Chapter 5: § 61(a)(1) Compensation
As just described in the introduction to this unit, this chapter will consider the general contours
of the compensation inclusion under § 61(a)(1), two statutory exclusions pertaining to
compensation (§§ 119 and 132), as well as the rules in § 83 that apply to property paid in kind as
compensation that is subject to a substantial risk of forfeiture. The most important compensation
exclusion (for employer-provided health care) will be examined in Chapter 17 (pertaining to the
personal consumption tax expenditures), certain education fringe benefits will be addressed in
Chapter 16 (addressing the acquisition of human capital), and an introductory consideration of
compensation paid to tax-preferred retirement accounts will be considered in Chapter 21 (in
connection with the cash method of accounting). The employer’s § 162(a)(1) deduction for
compensation paid is also briefly considered here.
A payment made by an employer to an employee (or made by a services recipient to an
independent contractor services provider) is expressly listed as Gross Income in the very first listed
item in § 61(a)(1). Notice how broad the language found there is: “compensation for services,
including fees, commissions, fringe benefits, and similar items.” The name attached to the payment
is irrelevant to the taxation of that payment. And the payment need not necessarily ever touch the
employee’s or independent contractor’s hands, as illustrated in the relatively early Supreme Court
OLD COLONY TRUST CO. v. COMMISSIONER
279 U.S. 716 (1929)
MR. CHIEF JUSTICE TAFT delivered the opinion of the Court.
William M. Wood was president of the American Woolen Company during the years 1918,
1919 and 1920. In 1918 he received as salary and commissions from the company $978,725, which
he included in his Federal income tax return for 1918. In 1919 he received as salary and
commissions from the company $548,132.27, which he included in his return for 1919.
August 3, 1916, the American Woolen Company had adopted the following resolution, which
was in effect in 1919 and 1920:
Voted: That this company pa y any and all income taxes, State and Federal, that may
hereafter become due and payable upon the salaries of all the officers of the
company, including the president, William M. Wood, to the end that said persons
and officers shall receive their salaries or other compensation in full without
deduction on account of income taxes, State or Federal, which taxes are to be paid
out of the treasury of this corporation.
Pursuant to these resolutions, the company paid to the collector of internal revenue Mr. Wood's
Federal income and surtaxes due to salary and commissions paid him by the company, as follows:
taxes paid for 1918: $681,169.88; taxes paid for 1919: $351,179.20.
The decision of the Board of Tax Appeals here sought to be reviewed was that the income taxes
paid by the company for Mr. Wood were additional income to him for the years 1919 and 1920.
[W]e think the question presented is whether a taxpayer, having induced a third person to pay
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his income tax or having acquiesced in such payment as made in discharge of an obligation to him,
may avoid the making of a return thereof and the payment of a corresponding tax. We think he
may not do so. The payment of the tax by the employers was in consideration of the services
rendered by the employee and was a gain derived by the employee from his labor. The form of the
payment is expressly declared to make no difference. Section 213, Revenue Act of 1918, c. 18, 40
Stat. 1065 [current § 61(a)(1)]. It is therefore immaterial that the taxes were directly paid over to
the Government. The discharge by a third person of an obligation to him is equivalent to receipt
by the person taxed. The certificate shows that the taxes were imposed upon the employee, that
the taxes were actually paid by the employer and that the employee entered upon his duties in the
years in question under the express agreement that his income taxes would be paid by his employer.
This is evidenced by the terms of the resolution passed August 3, 1916, more than one year prior
to the year in which the taxes were imposed. The taxes were paid upon a valuable consideration,
namely, the services rendered by the employee and as part of the compensation therefor. We think
therefore that the payment constituted income to the employee.
Nor can it be argued that the payment of the tax was a gift. The payment for services, even
though entirely voluntary, was nevertheless compensation within the statute.
It is next argued against the payment of this tax that if these payments by the employer constitute
income to the employee, the employer will be called upon to pay the tax imposed upon this
additional income, and that the payment of the additional tax will create further income which will
in turn be subject to tax, with the result that there would be a tax upon a tax. This it is urged is the
result of the Government’s theory, when carried to its logical conclusion, and results in an
absurdity which Congress could not have contemplated.
In the first place, no attempt has been made by the Treasury to collect further taxes, upon the
theory that the payment of the additional taxes creates further income, and the question of a tax
upon a tax was not before the Circuit Court of Appeals and has not been certified to this Court.
We can settle questions of that sort when an attempt to impose a tax upon a tax is undertaken, but
not now. It is not, therefore, necessary to answer the argument based upon an algebraic formula to
reach the amount of taxes due. The question in this case is, “Did the payment by the employer of
the income taxes assessable against the employee constitute additional taxable income to such
employee?” The answer must be “Yes.”
Note the Court’s rejection of exclusion by Mr. Wood as a “gift.” In 1986, Congress amended §
102 by adding subsection (c), which expressly denies exclusion of payments made by an employer
to an employee as a gift. Section 102(c)(2), however, helpfully reminds us that other statutory
exclusions may apply, including exclusion as a de minimis fringe under § 132(e) (considered
below) or as an employee achievement award under § 74(c).
Although the case does not use the words, you can think of Old Colony Trust as one of the first
cases to apply the very important “substance over form” doctrine in tax. Under the substance
over form doctrine, a transaction is taxed according to its underlying economic substance if
its form does not fairly reflect that underlying substance. In form, cash went directly from the
company to the IRS, not to Mr. Wood as compensation. In substance, however, the cash implicitly
went first to Mr. Wood (includable compensation) and then from Mr. Wood to the IRS and to his
state’s treasury. Or this could case could illustrate another common law doctrine: the step
transaction doctrine. In form, one step occurs (the payment of money by the corporation to the