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

• Author: William Kratzke
• Pages: 544-567

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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

(AGI))

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

inflation)

MINUS (credits against tax)

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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.