Gross Income

Gross Income

On February 3, 1913, the 16th Amendment was ratified and became part of the United States Constitution. It provides, in its entirety, as follows:

                The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.

Those latter two clauses—“without apportionment” and “without regard to any census”—overcame certain barriers to a federal income tax that were part of the original Constitution. Indeed, less than twenty years before the 16^th Amendment (in 1895) the Supreme Court had struck down a 2% federal tax on incomes over $4,000 because the law failed to apportion the revenue appropriately.[1] With ratification of the 16th Amendment, however, those limitations on Congress’s power to tax were removed.

Congress acted quickly after that and passed, a mere eight months later, the “Federal Income-tax Law” (in October 1913). In 1939, a new division, Title 26, of the United States Code was set aside for the act and was dubbed the “Internal Revenue Code.” There have been two major overhauls of the Code since then, most recently in 1986 under Ronald Reagan. Our modern version is therefore called the Internal Revenue Code of 1986.[2]

The current section 61 of the Code provides that “gross income means all income from whatever source derived,”[3] and goes on to list many examples, including, inter alia, compensation for services, gross income from business, gains derived from dealings in property, and more. Judicial interpretations of this definition (including its predecessor provisions in previous incarnations of the Code) have given Congress the widest possible breadth in taxing income. Nevertheless, there are some limitations on what “income” means, and for various policy and other reasons some increases to a taxpayer’s wealth that could easily be considered “income” are specifically excluded.

Accessions to wealth, clearly realized

In the 1920 case Eisner v. Macomber[4] the Supreme Court decided that “income” for purposes of the tax law meant “the gain derived from capital, from labor, or from both combined.” Income, in other words, could arise by way of a taxpayer’s personal efforts (her labor); the compensation one receives for personal services (usually, wages) would be considered this kind of income. Income could also arise without a taxpayer’s personal participation, however, by way of the use of the taxpayer’s capital. One might invest money into a business, for example, and receive a return on that investment above and beyond the original amount contributed. This would be income “from capital.” Both types (or even some combination of the two) were “income,” according to the Court, for purposes of Congress’s 16th Amendment power to tax.

Later, in 1955, the Court expanded the Eisner v. Macomber definition of income in the case Commissioner v. Glenshaw Glass Co.[5] In this case the Court was considering whether the damages a taxpayer received in a fraud case should be included in income. Admittedly, this payment did not arise from the taxpayer’s labor or from its capital, thus it did not seem to fall under the previously accepted definition of “income.” Nevertheless, the Court found that it was income, and that Congress could tax it. It made this decision on two principal bases: First, the tax law’s definition of “gross income” as including “income from whatever sourced derived” was Congress’s way of exerting “the full measure of its taxing power” in the 16th Amendment. Congress could, in other words, tax nearly everything (or at least could include almost everything in gross income). Indeed, according to the Court, the 16th Amendment gave Congress the power to tax all items of income except those Congress specifically chooses to exclude.

The second basis for the decision was that the old definition (“from capital, from labor, or from both”), while not wrong, was nevertheless inadequate. “Income,” the Court decided, includes “undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.” So long as it can be said that a taxpayer has gotten richer, in other words, the taxpayer has income that Congress can tax. This definition encompasses income from labor and capital, but it also includes damages a taxpayer receives in a fraud case even though not realized from the taxpayer’s labor or capital.

The Realization Requirement

Throughout a study of tax law a person will encounter two terms that must be clearly understood: realization and recognition. “Realization” refers to the actual increase in wealth. A taxpayer “realizes” income, for example, not just by some item of property increasing in value, but by the taxpayer actually disposing of the property and “realizing” the inherent gain. Similarly, merely providing a service for compensation does not create income until the taxpayer actually “realizes” the income by becoming legally entitled to the fee or wage for the services (for example, by sending an invoice to his customer). “Recognition,” on the other hand, refers to the legal requirement (by way of a statute or regulation, for example) that income a taxpayer has realized be included in her gross income. Taxpayers may realize all kinds of income every day, but need not actually “recognize” the gross income for tax purposes because of some applicable exclusionary rule.

A good example of this is section 1001 of the Code. This is the rule that provides that a taxpayer’s gain or loss on the sale or other disposition of property is measured by the difference between the “amount realized” on the sale (generally, the sales price or consideration received in the exchange) and the taxpayer’s adjusted basis in the property given up. If a taxpayer sells a piece of property for $100,000 in which the taxpayer had a $10,000 adjusted basis, section 1001 provides that the taxpayer’s gain is $90,000. (If the figures were switched—amount realized of $10,000 and a $100,000 adjusted basis—then section 1001 provides that the taxpayer has realized a $90,000 loss.) Subsection (c) of section 1001 provides that “the entire amount of the gain or loss…on the sale or exchange of property shall be recognized.” In other words, the gain or loss realized must also be recognized (that is, included in gross income).

Sections 61 and 1001 are examples of “inclusionary” rules—laws requiring that a certain kind of income that has been realized must also be recognized. The Code also contains many “exclusionary” rules, however—rules that provide that while some item of income may have been realized, it should not be recognized. For example:

·         Section 721 provides that when property is contributed to a partnership in exchange for a partnership interest, no gain or loss shall be recognized. This rule is necessary (assuming Congress intends that partnerships be formed without triggering gross income for the partners) because otherwise section 1001 would require recognition of some gain or loss if the fair market value of the property received (the partnership interest) was different from the adjusted basis of the property contributed to the partnership.[6]

·         Section 1031—the “Like-kind Exchange” rule—also provides for an exclusion from having to recognize realized gain. It provides that when a taxpayer exchanges one property for another property of “like kind” (a piece of real estate for another piece of real estate, for example) the taxpayer does not recognize gain even though the fair market value of the property received may exceed the adjusted basis of the property given up.[7]

There are numerous other examples of exchanges and the like that Congress could, if it wanted to, require the recognition of realized gain. There are also several other sorts of “undeniable accessions to wealth” that Congress has chosen to specifically exclude, such as

·         Gifts and inheritances (IRC § 102);

·         Certain discharges of indebtedness (IRC § 108); and

·         Certain employee fringe benefits (IRC § 132).

There are too many exclusions (believe it or not) to realistically list in this presentation. Nevertheless, the general rule set forth in the Glenshaw Glass case and its realization requirement—the easier rule to remember and to follow—is that all income is includible unless an exclusion applies.[8]

Liabilities

One final aspect of gross income that people often struggle with is that of liabilities. If a taxpayer borrows, say, $100,000 from a bank, is the $100,000 includible in gross income? After all, the taxpayer has clearly realized an accession to wealth, no? Well, no.

Consider the basic accounting formula: A = L + C. Read as “assets are the sum of liabilities and capital,” this formula is the cornerstone of modern accounting and, in fact, is the skeleton for a business’s balance sheet, with assets appearing on one side of the balance sheet (or at the top) and liabilities and capital on the other side (or on the bottom). In order for the formula to balance, whenever the left (asset) side increases, the right (liabilities and capital) side must also increase. Thus, when a taxpayer borrows $100,000 and deposits that money into a bank account, the left side increases by $100,000. At the same time, however, liabilities also increase by $100,000, keeping the formula balanced ($100,000 = $100,000 + 0). If the C, capital, is a measurement of the taxpayer’s wealth, she has not gotten any richer by borrowing this money. Her capital is unchanged and thus, under Glenshaw Glass, there has been no “accession to wealth.”[9]

From a legal standpoint, deciding whether an increase to one’s assets is an “accession to wealth” that is includible in gross income the question becomes, “Is there an obligation to repay the amount borrowed?” In other words, any true, lawful, enforceable debt will not give rise to gross income. For example, when a tenant pays a landlord a security deposit, the landlord is legally obligated to repay that deposit when the tenant vacates the property (unless, of course, the security deposit is used to offset some amount the tenant owes the landlord, like back rent or damages to the premises). Because the landlord has an “obligation to repay” the security deposit, it is not gross income to the landlord. Remove that obligation, however—by, say, the tenant vacating the premises and allowing the landlord to keep the deposit to pay back rent—then the impediment is removed and the landlord must recognize gross income.[10]