Timing of Income and Deductions: Annual Accounting and Character of Income and Computation of Tax

AuthorWilliam Kratzke
Chapter 10: Character of Income and Computation of Tax
Recall that there are three principl es that guide us through every question of income
tax. See chapter 1. The first of these principles is that “[w]e tax income of a
particular taxpayer once and only once.” A good bit of our study to this point has
been to identify inconsistencies or anomalies with this principle, i.e., exclusions
from gross income and certain deductions. In this chapter, we refine the notion of
taxing all income once by adding this caveat: not all income is taxed the same.
Taxable income has a “character” that determines the tax burden to which it is
subject. Under § 1(h), an individual’s tax liability is actually the sum of the taxes
of different rates on income of several different characters.
We have also seen that the Code states
rules whose effect is to match income and
expenses over time. See Idaho Power,
Encyclopaedia Britannica, supra. We
now find that the Code requires taxpayers
with only quite limited exceptions to
match income, gains, losses, and
expenses with respect to character.
Taxpayers who perceive these points may
try to manipulate the character of income
and associated expenses, and the Code
addresses these efforts. Generally, a
taxpayer prefers gains to be subject to a
lower rate of tax, and deductions to be
taken against income subject to a higher
rate of tax.
We consider here incomes of the
following characters: long-term capital
gain (and its variations), short-term capital gain, depreciation recapture, § 1231
gain, dividends, and passive income.
The Tax Formula:
(gross income)
MINUS deductions named in § 62
EQUALS (adjusted gross income
MINUS (standard deduction or
itemized deductions)
MINUS (personal exemptions)
EQUALS (taxable income)
C o m p u te in c o m e t a x lia b ilit y
from tables in §
1 (indexed for
MINUS (credits against tax)
I. Capital Gain
We have already seen that § 61(a)(3) includes within the scope of “gross income”
“gains derived from dealings in property.” Section 1001(a) informed us that
taxpayer measures such gains (and losses) by subtracting “adjusted basis” from
“amount realized.” Individual taxpayers’ gains from the sale or exchange of
“capital assets” might be subject to tax rates lower than those applicable to
“ordinary income.”
So we begin with a definition of “capital asset.”
A. “Capital Asset:” Property Held by the Taxpayer
Read § 1221(a). Notice the structure of the definition, i.e., all property except ...
Do not the first two lines of this section imply that “capital asset” is a broad
concept? Is there a common theme to the exceptions at least to some of them?
In Corn Products Refining Co. v. Commissioner, 350 U.S. 46 (1955), taxpayer was
a manufacturer of products made from corn. Its profitability was vulnerable to price
increases for corn. In order to protect itself against price increases and potential
shortages, taxpayer “took a long position in corn futures[187]” at harvest time when
prices were “favorable.” Id. at 48. If no shortage appeared when taxpayer needed
corn, it would take delivery on as much corn as it needed and sell the unneeded
futures. However, if there were a shortage, it would sell the futures only as it was
able to purchase corn on the spot market. In this manner, taxpayer protected itself
against seasonal increases in the price of corn. Taxpayer was concerned only with
losses resulting from price increases, not from price decreases. It evidently
purchased futures to cover (much) more than the corn it would actually need. See
id. at 49 n.5. Hence, taxpayer sold corn futures at a profit or loss. Over a period
when its gains far exceeded its lo sses, taxpayer treated these sales as sales of capital
assets. This would subject its gains to tax rates lower than the tax rate on its ordinary
income.188 At the time, the Code did not expressly exclude transactions of this
187 A “future” entitles the holder to purchase the commodity in the future for a fixed price.
188 At the time, corporate taxpayers enjoyed lo ng term capital gain tax rates lower than the tax rates on
their ordinary income.

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