any provision of the Code.

Gift v. Compensation: Commissioner v. Duberstein
The Commissioner v. Duberstein82 case involves the consolidation of two cases that involve the same tax issue: what is an excludable “gift” for federal tax purposes? In Duberstein, a supplier (Mohawk Metal) gave the taxpayer a Cadillac in appreciation for referrals to potential customers in the industry. In Stanton, Stanton, the comptroller of a church, who also served as president of the operating company which managed the church’s extensive real estate holdings, resigned after the operating company’s treasurer was terminated by its directors. The directors passed a resolution granting Stanton $20,000 “in appreciation of the services rendered” by him.

In both situations, the IRS contended that a gift should be viewed as a transfer for personal reasons only, that the definition of a gift for gift tax purposes is not controlling, and that the lack of an obligation does not make a transfer a gift. In short, the facts of the case indicated that the transfers were business related and should be viewed as compensation.83 The taxpayers in both situations responded that there was a lack of an obligation, the transfers represented a “detached generosity”, and that the transferors in both cases intended the transfers to be nontaxable gifts. The Supreme Court granted certiorari because of a conflict among the circuits.

The Court looked for guidance by examining the definition of a gift as used in prior decisions such as Commissioner v. LoBue84 (proceeding from “a detached and disinterested generosity”) and Robertson v. United States85 (“out of affection, respect, admiration, charity, or like impulses”), determining that “what controls is the intention with which payment, however voluntary, has been made.”86 The Court agreed with the government’s application of the “maxims of experience,” and concluded that whether something is a gift is a question of fact in each case.87 In Duberstein, the Court held that the transfer was compensation, either for past or future services.88 However, in Stanton, the Court vacated the decision and remanded the case to the lower courts to reveal the facts, stating that the sparse facts used in the original case were insufficient for a decision. On remand, the District Court in determined that the transfer was a gift, and this decision was upheld on appeal.89

In reaching its decision, the Supreme Court noted that their conclusion “may not satisfy an academic desire for tidiness, symmetry and precision in this area,” but stated that if Congress feared more fact-based litigation, it could provide more explicitness in the law by delineating the factors that are controlling in gift situations.90 In a strongly worded partial dissent, Justice Frankfurter noted that greater explicitness was possible in arriving at a decision.91

Both cases bring up a broader issue: can a corporation ever make a “gift” to an employee? Certainly not, if they deduct it like Mohawk did; gift deductions are generally limited to $25 per donee per year. The Code92 now provides exclusions for a variety of fringe benefits offered to employees that at one time may have been considered “gifts”. Examples include courtesy discounts, de minimis Christmas gifts, free access to company athletic facilities, and free flights for airline employees. But unanswered questions remain: for example, if an employer offered $1,000 to any employee who quit smoking, would that be a gift or compensation?

What about voluntary employer payments to the surviving family members of deceased employees—would this be a nontaxable gift? At one time the Code granted a $5,000 exclusion for such payments just to reduce the volume of such cases in the courts system. However, as part of the broadening of the tax base to finance the 1996 tax cuts, Congress repealed this provision. So taxpayers and the IRS are back to the gift issue once again. If the employer did not deduct the payment, the family members may once again try to convince the IRS that the transfer was in the nature of a “detached generosity.”93

Administrative Convenience Parameters
A common theme throughout much of the judicial authority summarized above is the simple principle that an amount of income is presumed to be taxable unless specifically exempted in the Code. However, taken to the extreme, this would mean that such small items such as free samples of soap received in the mail would be taxable. For this reason, the IRS and the Courts have carved out some guidance to permit exclusion of de minimis amounts of gross income.

Frequent Flyer Miles: Announcement 2002-18
Perhaps one of the most interesting tax questions in this regard is the taxability of frequent flyer miles earned by an employee while on business travel for an employer. Do these earned miles constitute income to the employee? In Announcement 2002-1894 the IRS stated that the receipt of such miles will not constitute income to the employee, even if the miles are subsequently used for personal travel. However, the Service intends to continue to study the issue, but has promised not to make any retroactive changes to this stated policy.

What if the employee in the above situation is able to convert these miles to cash? In Charley v. Commissioner,95 the Court ruled that such conversion creates taxable income, as the transfer is in a business setting and is not a “gift” from employer to employee. Since the company did not offer compensation in the form of travel credits, the amount could not be excluded as a de minimis fringe benefit.

Free Samples: Haverly v. United States
In Haverly v. United States,96 a principal of a public elementary school received unsolicited sample textbooks from a publisher and subsequently donated the textbooks to the school’s library. The taxpayer claimed a charitable deduction for the contribution, but did not recognize income related to the receipt of the books. The IRS contended that the taxpayer had accepted the books as his own, and that such an exercise of dominion and control requires that income be recognized if such books generate a tax benefit (a deduction) in the future. The taxpayer contended that his intent was irrelevant, and that nothing under IRC Section 61 required the value of unsolicited samples to be taxed.

The lower court had ruled in favor of the taxpayer, noting that the acceptance issue was somewhat of a red herring in that the taxpayer could have exercised the same control and not have taken a deduction for the donation.97 However, the Court of Appeals for the Seventh Circuit overturned the district court’s decision, noting that the combination of excluding the income and then taking a deduction would provide a double tax benefit. The Court found that the taxpayer’s act of taking a charitable deduction for the donation of the books was a manifestation of his intent to accept the property and exercise complete dominion over it. It held that when a tax deduction was taken for the donation of unsolicited samples the value of the samples received must be included in the taxpayer’s gross income.

In Revenue Ruling 70-330,98 the Service indicated that the mere retention of unsolicited books by a book reviewer was enough to cause the value of the books to be reported as gross income. However, in Revenue Ruling 70-498,99 which superseded the prior ruling, the Service indicated that the value of the books is income only if the books are subsequently donated to a charitable organization and a charitable deduction is taken. Apparently, the mere receipt of the unsolicited sample alone does not constitute a realization event for federal tax purposes.

FOOTNOTES (26) Rev Rul 60-85, 1960-1 CB 181, modified, Rev Rul 71-299, 1971-2 CB 218.

(27) IRC § 1033(a)(2).

(28) 252 US 189, 40 S Ct 189, 64 L Ed 521 (1920).

(29) 252 US at 207.

(30) 252 US 189, 40 S Ct 189, 64 L Ed 521 (1920).

(31) 252 US at 206.

(32) 252 US at 213.

(33) 252 US at 220.

(34) 136 US 549, 10 S Ct 1057, 34 L Ed 525 (1890).

(35) 136 US at 559-560.

(36) 309 US 461, 60 S Ct 631, 84 L Ed 864 (1940).

(37) Id at 461, citing Hewitt Realty Co v Commissioner, 76 F2d 880 (1935).

(38) 309 US at 469.

(39) Id.

(40) 69 TC 675 (1978).

(41) See Rev Rul 76-130, 1976-1 CB 16. See also Treas Reg § 1.61-12(a).

(42) 434 US 77, 98 S Ct 315, 54 L Ed 2d 252 (1977).

(43) 279 US 716, 49 S Ct 499, 73 L Ed 918 (1929).

(44) 279 US at 729.

(45) Id.

(46) 279 US at 730.

(47) See Treas Reg §§ 1.61-7, 1.61-10.

(48) United States v Joliet & CR Co, 315 US 44, 62 S Ct 442, 86 L Ed 658 (1942).

(49) 696 F2d 1386 (Fed Cir 1983).

(50) 696 F2d at 1389.

(51) 286 US 417, 52 S Ct 613, 76 L Ed 1197 (1932).

(52) 286 US at 423.

(53) 340 US 590, 71 S Ct 522, 95 L Ed 560 (1951).

(54) See James v United States, 366 US 213, 81 S Ct 1052, 6 L Ed 2d 246 (1961), and Dominion Resources, Inc v US, 219 F3d 359 (4th Cir Va 2000).

(55) 493 US 203, 110 S Ct 589, 107 L Ed 2d 591 (1990).

(56) Lucas v Earle, 281 US 111 (1930). See discussion in § 1A:1.02[6][a].

(57) Id.

(58) Tibbits v Commr, TC Memo 1965-130 (1965).

(59) Stone v Commr, TC Memo 1987-454 (1987), aff’d, 867 F2d 613 (9th Cir 1989).

(60) Tax Reform Act of 1986, Pub L No 99-514, 99th Cong, 2d Sess § 103(b) (modifying IRC § 151(d)) and § 1411 (modifying IRC § 1(i)) (Oct. 22, 1986).

(61) 281 US 111, 50 S Ct 241, 74 L Ed 731 (1930).

(62) 281 US at 115 (emphasis added).

(63) 281 US 111, 50 S Ct 241, 74 L Ed 731 (1930).

(64) Id at 114.

(65) See Hundley v Commr, 48 TC 339 (1967), acq in result, 1967-2 CB 2.

(66) 311 US 112, 61 S Ct 144, 85 L Ed 75 (1940).

(67) 311 US at 115.

(68) 311 US at 118.

(69) Treas Reg § 1.61-7(d); Estate of Smith v Commr, 292 F2d 478 (3d Cir 1961).

(70) IRC § 61.

(71) 348 US 426, 75 S Ct 473, 99 L Ed 483 (1955).

(72) 348 US at 429.

(73) See, eg, Burke v US, 504 US 229 (1992) (back wages recovered in sex discrimination claim under Title VII of the Civil Rights Act of 1964 were taxable).

(74) IRC § 104(a)(2).

(75) 296 F Supp 3 (ND Ohio 1969), aff’d, 428 F2d 812 (6th Cir 1970).

(76) 296 F Supp at 6.

(77) Treas Reg § 1.61-14(a).

(78) 296 F Supp at 6-7.

(79) cited in Cesarini v United States, 296 F Supp 3, 6 (ND Ohio 1969). See also TD 6272, 1957-2 CB 18.

(80) IR 98-56, September 8, 1998.

(81) 121 TC 160 (2003).

(82) 363 US 278, 80 S Ct 1190, 4 L Ed 2d 1218 (1960).

(83) 363 US at 289 The IRS also pointed out that Mohawk Company had deducted the cost of the Cadillac, an indication to the Service that the transfer was in the nature of compensation.

(84) 351 US 243, 76 S Ct 800, 100 L Ed 1142 (1956).

(85) 343 US 711, 72 S Ct 994, 96 L Ed 1237 (1952).

(86) Bogardus v Commr, 302 US 34, 41 (1937).

(87) 363 US at 290.

(88) 363 US at 291-292.

(89) United States v Stanton, 287 F2d 876 (2d Cir 1961).

(90) 363 US at 290.

(91) 363 US at 296.

(92) IRC § 132.

(93) See, eg, Harper v United States, 454 F2d 222 (9th Cir 1972); United States v Frankel, 302 F2d 666 (8th Cir 1962); Small Business Job Protection Act of 1996, Pub L No 104-188, 108th Cong, 2d Sess § 1402(a) (August 20, 1996), repealing IRC § 101(b).

(94) 2002-1 CB 621.

(95) 91 F3d 72 (9th Cir 1996).

(96) 513 F2d 224 (7th Cir), cert. denied, 423 US 912, 96 S Ct 216, 46 L Ed 2d 140 (1975).

(97) 374 F Supp 1041, 1045.

(98) 1970-1 CB 14, superseded, Rev Rul 70-498, 1970-2 CB 6.

(99) Rev Rul 70-498, 1970-2 CB 6. LexisNexis Tax Advisor -- Federal Topical § 1A:1.02