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2023
Corporations, Partnerships,
Estates & Trusts
Raabe
Young
Nellen
Cripe
Lassar
Persellin
Cuccia
Corporations,
Partnerships, Estates
& Trusts
Included:
Raabe • Young
Nellen • Cripe • Lassar
Persellin • Cuccia
2023
SE/Raabe, Young, Nellen, Cripe, Lassar, Persellin, Cuccia, Corporations, Partnerships, Estates & Trusts 2023 ISBN-13: 9780357719961 ©2023 Designer: Chris Doughman
Printer: Binding: Casebound Trim: 8.5” x 10.875” CMYK
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Income Tax Rates—Estates and Trusts
Tax Year 2022
Taxable Income
The Tax Is:
Of the
Amount
Over—
Over—
But not
Over—
$
0
$ 2,750
10%
2,750
9,850
$ 275 1 24%
9,850
13,450
1,979 1 35%
9,850
13,450
………
3,239 1 37%
13,450
$
0
2,750
Income Tax Rates—C Corporations,
2018 and after
For all income levels, the tax rate is 21%.
Tax Formula for Corporate Taxpayers
Income (from whatever source). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ xxx,xxx
Less: Exclusions from gross income. . . . . . . . . . . . . . . . . . . . . . . .
2 xx,xxx
Gross Income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ xxx,xxx
Less: Deductions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2 xx,xxx
Taxable Income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$ xxx,xxx
Applicable tax rates. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Gross Tax. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Less: Tax credits and prepayments. . . . . . . . . . . . . . . . . . . . . . . . .
Tax Due (or refund). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
19961_end02-05_hr.indd 2
3
xx%
$ xx,xxx
2
x,xxx
$ xx,xxx
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Unified Transfer Tax Rates
For Gifts Made and for Deaths after 2012
19961_end02-05_hr.indd 3
If the Amount with Respect to Which
the Tentative Tax to Be Computed Is:
The Tentative Tax Is:
Not over $10,000
Over $10,000 but not over $20,000
Over $20,000 but not over $40,000
Over $40,000 but not over $60,000
Over $60,000 but not over $80,000
Over $80,000 but not over $100,000
Over $100,000 but not over $150,000
Over $150,000 but not over $250,000
Over $250,000 but not over $500,000
Over $500,000 but not over $750,000
Over $750,000 but not over $1,000,000
Over $1,000,000
18 percent of such amount.
$1,800, plus 20 percent of the excess of such amount over $10,000.
$3,800, plus 22 percent of the excess of such amount over $20,000.
$8,200, plus 24 percent of the excess of such amount over $40,000.
$13,000, plus 26 percent of the excess of such amount over $60,000.
$18,200, plus 28 percent of the excess of such amount over $80,000.
$23,800, plus 30 percent of the excess of such amount over $100,000.
$38,800, plus 32 percent of the excess of such amount over $150,000.
$70,800, plus 34 percent of the excess of such amount over $250,000.
$155,800, plus 37 percent of the excess of such amount over $500,000.
$248,300, plus 39 percent of the excess of such amount over $750,000.
$345,800, plus 40 percent of the excess of such amount over $1,000,000.
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i
Corporations,
Partnerships,
Estates & Trusts
2023
General Editors
William A. Raabe
Ph.D., CPA
James C. Young
Ph.D., CPA
Sharon S. Lassar
Ph.D., CPA
Annette Nellen
J.D., CPA, CGMA
Mark B. Persellin
Ph.D., CPA, CFP®
Bradrick M. Cripe
Ph.D., CPA
Andrew D. Cuccia
Ph.D., CPA
Contributing Authors
James H. Boyd
Steven C. Dilley
Annette Nellen
Toby Stock
Ph.D., CPA
Arizona State University
J.D., Ph.D., CPA
Michigan State University
J.D., CPA, CGMA
San Jose State University
Ph.D., CPA
Ohio University
Bradrick M. Cripe
Sharon S. Lassar
Mark B. Persellin
James C. Young
Ph.D., CPA
Northern Illinois University
Ph.D., CPA
University of Denver
Ph.D., CPA, CFP®
St. Mary’s University
Ph.D., CPA
Northern Illinois University
D. Larry Crumbley
David M. Maloney
William A. Raabe
Kristina Zvinakis
Ph.D., CPA
Texas A&M University –
Corpus Christi
Ph.D., CPA
University of Virginia
Ph.D., CPA
Philadelphia, Pennsylvania
Ph.D.
The University of Texas at
Austin
Andrew D. Cuccia
Ph.D., CPA
University of Oklahoma
Australia • Brazil • Canada • Mexico • Singapore • United Kingdom • United States
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South-Western Federal Taxation: Corporations,
Partnerships, Estates & Trusts, 2023 Edition
William A. Raabe, James C. Young, Annette
Nellen, Bradrick M. Cripe, Sharon S. Lassar,
Mark B. Persellin, Andrew D. Cuccia
SVP, Product: Erin Joyner
VP, Product: Thais Alencar
Last three editions, as applicable: © 2023, © 2022, © 2021
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Preface
Committed to Educational Success
S
outh-Western Federal Taxation (SWFT) is the
most trusted and best-selling taxation series
used by colleges and universities. We are focused
exclusively on providing the most useful, comprehensive,
and up-to-date tax texts, online study aids, tax preparation tools, and research tools to help instructors and students succeed in their tax courses and beyond.
SWFT is a comprehensive package of teaching and
learning materials, significantly enhanced with each edition to meet instructor and student needs and to add
overall value to learning taxation.
Corporations, Partnerships, Estates & Trusts, 2023 Edition provides a dynamic learning experience inside and
outside of the classroom. Built with resources and tools
that have been identified as the most important, our complete learning system provides options for students to
achieve success.
In addition, Corporations, Partnerships, Estates &
Trusts, 2023 Edition covers tax concepts as they affect
corporations, partnerships, estates, and trusts. The authors
provide accessible, comprehensive, and authoritative coverage of relevant tax code and regulations, as well as
all major developments in Federal income taxation. This
­market-leading text is intended for students who have
had at least one previous course in taxation.
In revising the 2023 Edition, we focused on:
• Accessibility. Clarity. Substance. The authors
and editors made this their focus as they revised
the 2023 edition. Coverage has been streamlined
to make it more accessible to students, and difficult concepts have been clarified, all without
losing the substance that makes up the SouthWestern Federal Taxation series.
• Developing professional skills. SWFT excels
in bringing students to a professional level
in their tax knowledge and skills, to prepare
them for immediate success in their careers.
We include development of written and verbal
­communication skills, the use of tax preparation
and tax research software, orientation toward success on the CPA Exam (including the upcoming
CPA Evolution version of the exam), exposure
to tax policy and tax law development, consideration of the time value of money in the tax
planning ­process, and ­experience with advanced
spreadsheet ­applications and data analytics.
• CNOWv2 as a complete learning ­system. Cengage Learning understands that digital learning
solutions are central to the classroom. Through
sustained research, we continually refine our learning solutions in CNOWv2 to meet evolving student
and instructor needs. CNOWv2 fulfills learning
and course management needs by offering a personalized study plan, video lectures, auto-graded
homework, auto-graded tests, and a full eBook
with features and advantages that address common
challenges.
v
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Learning Tools and Features to Help Students Make the Connection
Full-Color Design: We understand that students struggle with learning difficult tax law concepts and
applying them to real-world scenarios. The 2023 edition uses color to bring the text to life, capture student attention,
and present the tax law in an understandable and logical format.
Corporations: Organization
and Capital Structure
4
C h a p t e r
❏❏ Selected content is streamlined
to guide students in focusing on
the most important concepts for
the CPA Exam while still providing
in-depth coverage of topics.
L e a r n i n g O b j e c t i v e s : After completing Chapter 4, you should be able to:
LO.1
Explain the tax consequences of incorporating a
business.
LO.5
Characterize the tax differences between debt and
equity investments.
LO.2
Identify the basis issues relevant to the shareholder
and the corporation.
LO.6
Determine the tax treatment of shareholder debt and
stock gains and losses.
LO.3
Describe the special rules that apply when
corporation assumes shareholder liabilities.
LO.7
Identify tax planning opportunities associated with
organizing and financing a corporation.
LO.4
Explain the tax aspects of the capital structure of a
corporation.
The Big Picture
Chapter Outline
4-3 Investor Losses, 4-21
4-3a Stock and Security Losses, 4-21
4-3b Business versus Nonbusiness Bad Debts, 4-21
4-3c Section 1244 Stock, 4-23
4-1 Organization of and Transfers to Controlled
Corporations, 4-2
4-1a Section 351 Rationale and General Rules, 4-2
4-1b Property Defined, 4-5
4-1c Stock Transferred, 4-6
4-1d Control of the Corporation, 4-6
4-1e Basis Determination and Related Issues, 4-10
4-1f Assumption of Liabilities—§ 357, 4-14
4-4 Gain from Qualified Small Business Stock, 4-24
4-5 Tax Planning, 4-24
4-5a Working with § 351, 4-24
4-5b Selecting Assets to Transfer, 4-26
4-5c Debt in the Capital Structure, 4-26
4-5d Investor Losses, 4-27
4-5e Corporations versus Flow-Through Entities, 4-28
4-2 Capital Structure of a Corporation, 4-18
4-2a Capital Contributions, 4-18
4-2b Debt in the Capital Structure, 4-18
GOODLUZ/SHUTTERSTOCK.COM
The Vehicle for Business Growth Is the Corporate Form
Emily has operated her startup venture as a sole proprietorship since launching the business two years ago.
Marco, a friend from college, has been collaborating with Emily. Together they have developed an innovative software app. They were overjoyed when, as soon as they introduced the app into the market, it was
an immediate hit—and it has gained increasing recognition and market traction as sales continue to rise.
After only a short period of success though, Emily becomes convinced that the upside potential for even
more growth is significant. However, she realizes that a leap to that level of growth and market penetration
can only be achieved with a large infusion of capital that she is unable to fund from her resources.
Fortunately, Emily’s friend Ethan, who is a venture capitalist, is enthusiastic about making a large investment in the business in exchange for an equity stake. Ethan agrees that Emily’s startup easily will enjoy
remarkable success once it has the necessary additional resources. To integrate Ethan’s capital into the venture, Emily and Ethan will create Transformation, Inc. Emily will contribute her sole proprietorship assets,
and Ethan will contribute cash for Transformation, Inc. stock. Emily also has asked Marco, an invaluable
employee and a major contributor to the app’s development, if he would be interested in becoming a shareholder in Transformation. He was given the option of transferring either property or services in exchange
for stock. However, at this point, Marco is not sure what he will do.
Emily will receive 200 shares of Transformation stock in exchange for transferring the following sole
proprietorship assets to the new corporation:
Adjusted Basis
4-4
Part 2
Corporations
Chapter 4
In a manner similar to a like-kind exchange, gain and loss deferral is not absolute.
If a taxpayer transfers property to a corporation and receives “boot” (cash or property
other than stock), the taxpayer recognizes gain (but not loss) to the extent of the lesser
of the gain realized or the value of the boot received. The tax character of the gain
(e.g., ordinary, capital) depends on the type of assets transferred.2 As discussed in
more detail later, a substituted basis in the shareholder’s stock accomplishes gain or
loss deferral by reducing basis by the deferred gain or increasing basis by the deferred
loss.3 Example 2 illustrates this gain recognition rule.
Example
2
ab
If Tax
Gain
Realized
If Ta
x
Loss
Realized
If Ta
x
$ 50,000
400,000
1,550,000
$2,000,000
Read the chapter and formulate your response.
4-1
Loss recognized; basis of stock received
equals its FMV.
rred
Loss deferred under § 351; basis of stock
received equals its FMV + deferred loss.
Quail
Corporation
4-1b Property Defined
Calvin
Quail Stock
FMV $60,000
Amanda has an unrecognized gain of $30,000, and Calvin has an unrecognized loss of $10,000.
Both have a substituted basis in the stock in Quail Corporation. Amanda has a basis of $30,000 in her
stock, and Calvin has a basis of $70,000 in his stock. Therefore, if either Amanda or Calvin later disposes of the Quail stock in a taxable transaction (e.g., a sale), this deferred gain/loss will then be fully
recognized—a $30,000 gain to Amanda and a $10,000 loss to Calvin.
Alternatively, suppose that Amanda and Calvin each received Quail stock worth $50,000 and cash
of $10,000. In this case, Amanda would recognize $10,000 of the $30,000 realized gain because she
received boot of $10,000. In contrast, Calvin’s receipt of boot would not trigger the recognition of a
loss because receiving boot can only trigger gain recognition. This rule means that a shareholder can
never recognize a loss if § 351 applies to a transaction. Additional discussion of gain/loss recognition
and the basis of stock received appears later in the chapter.
The definition of property for § 351 purposes is broad. For example, along with plant
and equipment, unrealized receivables of a cash basis taxpayer and installment notes
4
Proprietary processes and formulas as well as proprietary
information in the general nature of a patentable invention also qualify as property
under § 351.5
Code § 351 specifically excludes services from the definition of property. So a taxpayer must always report as income the fair market value of stock and any other consideration as compensation for services.6 Consequently, when a taxpayer receives stock
as consideration for rendering services to the corporation, the income the taxpayer
recognizes equals the fair market value of the stock received. This immediate taxation
results in a fair market value stock basis for the taxpayer.
Ann and Bob form Olive Corporation with the transfer of the following consideration:
Concept Summary 4.1 summarizes the major shareholder consequences of a taxable
property transaction versus a tax-deferred transaction.
Code § 351 is mandatory if a transaction satisfies the provision’s requirements. As
explained in the following sections, the three requirements for nonrecognition of gain or
loss under § 351 are that (1) property is transferred (2) in exchange for stock
property transferors are in control of the corporation after the exchange. Therefore, if
recognition of gain or loss is desired, the taxpayer must plan to fail to meet at least one
of these requirements.
3
Example
3
Consideration Transferred
Basis to
Transferor
§ 351(b) and Rev.Rul. 68–55.
Defe
–0–
100,000
300,000
$400,000
Gain deferred under § 351; basis of stock
received equals its FMV – deferred gain.
able
If Tax
Amanda
2
rred
Fair Market Value
$
Ethan will contribute $48,000,000 of cash for 4,800 shares of Transformation stock.
What will be the tax and nontax implications relating to the formation of Transformation, Inc.?
Gain recognized; basis of stock received
equals its FMV.
le
Defe
Amount realized
– adjusted basis of
consideration
transferred.
Equipment
FMV $60,000, adjusted basis $30,000
Equipment
FMV $60,000, adjusted basis $70,000
Accounts receivable
Building
Proprietary information—app
4-5
Shareholder Consequences: Taxable Corporate Formation versus Tax-Deferred § 351 Transaction
Amanda and Calvin form Quail Corporation. Amanda transfers equipment with an adjusted basis
of $30,000, fair market value of $60,000, for 50% of the stock, worth $60,000. Calvin transfers
equipment with an adjusted basis of $70,000, fair market value of $60,000, for the remaining 50%
of the stock. The transfers qualify under § 351.
Quail Stock
FMV $60,000
Corporations: Organization and Capital Structure
Concept Summary 4.1
From Ann:
Personal services rendered to Olive
Corporation
From Bob:
Installment note receivable
Inventory
Proprietary process
Fair Market
Value
Number of Shares
Issued
–0–
$20,000
200
5,000
10,000
–0–
40,000
30,000
10,000
$
800
continued
4-14
§ 358(a). See the discussion preceding Example 22.
4
Part 2
Corporations
5
Hempt Brothers, Inc. v. U.S., 74–1 USTC ¶9188, 33 AFTR 2d 74–570, 490 F.2d
1172 (CA–3), and Reg. § 1.453–9(c)(2).
Rev.Rul. 64–56; Rev.Rul. 71–564.
§§ 61 and 83.
6
Chapter 4
The corporation’s holding period for property acquired in a § 351 transfer is the
holding period of the transferor-shareholder regardless of the character of the property
in the transferor’s hands. For instance, whether the property transferred is an ordinary
asset (e.g., inventory), a § 1231 asset, or a capital asset, the corporation’s holding period
is the same as the transferor’s.22
Recapture Considerations
❏❏ Examples are clearly labeled
and directly follow concepts to
assist with student application. An
average of over 40 examples
in each chapter use realistic
situations to illustrate the com­
plexities of the tax law and allow
students to integrate chapter
concepts with illustrations and
examples.
Sales of depreciable assets with a value that exceeds their basis result in ordinary gain
up to the accumulated depreciation deducted. The rest of the gain usually is § 1231 gain.
Because § 351 defers the gain when a shareholder contributes depreciable property to
a corporation, the depreciation recapture potential also transfers to the corporation.23
That is, any recapture potential associated with the property carries over to the corporation. This rule prevents taxpayers from converting ordinary income into § 1231 gain by
transferring the property to a controlled corporation.
Example
22
Paul transfers equipment (adjusted basis of $30,000, original cost of $120,000, and fair market value
of $100,000) to a controlled corporation in return for stock. If Paul had sold the equipment, it would
have yielded a gain of $70,000, all of which would have been treated as ordinary income under the
§ 1245 depreciation recapture rules.
Because the transfer qualifies under § 351, Paul has no recognized gain and no depreciation to
recapture. However, if the corporation later disposes of the equipment in a taxable transaction, it
must take into account the § 1245 recapture potential originating with Paul.
For example, if the corporation were to sell the asset shortly after incorporation for $100,000,
all of the $70,000 gain recognized would be given ordinary treatment because of the depreciation
recapture rules.
It is not uncommon to form a corporation by transferring assets and liabilities of an
unincorporated business. Absent a special rule, the party that enjoys the debt relief
treats it as cash received equal to the debt relief. Without a provision to the contrary,
the transfer of mortgaged property to a controlled corporation could trigger gain to the
property transferor if the corporation took over the mortgage. Paying tax on this “gain”
could discourage corporate formations. For this reason, § 357(a) provides that when a
corporation assumes a liability in a § 351 transaction, the liability is not boot received
treated as boot in determining the basis of the stock received by the shareholder.) As a
result, the liabilities the corporation assumes reduce the basis of the shareholder’s stock.
The Big Picture
Example
23
Return to the facts of The Big Picture on p. 4-1. Assume that you learn that Marco is not interested in
becoming a stockholder in Transformation, Inc., and that Emily and Ethan will transfer their property for
100% of the stock. In addition, you learn that Emily’s building is subject to a liability of $70,000 that Transformation assumes. Consequently, Emily receives her Transformation stock, is relieved of the $70,000
liability, and contributes property with an adjusted basis of $400,000 and fair market value of $2,000,000.
The exchange is tax-free to Emily under § 351 because § 357(a) precludes treating the debt relief
as boot for determining recognized gain. However, the basis to Emily of the Transformation stock is
$330,000 [$400,000 (basis of property transferred) 2 $70,000 (amount of the liability Transformation
assumes)]. This basis reduction reflects the economic benefit that Emily enjoys by transferring her
mortgage to the corporation.
Code § 357(b) provides that if the principal purpose of the assumption of the liabilities is
to avoid tax or if there is no bona fide business purpose behind the exchange, the liabilities are treated as boot for determining recognized gain. Satisfying the bona fide business
purpose under § 357(b) is not difficult if the shareholder incurs the liabilities in the normal
course of conducting a trade or business. But what if the shareholder borrows money
shortly before transferring the property and uses the proceeds for personal purposes?24
This type of situation is economically equivalent to the corporation transferring both
stock and cash to the shareholder, resulting in boot treatment for the liabilities assumed.
Dan transfers real estate with a basis of $140,000 and fair market value of $190,000 to a controlled
corporation in return for stock in the corporation. However, shortly before the transfer, Dan mortgages
the real estate and uses the $20,000 of proceeds to meet personal obligations.
In this case, the assumption of the mortgage lacks a bona fide business purpose. Consequently,
§ 357(b) treats the debt relief as boot received, and Dan has a taxable gain of $20,000 on the transfer.25
Amount realized:
Stock
Release of liability—treated as boot
Total amount realized
Less: Basis of real estate
Realized gain
Recognized gain
§§ 1223(1) and (2).
23
§§ 1245(b)(3), 1250(d)(3), and § 291(a)(1).
Example
24
$ 170,000
20,000
$ 190,000
(140,000)
$ 50,000
$ 20,000
The effect of the application of § 357(b) is to taint all liabilities transferred even if
some have a bona fide business purpose.
Tim, an accrual basis taxpayer, incorporates his sole proprietorship. Among the liabilities transferred
to the new corporation are trade accounts payable of $100,000 and a credit card bill of $5,000. Tim
had used the credit card to purchase an anniversary gift for his spouse.
Under these circumstances, § 357(b) treats all of the $105,000 of liabilities as boot and triggers
gain recognition up to the amount of realized gain.
Example
25
Exception (2): Liabilities in Excess of Basis
The second exception in § 357(c) provides that if the corporation assumes shareholder liabilities that exceed the shareholder’s adjusted basis of contributed
property, the difference is taxable gain. Without this provision, when there are
liabilities in excess of basis in a property exchange, a taxpayer would have a negative
basis in the stock received in the controlled corporation. 26 Code § 357(c) precludes
the negative basis possibility by treating the excess over basis as gain to the transferor.
24
22
4-15
Exception (1): Tax Avoidance or No Bona Fide Business Purpose
4-1f Assumption of Liabilities—§ 357
LO.3
Describe the special rules that
apply when a corporation
assumes shareholder liabilities.
Corporations: Organization and Capital Structure
While treating contributed debt as something other than boot seems like it should
be an easy rule to apply, it creates two potential problems. The first is that shareholders might contribute debt that they only recently incurred and “pocket the cash.” The
shareholder might have done this innocently or might have done it deliberately to get
some cash without recognizing gain. The second problem arises from the stock basis
calculation discussed previously: reducing the stock basis by the debt relief can result
in a stock basis that is less than zero, which makes little sense. The paragraphs below
discuss each of these problems and the tax law’s solutions in detail.
See, for example, Campbell, Jr. v. Wheeler, 65–1 USTC ¶9294, 15 AFTR 2d
578, 342 F.2d 837 (CA–5).
25
§ 351(b).
26
Jack L. Easson, 33 T.C. 963 (1960), rev’d in 61–2 USTC ¶9654, 8 AFTR 2d
5448, 294 F.2d 653 (CA–9).
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Computational Exercises: Students need to learn to apply the rules and concepts covered in each chapter
to truly understand them. These exercises, many of which mirror text examples, allow students to practice and apply what
they are learning.
❏❏ Found in the end-of-chapter sections of the textbook
❏❏ CNOWv2 provides algorithmic versions of these problems
Computational Exercises
19. LO.1, 2 Marie and Ramesh form Roundtree Corporation with the transfer of the
following. Marie performs personal services for the corporation with a fair
market value of $80,000 in exchange for 400 shares of stock. Ramesh contributes
an installment note receivable (basis $25,000; fair market value $30,000), land (basis
$50,000; fair market value $170,000), and inventory (basis $100,000; fair market
value $120,000) in exchange for 1,600 shares. Determine Marie and Ramesh’s current
income, gain, or loss; calculate the basis that each takes in the Roundtree stock.
20. LO.1, 2 Grady exchanges property with a basis of $12,000 and fair market value
of $18,000 for 60% of the stock of Eadie Corporation. Pedro acquired the
other 40% of the stock five years ago. Calculate Grady’s current income, gain, or loss
and the basis he takes in his shares of Eadie stock as a result of this transaction.
Research and Data Analytics Problems:
❏❏ Research Problems provide students with vital practice in an increasingly demanded skill area.
These end-of-chapter items ask students to find and analyze tax documents, helping them to
understand the application of this information in various scenarios. These essential features prepare students for professional tax environments.
Becker Professional Education Review Questions: End-of-chapter CPA Review Questions
from Becker PREPARE STUDENTS FOR SUCCESS. Students review key concepts using proven questions from Becker Professional
Education®—one of the industry’s most effective tools to prepare for the CPA Exam.
❏❏ Located in select
end-­of-chapter sections
❏❏ Tagged by concept in
CNOWv2
❏❏ Questions similar to what
students would actually
find on the CPA Exam
and reporting your findings.
Becker CPA Review Questions
1. Olinto, Inc., has taxable income (before special deductions and the net operating loss
deduction) of $92,000. Included in that amount is $12,000 of interest and dividend
income. Forty percent of Olinto’s property, payroll, and sales are in its home state.
What amount of this taxable income will be taxed by Olinto, Inc.’s home state?
a. $12,000
c. $44,000
b. $36,800
d. $90,000
vii
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See how the SWFT series helps students understand the big picture
and the relevancy behind what they are learning.
The Big Picture
TETRA IMAGES/GETTY
IMAGES
EDWARD ROZZO/CORBIS/GLOW
IMAGES
INC.
Structuring Acquisitions
Rock & Water Corporation (R&W) specializes in industrial park landscaping, like rock walls, holding ponds,
water fountains, and indigenous vegetation. One of R&W’s central missions is to cause as little negative
impact on the environment as possible. Until recently, R&W applied this policy only to its own work, but
the new CEO, Tony Turner, wants to extend its corporate responsibility to its suppliers.
R&W uses several types of chemicals and fertilizers in its business and is aware that three of its suppliers
do not use environmentally sound practices. Realizing that simply changing suppliers will not eliminate
these problematic practices, R&W is considering acquiring these three suppliers. Using this strategy, R&W
would control the production practices of these corporations.
R&W is unsure about how to structure these potential acquisitions of its suppliers and seeks your advice.
R&W gives you the following information about these potential acquisitions.
• BrineCo is a profitable corporation that has been owned predominantly by the Adams family since its
incorporation in 1990. It has virtually no debt because most of its assets date from its incorporation.
• AcidCo, started in 1997, has been having legal troubles and has continually been fined since more stringent EPA standards came into existence. Besides chemicals used by R&W, AcidCo produces acids for the
mining industry. R&W is only interested in acquiring the landscaping chemical business.
• ChemCo is a new fertilizer producer with the technology to produce environmentally safe products.
Its management is inexperienced, however, and the result has been inefficiencies in production and
unintended harm to its surroundings. ChemCo has yet to show a profit.
How will you advise R&W to approach each of these acquisitions?
Read the chapter and formulate your response.
The Big Picture: Tax Solutions for the
Real World. Taxation comes alive at the start of
each chapter as The Big Picture examples provide
a glimpse into the lives, families, careers, and tax
situations of typical taxpayers. Students will follow
a family, individual, or other taxpayer throughout
the chapter, to discover how the concepts they are
learning apply in the real world.
Finally, to solidify student comprehension, each
chapter concludes with a Refocus on The Big
Picture summary and tax planning scenario. These
scenarios re-emphasize the concepts and topics
from the chapter and allow students to confirm their
understanding of the material.
Financial Disclosure Insights:
Tax professionals need to understand how
taxes affect the financial statements. Financial
Disclosure Insights, appearing throughout
the text, use current information about existing
taxpayers to highlight book-tax reporting
differences, effective tax rates, and trends in
reporting conventions.
Financial Disclosure Insights Where Does GAAP Come From?
Tax law has many sources, including Congress
and the legislators of other countries, the courts, and the IRS.
Similarly, accounting principles also have many sources. In
reconciling the tax and financial accounting reporting of a
transaction, the tax professional needs to know the hierarchy
of authority of accounting principles so that the proper level of
importance can be assigned to a specific GAAP document. The
diagram shown below presents the sources of GAAP listed in
general order of authority from highest to lowest.
Highest
Authority
Professional research is conducted to find and analyze
the sources of accounting reporting standards in much the
same way tax professionals conduct research into open
tax questions. In fact, many of the publishers that provide
tax research materials also can be used to find GAAP and
IFRS documents. The Financial Accounting Standards Board
(FASB) also makes its standards and interpretations available
by subscription.
• Financial Accounting Standards and Interpretations of the FASB.
• Pronouncements of bodies that preceded the FASB, such as the Accounting Principles Board (APB).
• FASB Technical Bulletins.
• Audit and Accounting Guides, prepared by the American Institute of CPAs (AICPA) and cleared by the FASB.
• Practice Bulletins, prepared by the AICPA and cleared by the FASB.
•
•
•
•
•
Interpretation Guides of the FASB Staff.
Accounting Interpretations of the AICPA.
IASB Accounting Standards.
FASB Concepts Standards.
Widely accepted accounting practices, professional journals, accounting textbooks, and treatises.
viii
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Ethics & Equity
The Costs of Good Tax Planning
High Tech Tops (HTT), a C corporation based
in California, manufactures resilient cases and covers for laptops, smartphones, and tablets. Its sales and profits have more
than doubled in each of the last five years (i.e., the company
is growth-oriented and recession-proof ). Its employees and
contractors make above-average wages, so they make important contributions to the local individual income, sales, and
property tax collections.
But the Federal and state corporate income tax is
another story. Using legal and effective transfer pricing
techniques, HTT shifts most of its operating profits to
low-tax subsidiaries in Ireland and Singapore. Most of the
firm’s executives, engineers, and designers are based in
the United States, but almost all of the sales operations
are run from overseas. HTT’s customers live around the
world, but its tax liabilities are concentrated in the low-tax
jurisdictions.
You are the president of State University, across town
from HTT’s headquarters. The company sends hundreds of
its employees to take graduate and professional courses on
your campus, and several of the corporate leaders are frequent
guest speakers and adjunct lecturers in classes.
Still, the state income tax the company avoids through its
transfer pricing plans would fund millions of dollars of campus
growth and improvements for State University.
Should you become involved in the politics of the matter
and lobby at your statehouse for tighter rules on transfer pricing? Such an action might result in tax increases that would
improve your university’s situation, but it also might force HTT
to consider moving its headquarters to another location.
Ethics & Equity: These features will
spark critical thinking and invite classroom
discussion, enticing students to evaluate
their own value system. Suggested reactions
to Ethics & Equity scenarios appear in the
Solutions Manual.
9-8 Tax Planning
Tax Planning: Chapters include
a separate section calling attention to
how taxpayers can use the law to reach
financial and other goals. Tax planning
applications and suggestions appear
throughout each chapter, as pertinent
topics are discussed.
Tax planning techniques for the multinational taxpayer are effective when they combine
opportunities presented by Federal income tax law, the tax provisions and economic
incentives offered by the overseas jurisdictions in which business is conducted, incomeshifting devices, and the use of tax treaties and tax havens.
Return to the timeline of Exhibit 9.6, and consider the decision to operate a multinational business entity as a branch and when to convert the structure of the business
to an overseas subsidiary. Exhibit 9.9 identifies the major advantages and disadvantages
for each of these decisions from a Federal income tax standpoint.
Additional tax planning opportunities and considerations are discussed below.
9-8a The Foreign Tax Credit Limitation and
Sourcing Provisions
The FTC limitation is partially based on the amount of foreign-source taxable income
in the numerator of the limitation formula. Consequently, the sourcing of income is
extremely important. Generally, in this regard, the U.S. taxpayer benefits when the
sourcing rules work to:
• Generate income items that are foreign-source, to maximize net foreign-source
income (the numerator of the FTC fraction). Alternatively, a branch or flow-through
entity might want overseas income to be U.S.-source, to increase its 20 percent
deduction for qualified business income.61
• Realize deduction items as U.S.-source, to minimize any reduction in net foreignsource income (the numerator of the FTC fraction).
Global Tax Issues
Tax Reform Adds a New Wrinkle to the Choice of
Organizational Form When Operating Overseas
When the management of a corporation decides to expand its
business by establishing a presence in a foreign market, the new
business venture may take one of several organizational forms.
As each form comes with its respective advantages and disadvantages, making the best choice can be difficult. And the choice
is even more challenging now because a new set of rules applies
to the taxation of international operations with the enactment
of the Tax Cuts and Jobs Act (TCJA) of 2017.
One common approach is to conduct the foreign activity as
a branch operation of the U.S. corporation. The foreign branch
is not a separate legal entity, but a division of the U.S. corporation established overseas. As a result, the U.S. corporation
includes in its financial results any gains and losses that the
foreign branch produces.
Another common approach to foreign expansion is to
organize the foreign operations as a subsidiary of the U.S.
parent corporation. The subsidiary may be either a domestic
subsidiary (i.e., organized in the United States) or a foreign subsidiary (organized under the laws of a foreign country).
One fundamental tax difference between these two
approaches is that parent corporations can elect to consolidate
the gains and losses of a domestic subsidiary with the operations of the U.S. parent, but not with the operations of a foreign
subsidiary. Thus, the use of a domestic subsidiary to conduct
foreign operations generally yields the same final result as the
use of a branch. With both approaches, the financial statements
of the U.S. parent reflect the results of its worldwide operations.
The TCJA of 2017 changed many of the tax rules associated
with international operations and their impact on organizational
forms. Now the United States uses a “territorial system” when
taxing foreign earnings from a foreign subsidiary. These rules
generally require U.S. corporations to pay U.S. tax only on their
domestic income. Given the complexity of the organizational
form decisions and the significance of the changes to international taxation rules in the TCJA of 2017, it will take time for tax
professionals to determine the most tax-effective ways of structuring foreign operations of U.S. corporations. See Chapter 9 for
additional discussion of the taxation of international operations.
Global Tax Issues: This
feature gives ­insight into the ways
in which taxation is affected by
international concerns and illustrates
the effects of various events on tax
liabilities across the globe.
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Take your students from Motivation to Mastery with CNOWv2
CNOWv2 is a powerful course management tool and online homework
resource that elevates student thinking by providing superior content designed
with the entire student workflow in mind.
❏❏ Motivation: engage students and better prepare them for class
❏❏ Application: help students learn problem-solving behavior and skills
to guide them to complete taxation problems on their own
❏❏ Mastery: help students make the leap from memorizing concepts to
actual critical thinking
Motivation —
To help with student engagement and
preparedness, CNOWv2 for SWFT offers:
❏❏ “Tax Drills” test students on key
concepts and applications. With
three to five questions per learning
objective, these “quick-hit” questions
help students prepare for class
lectures or review prior to an exam.
Application —
Students need to learn problem-solving
behavior and skills, to guide them to
complete taxation problems on their own.
However, as students try to work through
homework problems, sometimes they need
extra help. To reinforce concepts and keep
students on the right track, CNOWv2 for
SWFT offers the following:
❏❏ End-of-chapter homework from the
text is expanded and enhanced to follow
the workflow a professional would use
to solve various client scenarios. These
enhancements better engage students
and encourage them to think like a tax
professional.
x
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❏❏ Algorithmic versions of end-of-chapter homework are available for computational exercises and at least
15 problems per chapter.
❏❏ “Check My Work” Feedback. Homework questions include immediate feedback so students can learn as they
go. Levels of feedback include an option for “check my work” prior to submission of an assignment.
❏❏ Post-Submission Feedback. After submitting an assignment, students receive even more extensive feedback
explaining why their answers were incorrect. Instructors can decide how much feedback their students receive
and when, including the full solution.
❏❏ Built-in Test Bank for online assessment.
Mastery —
❏❏ Tax Form Problems give students the
option to complete the Cumulative Intuit
ProConnect Tax problems and other
home­
work items found in the end-ofchapter material manually or in a digital
environment.
❏❏ An Adaptive Study Plan comes complete with an eBook, practice quizzes,
glossary, and flashcards. It is designed to
help give students additional support and
prepare them for the exam.
CNOWv2 Instant Access Code ISBN:
978-0-357-72001-1
Contact your Cengage Learning Consultant
about different bundle options.
xi
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xii
Preface
Extensively Revised. Definitively Up to Date.
Each year the South-Western Federal Taxation
series is updated with thousands of changes to each
text. Some of these changes result from the feedback
we receive from instructors and students in the form
of reviews, focus groups, web surveys, and personal
e-mail correspondence to our authors and team members. Other changes come from our careful analysis
of the evolving tax environment. We make sure that
every tax law change relevant to the second taxation course was considered, summarized, and
fully integrated into the revision of text and supplementary ­materials.
The South-Western Federal Taxation authors
have made every effort to keep all materials up to date
and accurate. All chapters contain the following general
changes for the 2023 Edition:
•• Updated materials to reflect changes made
through legislative action, new administrative
rulings, and court decisions.
•• Streamlined chapter content (where applicable)
to clarify material and make it easier for students
to understand.
•• Revised numerous materials as the result of
changes caused by indexing of statutory amounts.
•• Revised Problem Materials, Computational
Exercises, and CPA Exam problems.
•• Updated Chapter Outlines to provide an overview
of the material and to make it easier to locate
specific topics.
•• Revised Financial Disclosure Insights and Global
Tax Issues for current developments.
•• Added a “Planning” icon to end-of-chapter
questions requiring tax planning considerations.
In addition, the following materials are available online:
•• An appendix that helps instructors broaden and
customize coverage of important tax provisions
of the Affordable Care Act. (Instructor Companion
Website at www.cengage.com/login)
•• The Depreciation and the Accelerated Cost
Recovery System (ACRS) appendix. (Instructor
Companion Website at www.cengage.com/login)
Chapter 1
•• Chapter materials (including various references
and citations) were updated; exhibits and concept
summaries were modified for new sources
(including IRS FAQs).
19961_fm_hr_i-xxxvi.indd 12
•• Added several new problems (simple research
exercises) and updated other end-of-chapter
materials as needed.
Chapter 2
•• Modified The Big Picture example to include a
“name, image, and likeness” (NIL) contract and
ask whether the activity is a trade or business.
•• Added a The Big Picture example related to
what activities constitute a trade or business for
purposes of § 199A.
•• Updated example illustrating the completion of
2021 Form 8995–A and Schedule A (Form 8995–A).
•• Revised and clarified materials based on feedback
from adopters.
•• Updated end-of-chapter materials as needed
(including revisions for inflation adjustments to
threshold limits and 2021 Form 8995).
Chapter 3
•• Revised and clarified chapter materials as needed
(including inflation adjustments).
•• Added discussion regarding 2022 change in
computation of adjusted taxable income for
purposes of the business interest expense
limitation; depreciation (and some other items) no
longer reduce ATI. Added an example illustrating
the impact of this change.
•• Added new Research Problem 6 requiring data
analytics and the use of visual presentation (i.e.,
pie chart).
•• Added two new Becker CPA Review Questions.
Chapter 4
•• Emphasized the tax planning aspects of two problems.
•• Modified a “thin capitalization” problem to
emphasize critical thinking and practice-related
aspects of the problem.
•• Further streamlined the writing in the chapter to
reduce passive voice sentences.
•• Revised and updated chapter materials as needed.
Chapter 5
•• Revised and updated chapter materials based
on adopter feedback; updated end-of-chapter
materials as needed.
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Preface
Chapter 6
•• Revised and clarified chapter materials as needed.
•• Added new Research Problem 4 requiring the use
of Thomson Reuters Checkpoint™.
Chapter 7
•• Added new Ethics & Equity feature entitled
“Trafficking in Net Operating Losses.”
•• Added new Financial Disclosure Insights feature
entitled “Blank Check Companies.”
•• Added new Financial Disclosure Insights feature
entitled “Offensive versus Defensive Reorganizations.”
•• Exhibit 7.6 illustrates three possibilities for a
proposed reorganization transaction.
•• Updated visualization tools for some problems in
the text to improve understanding of proposed
and completed transactions.
Chapter 8
•• Added text Section 8-6e in Tax Planning section.
•• Updated statistics about consolidated federal
income tax returns.
•• Revised discussion concerning various motivations
to create a consolidated Federal tax group.
•• Revised tax effects listed in Exhibit 8.1.
•• Revised language concerning subsidiary stock
basis and excess loss accounts.
Chapter 9
•• Expanded the discussion of text Section 9-5e
[Global Intangible Low-Taxed Income (GILTI)],
including Concept Summary 9.5 on computing
GILTI, and Exhibit 9.8 on computing gross and
net tested income, and added a number of new
examples to illustrate the text materials.
•• Updated and added statistics about the global
economy, worldwide tax rates, treaty withholding
rates, advance pricing agreements, FTC deferrals,
and CFCs.
•• Added new discussion question, computational
exercise, and problem related to GILTI.
•• Based on adopter feedback, revised remainder of
text and end-of-chapter materials.
Chapter 10
•• Added references to § 721(c) and new Schedules
K–2 and K–3.
19961_fm_hr_i-xxxvi.indd 13
xiii
•• Expanded discussion for new tax basis capital
account reporting. The chapter provides more
detailed comparisons between tax basis capital
accounts, GAAP capital accounts, and § 704(b)
book capital accounts, as well as ramifications of
new reporting requirements.
•• Added reference to the new § 1061 regulation
project and pending legislation.
Chapter 11
•• Refined outline of text Section 11-3b to include
separate subsections for hot assets and carried
interests.
•• Modified Global Tax Issues to include discussion
of current SALT (state and local taxation) issues.
•• Updated Death of a Partner section to include
notes regarding successor partner’s capital account.
•• Modified end-of-chapter materials to include
planning and practice components where relevant.
Chapter 12
•• Updated Exhibit 12.1 statistics comparing
business entities.
•• Made minor revisions and clarifications, including
many date changes.
•• Added two new Research Problems, including
one requiring the use of Thomson Reuters
Checkpoint™.
•• Added two new Becker CPA Review Questions.
Chapter 13
•• Updated information in Exhibit 13.1 for number
of businesses conducted in various organizational
forms.
•• Expanded the discussion of the nontax
characteristics of various organizational forms,
relating them more directly to the conduit and
entity perspectives taken to business entities, and
describing them as contributing to the relative
ability of each to raise capital.
•• Added description of publicly traded partnerships.
•• Enhanced the distinction of partnerships and LLCs
in various problems covering the tax and nontax
characteristics of each.
•• Added a new problem requiring the review of
a semi-complete Schedule K–1 (1065) and the
computation of self-employment earnings for a
partner.
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xiv
Preface
Chapter 14
•• Deleted text Section 14-4c (Repeal of the
Corporate Alternative Minimum Tax); text
discussed the corporate alternative minimum tax
and the deferred tax assets it created.
•• Updated Financial Disclosure Insights feature to
discuss profitable corporations paying no income
tax in 2020.
•• Revised Ethics & Equity feature with new
information regarding uncertain tax positions on
companies reporting benefits for positions that
have failed to be upheld in court.
•• Added a computational exercise on the effect of
tax rates changes on reported tax expense.
•• Added a problem requiring the creation of an
Excel workbook to perform calculations related to
a tax provision.
•• Revised and updated remaining chapter text and
end-of-chapter materials as needed.
Chapter 15
•• Revised Learning Objective 4 and the title of text
Section 15-4 to include the term “public charities.”
•• Revised introduction to taxation of exempt
entities, and how the entity’s net earnings can be
used.
•• Updated statistics about the exempt economy and
Federal taxation of it, unrelated business income,
and concerning private foundations and university
endowments.
•• Revised the introduction to the tax on lobbying by
exempt entities.
•• Replaced Research Problem 2.
Chapter 17
•• Updated statistics about the IRS and the tax
collection/enforcement process.
•• Updated statistics about the tax gap and the
return on investment in the IRS, IRS user fees, and
taxpayer attitudes toward tax cheating.
•• Updated materials and statistics about the
abatement of penalties for first-time offenders.
•• Included the GLBA responsibilities of the
tax preparer as to data security for taxpayer
information and operating/storage systems.
•• Added a new Excel requirement to one
computational exercise and one problem.
Chapter 18
•• Replaced Research Problem 6 with a question
about the Ultra-Millionaire Tax Act.
•• Updated end-of-chapter material as needed;
revised other materials as needed.
Chapter 19
•• Updated chapter materials to reflect inflation
adjustments to §§ 2010, 2032A, 2503(b), and
6601(j).
•• Based on adopter feedback, revised other chapter
text and end-of-chapter materials as needed.
Chapter 20
•• Updated end-of-chapter materials as needed;
revised other materials as needed.
Chapter 16
•• Updated discussion of P.L. 86–272 for the
August 2021 update to the MTC’s Statement of
Information Concerning Practices of Multistate
Tax Commission and Signatory States Under
Public Law 86–272.
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Preface
xv
Tax Law Outlook
From your SWFT Series Editors:
Legislation related to the COVID-19 pandemic was a vehicle for tax changes in 2021, including a wide variety of tax changes incorporated into the American Rescue Plan Act of 2021. The Biden administration and
Congress continue to discuss a wide variety of tax law changes. Although the Build Back Better plan was not
enacted, pieces of that proposal are likely to be debated (and possibly adopted) before the end of 2022. In
addition, it is likely that Congress will return to its pattern of extending expired and expiring tax provisions
sometime in 2022.
Annually, the Joint Committee on Taxation publishes a report of all expired and expiring provisions in the
tax law. The report released in January 2022 lists 40 provisions that expired in 2021 (jct.gov/publications/
2022/jcx-1-22/). This list does not include the change to § 174 for R&D expenditures to be capitalized and
amortized (rather than currently expensed) for tax years beginning after 2021. The Build Back Better Act
passed by the House in November 2021 extended that date by four years. If that act does not become law, it
is likely that Congress will find another way to extend the effective date of this change that originated with
the Tax Cuts and Jobs Act of 2017.
Taxpayers and their advisers will need to evaluate how these changes affect their financial planning strategies and adjust their plans appropriately. The SWFT editors will be monitoring these activities and provide
updates to adopters as needed.
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xvi
Preface
Supplements Support Students and Instructors
Built around the areas students and instructors have identified as the most important, our integrated supplements
package offers more flexibility than ever before to suit the way instructors teach and students learn.
Online and Digital Resources
for Students
Online access to ProConnect™ Tax software is offered
with each NEW copy of the textbook—at no additional
cost to students.*
can use
www.cengage.com Students
www.cengage
CNOWv2 is a powerful course management and online
homework tool that provides robust instructor control
and customization to optimize the student learning experience and meet desired outcomes.
CNOWv2 Instant Access Code ISBN:
978-0-357-72001-1
Contact your Cengage Learning Consultant about different bundle options.
Thomson Reuters Checkpoint™
is the leading online tax
research database used by professionals. Checkpoint™ helps introduce students to tax
research in three simple ways.
•• Intuitive web-based design makes it fast and
simple to find what you need.
•• Checkpoint™ provides a comprehensive collection
of primary tax law, cases, and rulings along with
analytical insight you simply can’t find anywhere
else.
•• Checkpoint™ has built-in productivity tools such
as calculators to make research more efficient—a
resource more tax pros use than any other.
Six months’ access to Checkpoint™ (after activation) is
packaged automatically with every NEW copy of the
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•• It’s all online, so there’s nothing to install or maintain.
.com to select this textbook and access Cengage Learning
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the course. Buy printed materials, eBooks, and digital
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Online Student Resources
Students can go to www.cengage.com for free resources
to help them study as well as the opportunity to purchase additional study aids. These valuable free study
resources will help students earn a better grade.
•• Flashcards use chapter terms and definitions to aid
students in learning tax terminology for each chapter.
•• Online glossary for each chapter provides terms
and definitions from the text in alphabetical order
for easy reference.
•• Learning objectives can be downloaded for each
chapter to help keep students on track.
•• Tax tables used in the textbook are downloadable
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This version provides all the pages of the text in an unbound, three-hole-punched format for portability and
ease of use. Online access to ProConnect™ Tax software
is included with every NEW textbook as well as Checkpoint™ from Thomson Reuters.*
*NEW printed copies of the textbook are automatically packaged with access to Checkpoint™ and ProConnect™ Tax software. If students
purchase the eBook, they will not automatically receive access to Checkpoint™ and ProConnect™ Tax software.
19961_fm_hr_i-xxxvi.indd 16
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Preface
Comprehensive Supplements Support
Instructors’ Needs
CNOWv2 is a powerful course management and online
homework tool that provides robust instructor control and
customization to optimize the student learning experience
and meet desired outcomes. In addition to the features
and benefits mentioned earlier for students, CNOWv2
includes these features for instructors.
•• Learning Outcomes Reporting and the ability to analyze student work from the gradebook.
Each exercise and problem is tagged by topic,
learning objective, level of difficulty, estimated
completion time, and business program standards
to allow greater guidance in developing assessments and evaluating student progress.
•• Built-in Test Bank for online assessment. The
Test Bank files are included in CNOWv2 so that
they may be used as additional homework or
tests.
xvii
Each test item is tagged with its Estimated Time to
Complete, Level of Difficulty, and Learning Objective(s),
as well as the AACSB’s and AICPA’s core competencies—
for easier instructor planning and test item selection. The
2023 Test Bank is available in Cengage’s test generator
software, Cognero.
Cengage Learning Testing Powered by Cognero is a
flexible, online system that allows you to:
•• author, edit, and manage Test Bank content from
multiple Cengage Learning solutions
•• create multiple test versions in an instant
•• deliver tests from your LMS, your classroom, or
wherever you want
•• create tests from school, home, the coffee shop—
anywhere with Internet access (No special installs
or downloads needed.)
Test Bank files in Word format as well as versions to
­import into your LMS are available on the Instructor Companion Website. Cognero Test Banks are available via
single sign-on (SSO) account at www.cengage.com/
login.
Solutions Manual
Other Instructor Resources
Written by the South-Western Federal Taxation
­editors and authors, the Solutions Manual features solutions arranged in accordance with the sequence of chapter material.
Solutions to all homework items are tagged with
their Estimated Time to Complete, Level of Difficulty, and
Learning Objective(s), as well as the AACSB’s and AICPA’s
core competencies—giving instructors more control than
ever in selecting homework to match the topics covered.
The Solutions Manual also contains the solutions to the
Tax Return Problems and answers with explanations
to the end-of-chapter Becker CPA Review Questions.
Available on the Instructor Companion Website at
www.cengage.com/login.
All of the following instructor course materials are
available online at www.cengage.com/login. Once
logged into the site, instructors should select this textbook
to access the online Instructor Resources.
PowerPoint® Lectures with Notes
Cengage Learning Custom Solutions develops personalized solutions to meet your taxation education needs.
Consider the following for your adoption of South-­
Western Federal Taxation 2023 Edition.
The Instructor PowerPoint® Lectures contain more than
30 slides per chapter, including outlines and instructor
guides, concept definitions, and key points. Available on
the Instructor Companion Website at www.cengage
.com/login.
Test Bank
Written by the South-Western Federal Taxation editors
and authors, the Test Bank contains approximately 2,200
items and solutions arranged in accordance with the
sequence of chapter material.
19961_fm_hr_i-xxxvi.indd 17
•• Instructor Guide
•• Edition-to-edition correlation grids by chapter
•• An appendix that helps instructors broaden and
customize coverage of important tax provisions of
the Affordable Care Act
•• Depreciation and the Accelerated Cost Recovery
System (ACRS) appendix
Custom Solutions
•• Remove chapters you do not cover or rearrange
their order to create a streamlined and efficient
text.
•• Add your own material to cover additional topics
or information.
•• Add relevance by including sections from
Sawyers/Gill’s Federal Tax Research or your
state’s tax laws and regulations.
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xviii
Preface
Acknowledgments
We want to thank all the adopters and others who participated in numerous online surveys as well as the following individuals who provided content reviews and feedback in the development of the South-Western Federal Taxation 2023 titles.
William A. Raabe / James C. Young / Annette Nellen / Bradrick M. Cripe /
Sharon S. Lassar / Mark B. Persellin / Andrew D. Cuccia
Ken Abramowicz, University of Alaska
Fairbanks
Lindsay G. Acker, University of Wisconsin –
Madison
Deborah S. Adkins, Nperspective, LLC
Mark P. Altieri, Kent State University
Susan E. Anderson, Elon University
Henry M. Anding, Woodbury University
Jennifer A. Bagwell, Ohio University
George Barbi, Lanier Technical College
Terry W. Bechtel, Texas A&M University –
Texarkana
Chris Becker, LeMoyne College
Tamara Berges, UCLA
Ellen Best, University of North Georgia
Tim Biggart, Berry College
Rachel Birkey, Illinois State University
Israel Blumenfrecht, Queens College
Patrick M. Borja, Citrus College /
California State University, Los Angeles
Dianne H. Boseman, Nash Community
College
Cathalene Bowler, University of Northern
Iowa
Madeline Brogan, Lone Star College –
Montgomery
Darryl L. Brown, Illinois Wesleyan U
­ niversity
Timothy G. Bryan, University of Southern
Indiana
Robert S. Burdette, Salt Lake Community
College
Ryan L. Burger, Concordia University
Nebraska
Lisa Busto, William Rainey Harper College
Julia M. Camp, Providence College
Al Case, Southern Oregon University
Machiavelli W. Chao, Merage School of Business, University of California, Irvine
Eric Chen, University of Saint Joseph
Christine Cheng, Louisiana State University
James Milton Christianson, Southwestern
University and Austin Community
College
Wayne Clark, Southwest Baptist University
Ann Burstein Cohen, University at Buffalo,
The State University of New York
Ciril Cohen, Fairleigh Dickinson University
Seth Colwell, University of Texas – Rio
Grande Valley
Dixon H. Cooper, University of Arkansas
John P. Crowley, Castleton University
Susan E. M. Davis, South University
Dwight E. Denman, Newman University
James M. DeSimpelare, Ross School of
Business at the University of Michigan
19961_fm_hr_i-xxxvi.indd 18
John Dexter, Northwood University
James Doering, University of Wisconsin –
Green Bay
Michael P. Donohoe, University of Illinois
at Urbana Champaign
Deborah A. Doonan, Johnson & Wales
University
Monique O. Durant, Central Connecticut
State University
Wayne L. Edmunds, Virginia Commonwealth University
Rafi Efrat, California State University,
Northridge
Frank J. Faber, St. Joseph’s College
A. Anthony Falgiani, University of South
Carolina, Beaufort
Jason Fiske, Thomas Jefferson School of Law
John Forsythe, Eagle Gate College
Alexander L. Frazin, University of Redlands
Carl J. Gabrini, College of Coastal Georgia
Kenneth W. Gaines, East-West University,
Chicago, Illinois
Carolyn Galantine, Pepperdine University
Sheri Geddes, Hope College
Alexander Gelardi, University of St. Thomas
Joel Gelb, Farleigh Dickinson University
Daniel J. Gibbons, Waubonsee
Community College
Martie Gillen, University of Florida
Charles Gnizak, Fort Hays State University
J. David Golub, Northeastern University
George G. Goodrich, John Carroll
University
Marina Grau, Houston Community
College – Houston, TX
Vicki Greshik, University of Jamestown
College
Jeffrey S. Haig, Santa Monica College
Marcye S. Hampton, University of Central
Florida
June Hanson, Upper Iowa University
Donald Henschel, Benedictine University
Kenneth W. Hodges, Sinclair
Community College
Susanne Holloway, Salisbury University
Susan A. Honig, Herbert H. Lehman ­College
Jeffrey L. Hoopes, University of North
Carolina
Christopher R. Hoyt, University of Missouri
(Kansas City) School of Law
Marsha M. Huber, Youngstown State
University
Carol Hughes, Asheville-Buncombe
­Technical Community College
Helen Hurwitz, Saint Louis University
Richard R. Hutaff, Wingate University
Zite Hutton, Western Washington
University
Steven L. Jager, Cal State Northridge
Janeé M. Johnson, University of Arizona
Brad Van Kalsbeek, University of Sioux
Falls
Carl Keller, Missouri State University
Cynthia Khanlarian, Concord University
Bob G. Kilpatrick, Northern Arizona
University
Gordon Klein, UCLA Anderson
School
Taylor Klett, Sam Houston State University
Aaron P. Knape, Peru State College
Cedric Knott, Colorado State University –
Global Campus
Ausher M. B. Kofsky, Western New
­England University
Emil Koren, Saint Leo University
Jack Lachman, Brooklyn College – CUNY
Adena LeJeune, Louisiana College
Gene Levitt, Mayville State University
Teresa Lightner, University of North
Texas
Sara Linton, Roosevelt University
Roger Lirely, The University of Texas at
Tyler
Jane Livingstone, Western Carolina
University
Heather Lynch, Northeast Iowa
Community College
Mabel Machin, Florida Institute of
­Technology
Maria Alaina Mackin, ECPI University
Anne M. Magro, George Mason
University
Richard B. Malamud, California State
University, Dominguez Hills
Harold J. Manasa, Winthrop University
Barry R. Marks, University of Houston –
Clear Lake
Dewey Martin, Husson University
Anthony Masino, East Tennessee State
University
Norman Massel, Louisiana State University
Bruce W. McClain, Cleveland State
­University
Jeff McGowan, Trine University
Allison M. McLeod, University of
North Texas
Meredith A. Menden, Southern New
Hampshire University
Robert H. Meyers, University of Wisconsin –
Whitewater
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Preface
John G. Miller, Skyline College
Tracie L. Miller-Nobles, Austin Community
College
Jonathan G. Mitchell, Stark State College
Richard Mole, Hiram College
David Morack, Lakeland University
Lisa Nash, University of North Georgia
Mary E. Netzler, Eastern Florida State
College
Joseph Malino Nicassio, Westmoreland
County Community College
Mark R. Nixon, Bentley University
Garth Novack, Pantheon Heavy Industries
& Foundry
Claude R. Oakley, DeVry University, Georgia
Al Oddo, Niagara University
Sandra Owen, Indiana University –
Bloomington
Vivian J. Paige, Old Dominion University
Carolyn Payne, University of La Verne
Ronald Pearson, Bay College
Thomas Pearson, University of Hawaii at
Manoa
Nichole L. Pendleton, Friends University
Chuck Pier, Angelo State University
Lincoln M. Pinto, DeVry University
Sonja Pippin, University of Nevada – Reno
Steve Platau, The University of Tampa
Elizabeth Plummer, TCU
Walfyette Powell, Strayer University
Dennis Price, Samford University
Darlene Pulliam, West Texas A&M ­University
Thomas J. Purcell, Creighton University
John S. Repsis, University of Texas at
Arlington
Jennifer Hardwick Robinson, Trident
Technical College
Shani N. Robinson, Sam Houston State
University
Donald Roth, Dordt College
Richard L. Russell, Jackson State University
Robert L. Salyer, Northern Kentucky
­University
Rhoda Sautner, University of Mary
Bunney L. Schmidt, Keiser University
Allen Schuldenfrei, University of
Maryland – Baltimore County
Eric D. Schwartz, LaRoche College
Tony L. Scott, Norwalk Community College
Randy Serrett, University of Houston –
Downtown
Wayne Shaw, Southern Methodist University
Paul A. Shoemaker, University of
Nebraska – Lincoln
Kimberly Sipes, Kentucky State University
Georgi Smatrakalev, Florida Atlantic
University
Randy Smit, Dordt College
Leslie S. Sobol, California State University
Northridge
Eric J. Sommermeyer, Wartburg ­College
Marc Spiegel, University of California,
Irvine
Teresa Stephenson, University of Alaska
Anchorage
Beth Stetson, Oklahoma City University
Debra Stone, Eastern New Mexico University
Frances A. Stott, Bowling Green State
University
Todd S. Stowe, Southwest Florida College
Julie Straus, Culver-Stockton College
Martin Stub, DeVry University
James Sundberg, Eastern Michigan
University
xix
Kent Swift, University of Montana
Robert L. Taylor, Lees-McRae College
Francis C. Thomas, Richard Stockton
College of New Jersey
Randall R. Thomas, Upper Iowa
University
Ronald R. Tidd, Central Washington
University
MaryBeth Tobin, Bridgewater State
­University
James P. Trebby, Marquette University
Heidi Tribunella, University of Rochester
James M. Turner, Georgia Institute of
Technology
Anthony W. Varnon, Southeast Missouri
State University
Adria Palacios Vasquez, Texas A&M
University – Kingsville
Stanley Veliotis, Fordham University
Terri Walsh, Seminole State College of
Florida Marie Wang
Natasha R. Ware, Southeastern University
Mark Washburn, Sam Houston State
University
Bill Weispfenning, University of Jamestown
(ND)
Kent Williams, Indiana Wesleyan
University
Candace Witherspoon, Valdosta State
University
Sheila Woods, DeVry University,
Houston, TX
Xinmei Xie, Woodbury University
Thomas Young, Lone Star College – Tomball
Special Thanks
We are grateful to the faculty members who have diligently worked through the problems and test questions to ensure
the accuracy of the South-Western Federal Taxation homework, solutions manuals, test banks, and comprehensive
tax form problems. Their comments and corrections helped us focus on clarity as well as accuracy and tax law currency. We also thank Thomson Reuters for its permission to use Checkpoint™ with the text.
Sandra A. Augustine, (retired) Hilbert
College
Robyn Dawn Jarnagin, University of
Arkansas
Kate Mantzke, Northern Illinois University
Ray Rodriguez, Murray State University
19961_fm_hr_i-xxxvi.indd 19
Miles Romney, Florida State University
George R. Starbuck, McMurry University
Donald R. Trippeer, State University of
New York College at Oneonta
Raymond Wacker, Southern Illinois
­University, Carbondale
Michael Weissenfluh, Tillamook Bay
Community College
Marvin Williams, University of
Houston – Downtown
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The South-Western Federal Taxation Series
To find out more about these books, go to www.cengage.com.
Individual Income Taxes, 2023 Edition
(Young, Nellen, Raabe, Persellin, Lassar, Cuccia, Cripe,
Editors) provides accessible, comprehensive, and authoritative
coverage of the relevant tax code and regulations as they pertain
to the individual taxpayer, as well as coverage of all major
developments in Federal taxation.
(ISBN 978-0-357-71982-4)
Corporations, Partnerships, Estates & Trusts,
2023 Edition
(Raabe, Young, Nellen, Cripe, Lassar, Persellin, Cuccia, Editors)
covers tax concepts as they affect corporations, partnerships, estates,
and trusts. The authors provide accessible, comprehensive, and
authoritative coverage of relevant tax code and regulations, as well
as all major developments in Federal income taxation. This marketleading text is intended for students who have had at least one
previous course in tax.
(ISBN 978-0-357-71996-1)
xx
19961_fm_hr_i-xxxvi.indd 20
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Preface
xxi
Comprehensive Volume, 2023 Edition
(Young, Nellen, Maloney, Persellin, Cuccia, Lassar, Cripe,
Editors) Combining the number one individual tax text with
the number one tax entities text, Comprehensive Volume, 2023
Edition is a true winner. An edited version of the first two
South-Western Federal Taxation textbooks, this book is ideal
for undergraduate or graduate levels. This text works for either
a one-semester course in which an instructor wants to integrate
coverage of individual and corporate taxation or for a twosemester sequence in which the use of only one book is desired.
(ISBN 978-0-357-71968-8)
Essentials of Taxation: Individuals and Business
Entities, 2023 Edition
(Nellen, Cuccia, Persellin, Young, Editors) emphasizes tax
planning and the multidisciplinary aspects of taxation. This
text is designed with the AICPA Model Tax Curriculum in
mind, presenting the introductory Federal taxation course from
a business entity perspective. Its Tax Planning Framework
helps users fit tax planning strategies into an innovative
pedagogical framework. The text is an ideal fit for programs
that offer only one course in taxation where users need to be
exposed to individual taxation, as well as corporate and other
business entity taxation. This text assumes no prior course in
taxation has been taken.
(ISBN 978-0-357-72010-3)
Federal Tax Research, 12E
(Sawyers and Gill) Federal Tax Research, Twelfth Edition, offers
hands-on tax research analysis and fully covers computer-oriented
tax research tools. Also included in this edition is coverage on
international tax research, a review of tax ethics, and many new
real-life cases to help foster a true understanding of Federal tax
law.
(ISBN 978-0-357-36638-7)
19961_fm_hr_i-xxxvi.indd 21
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xxii
Preface
About the Editors
William A. Raabe, Ph.D.,
Annette Nellen, J.D., CPA,
CPA, was the Wisconsin
Distinguished Professor of
Taxation. He taught at Ohio
State, Arizona State, the
Capital University (OH) Law
School, and the Universities
of Wisconsin – Milwaukee
and Whitewater. A graduate of Carroll University
(Wisconsin) and the University of Illinois, Dr. Raabe was
a visiting tax faculty member for a number of public
accounting firms, bar associations, and CPA societies. He
has received numerous teaching awards, including the
Accounting Educator of the Year award from the Wisconsin Institute of CPAs.
CGMA, directs San José State
University’s graduate tax
program (MST) and teaches
courses in tax research, tax
fundamentals, accounting
methods, property transactions, employment tax,
ethics, leadership, and tax
policy. Professor Nellen is
a graduate of CSU Northridge, Pepperdine (MBA),
and Loyola Law School. Prior to joining SJSU in 1990, she
was with a Big 4 firm and the IRS. At SJSU, Professor
Nellen is a recipient of the Outstanding Professor and
Distinguished Service Awards. Professor Nellen is an active
member of the tax sections of the AICPA and ­American
Bar Association. In 2013, she received the AICPA Arthur
J. Dixon Memorial Award, the highest award given by
the accounting profession in the area of taxation. Professor Nellen is the author of BloombergBNA Tax Portfolio,
Amortization of Intangibles. She has published numerous articles in the AICPA Tax Insider, Tax Adviser, Tax
Notes State, and The Journal of Accountancy. She has
testified before the House Ways & Means and Senate
Finance Committees and other committees on Federal
and state tax reform. Professor Nellen maintains the 21st
Century Taxation Website and blog (21stcenturytaxation
.com) as well as Websites on tax policy and reform,
­virtual currency, and state tax issues (sjsu.edu/­people/
annette.nellen/).
James C. Young is the PwC
Professor of Accountancy at
Northern Illinois University. A graduate of Ferris
State University (B.S.) and
Michigan State University
­
(M.B.A. and Ph.D.), Jim’s
research focuses on taxpayer
responses to the income tax
using archival data. His
dissertation received the
PricewaterhouseCoopers/
American Taxation Association Dissertation Award, and
his subsequent research has received funding from a
number of organizations, including the Ernst & Young
Foundation Tax Research Grant Program. His work has
been published in a variety of academic and professional
journals, including the National Tax Journal, The Journal
of the American Taxation Association, and Tax Notes. Jim
is a Northern Illinois University Distinguished Professor,
received the Illinois CPA Society Outstanding Accounting Educator Award in 2012, and has received university
teaching awards from Northern Illinois University, George
Mason University, and Michigan State University.
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Preface
Bradrick M. Cripe, Ph.D.,
CPA, is a Presidential Teaching Professor and the D
­ onald
E. Kieso Endowed Chair of
Accountancy at Northern Illinois University. He is a graduate of New Mexico State
University (B.A., B.C.J., and
M.Acc.) and the University
of Nebraska-Lincoln (Ph.D.).
Prior to receiving his Ph.D.
in 2006, he worked on the
tax staff of a Big 4 accounting firm. Professor Cripe teaches
courses in taxation and business strategy, corporate taxation, international taxation, and advanced issues in taxation. He has published in The Accounting Review, Issues in
Accounting Education, Journal of Accountancy, Tax Notes,
and other academic and practitioner journals.
Sharon S. Lassar, Ph.D.,
CPA (Florida), is the John J.
Gilbert Professor and Director of the School of Accountancy at The University of
Denver. Dr. Lassar earned
her Ph.D. at the University of Southern California,
her Master of Taxation at
Bentley University, and her
Bachelor’s in Accounting
from West Virginia University. Prior to joining the University of Denver, Dr. Lassar
was the Director of the School of Accounting at Florida
International University and previously served on the
faculties of Florida Atlantic University and the University
of Arizona. She began her career with a Big 4 firm. Dr.
Lassar has served the profession in many ways, most
recently as a member of the AICPA Council. Dr. Lassar is
a past president of the Accounting Programs Leadership
Group and Past Chair of the Colorado Society of CPAs.
Dr. Lassar also served on the Accounting Accreditation
Task Force of AACSB International whose work resulted
in new standards for accreditation, the hallmark of them
being fully engaging practitioners in the accreditation
process.
19961_fm_hr_i-xxxvi.indd 23
xxiii
Mark B. Persellin, Ph.D.,
CPA, CFP®, is a Professor
of Accounting at St. Mary’s
University. He is a graduate
of the University of ­Arizona
(B.S.), the University of
Texas at Austin (M.P.A. in
Taxation), and the University of Houston (Ph.D.). He
teaches Personal Income
Tax, Business Income Tax,
and Research in Federal Taxation. Prior to joining St. Mary’s University in 1991, Professor Persellin taught at Florida Atlantic University and
Southwest Texas University (Texas State University) and
worked on the tax staff of a Big 4 firm. His research has
been published in numerous academic and professional
journals including The Journal of the American Taxation
Association, The Accounting Educators’ Journal, The Tax
Adviser, The CPA Journal, Journal of Taxation, Corporate
Taxation, The Tax Executive, TAXES—The Tax Magazine,
Journal of International Taxation, and Practical Tax
Strategies. In 2003, Professor Persellin established the
St. Mary’s University Volunteer Income Tax Assistance
(VITA) site, and he continues to serve as a trainer and
reviewer at the site.
Andrew D. Cuccia, Ph.D.,
CPA, is the Steed Professor
of Accounting at the University of Oklahoma. He is a
graduate of Loyola University, New Orleans (B.B.A.),
and the University of Florida
(Ph.D.). Prior to entering
academia, Andy practiced as
a CPA with a Big 4 accounting firm. Before joining the
University of Oklahoma, he
was on the faculty at Louisiana State University and the
University of Illinois. His research focusses on taxpayer
and tax professional judgment and decision making and
has been published in several journals including The
Accounting Review, The Journal of Accounting Research,
The Journal of the American Taxation Association, and
Tax Notes. He has taught undergraduate and graduate
courses in income tax fundamentals as well as graduate
courses in corporate tax, tax policy, and tax research.
Andy is a past president of the American Taxation Association and a member of the American Accounting Association, the National Taxation Association, and the AICPA.
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19961_fm_hr_i-xxxvi.indd 24
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Brief Contents
Part 1: Introduction to Taxation
and Business Entities
Chapter 1Understanding and Working with
the Federal Tax Law
1-1
Chapter 2The Deduction for Qualified Business
Income for Noncorporate Taxpayers
2-1
Part 2: Corporations
Chapter 3Corporations: Introduction and
Operating Rules
Chapter 4Corporations: Organization and
Capital Structure
3-1
4-1
Chapter 5Corporations: Earnings & Profits and
Dividend Distributions
5-1
Chapter 6
Corporations: Redemptions and Liquidations
6-1
Chapter 7
Corporations: Reorganizations
7-1
Chapter 8
Consolidated Tax Returns
8-1
Chapter 9
Taxation of International Transactions
9-1
Part 3: Flow-Through Entities
Chapter 10Partnerships: Formation, Operation, and Basis
10-1
Chapter 11Partnerships: Distributions, Transfer
of Interests, and Terminations
11-1
Chapter 12
12-1
S Corporations
xxv
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xxvi
Brief Contents
Part 4: Advanced Tax Practice Considerations
Chapter 13
Comparative Forms of Doing Business
13-1
Chapter 14
Taxes in the Financial Statements
14-1
Chapter 15
Exempt Entities
15-1
Chapter 16
Multistate Corporate Taxation
16-1
Chapter 17
Tax Practice and Ethics
17-1
Part 5: Family Tax Planning
19961_fm_hr_i-xxxvi.indd 26
Chapter 18
The Federal Gift and Estate Taxes
18-1
Chapter 19
Family Tax Planning
19-1
Chapter 20
Income Taxation of Trusts and Estates
20-1
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Contents
Part 1: Introduction to Taxation
Working with the Tax Law—Tax Planning
Nontax Considerations
Components of Tax Planning
Follow-Up Procedures
Tax Planning—A Practical Application
and Business Entities
Chapter 1
Understanding and Working with
the Federal Tax Law
The Big Picture: Importance of Tax Research
1-1
1-1
The Whys of the Tax Law
1-2
Revenue Needs
Economic Considerations
Social Considerations
Equity Considerations
Political Considerations
Influence of the Internal Revenue Service
Influence of the Courts
1-2
1-2
1-3
1-4
1-8
1-9
1-11
Summary1-13
Reconciling Accounting Concepts
1-13
Working with the Tax Law—Tax Sources
1-13
Statutory Sources of the Tax Law
Administrative Sources of the Tax Law
Judicial Sources of the Tax Law
Concept Summary: Federal Judicial System
Concept Summary: Judicial Sources
Other Sources of the Tax Law
1-14
1-17
1-20
1-22
1-25
1-27
Working with the Tax Law—Locating
and Using Tax Sources
1-28
Commercial Tax Services
Financial Disclosure Insights: Where Does GAAP Come From?
Using Electronic (Online) Tax Services
Noncommercial Electronic (Online) Tax Sources
1-28
1-29
1-29
1-30
Working with the Tax Law—Tax Research
1-31
Identifying the Problem
Locating the Appropriate Tax Law Sources
Assessing the Validity of Tax Law Sources
Ethics & Equity: Choosing Cases for Appeal
Arriving at the Solution or at Alternative Solutions
1-32
1-34
1-34
1-35
Communicating Tax Research
1-36
1-37
Taxation on the CPA Examination
Preparation Blueprints
Regulation Section
1-38
1-38
1-38
1-40
1-40
1-40
1-41
1-41
Chapter 2
The Deduction for ­Qualified
Business Income for Noncorporate
Taxpayers2-1
The Big Picture: Entrepreneurial Pursuits
Tax Treatment of Various Business Forms
2-1
2-2
Sole Proprietorships
2-2
Partnerships2-3
Corporations2-3
Concept Summary: Tax Treatment of Business Forms Compared
2-6
Global Tax Issues: U.S. Corporate Taxes and International
Business Competitiveness
2-7
Limited Liability Companies
2-7
The Challenges of Taxing Business Activities:
Entity Tax Rates
2-8
Challenges of Lowering Tax Rates
Lowering Tax Rates for Different Business Forms
2-8
2-9
The Deduction for Qualified Business
Income2-10
General Rule
The Overall Limitation: Modified Taxable Income
Definition of Qualified Business Income
Definition of a Qualified Trade or Business
Limitations on the QBI Deduction
Limitation Based on Wages and Capital Investment
Concept Summary: An Overview of the 2022 Qualified Business
Income Deduction
Limitation for “Specified Services” Businesses
Reporting the Qualified Business Income Deduction
Aggregation of Qualified Trades and Businesses
Under the § 199A Regulations
2-10
2-10
2-11
2-11
2-14
2-14
2-15
2-18
2-26
2-27
xxvii
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xxviii
Contents
Treatment of Losses
Coordination with Other Rules
Considerations for Partnerships and S Corporations
Other Items in the § 199A Regulations
Tax Planning
Corporate versus Noncorporate Forms of Business Organization
Optimizing the Deduction for Qualified Business Income
Refocus on The Big Picture: Entrepreneurial Pursuits
2-32
2-34
2-35
2-35
2-36
2-36
2-37
2-37
Part 2: Corporations
Chapter 3
Corporations: Introduction
and Operating Rules
The Big Picture: A Half-Baked Idea?
An Introduction to the Income
Taxation of Corporations
An Overview of Corporate versus Individual Income
Tax Treatment
Specific Provisions Compared
Accounting Periods and Methods
Capital Gains and Losses
Recapture of Depreciation
Business Interest Expense Limitation
Passive Activity Losses
Concept Summary: Special Rules Applicable to
Personal Service Corporations (PSCs)
Charitable Contributions
Excessive Executive Compensation
Net Operating Losses
Deductions Available Only to Corporations
Ethics & Equity: Pushing the Envelope on Year-End Planning
Concept Summary: Income Taxation of Individuals and
Corporations Compared
3-1
3-1
3-2
3-2
3-3
3-4
3-5
3-6
3-7
3-9
3-9
3-10
3-12
3-13
3-13
3-15
3-17
3-19
Corporate Income Tax Rates
Alternative Minimum Tax
Restrictions on Corporate Accumulations
3-19
3-19
3-19
Filing Requirements for Corporations
Estimated Tax Payments
Schedule M–1—Reconciliation of Income (Loss) per Books
with Income per Return
Schedule M–2—Analysis of Unappropriated Retained
Earnings per Books
Schedule M–3—Net Income (Loss) Reconciliation for
Corporations with Total Assets of $10 Million or More
Concept Summary: Conceptual Diagram of
Schedule M–1 (Form 1120)
Effect of Taxes on the Financial Statements
Form 1120 Illustrated
Consolidated Returns
19961_fm_hr_i-xxxvi.indd 28
3-21
3-21
3-21
3-22
3-23
3-23
3-24
3-26
3-27
3-36
3-36
Corporate versus Noncorporate Forms of Business Organization
Operating the Corporation
Refocus on The Big Picture: Cooked to Perfection
3-36
3-37
3-39
Chapter 4
Corporations: Organization
and Capital Structure
4-1
The Big Picture: The Vehicle for Business Growth Is the
Corporate Form
Organization of and Transfers
to ­Controlled Corporations
Determining the Corporate Income
Tax Liability
Procedural Matters
Tax Planning
Section 351 Rationale and General Rules
Global Tax Issues: Tax Reform Adds a New Wrinkle to the
Choice of Organizational Form When Operating Overseas
Concept Summary: Shareholder Consequences: Taxable
Corporate Formation versus Tax-Deferred § 351 Transaction
Property Defined
Stock Transferred
Control of the Corporation
Basis Determination and Related Issues
Concept Summary: Tax Consequences to the Shareholders
and Corporation: With and Without the Application of
§ 351 (Based on the Facts of Example 16)
Assumption of Liabilities—§ 357
Concept Summary: Tax Consequences of Liability Assumption
Capital Structure of a Corporation
Capital Contributions
Debt in the Capital Structure
Investor Losses
Stock and Security Losses
Ethics & Equity: Can a Loss Produce a Double Benefit?
Business versus Nonbusiness Bad Debts
Section 1244 Stock
4-1
4-2
4-2
4-3
4-5
4-5
4-6
4-6
4-10
4-11
4-14
4-17
4-18
4-18
4-18
4-21
4-21
4-21
4-21
4-23
Gain from Qualified Small Business Stock
4-24
Tax Planning
4-24
Working with § 351
Selecting Assets to Transfer
Debt in the Capital Structure
Investor Losses
Corporations versus Flow-Through Entities
Refocus on The Big Picture: The Vehicle for Business Growth
Is the Corporate Form
4-24
4-26
4-26
4-27
4-28
4-29
Chapter 5
Corporations: Earnings & Profits
and Dividend Distributions
5-1
The Big Picture: Taxing Corporate Distributions
5-1
Corporate Distributions—Overview
5-2
Earnings and Profits (E & P)—§ 312
5-3
Computation of E & P
5-3
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Contents
Summary of E & P Adjustments
Concept Summary: E & P Adjustments
Current versus Accumulated E & P
Allocating E & P to Distributions
Concept Summary: Allocating E & P to Distributions
Ethics & Equity: Shifting E & P
5-6
5-7
5-8
5-8
5-9
5-12
Dividends5-12
Rationale for Reduced Tax Rates on Dividends
Qualified Dividends
Property Dividends
Concept Summary: Noncash Property Distributions
Constructive Dividends
Stock Dividends and Stock Rights
Tax Planning
5-12
5-13
5-14
5-16
5-16
5-19
5-21
Corporate Distributions
Planning for Qualified Dividends
Constructive Dividends
Refocus on The Big Picture: Taxing Corporate Distributions
5-21
5-23
5-24
5-26
Chapter 6
Corporations: Redemptions
and Liquidations
6-1
The Big Picture: Family Corporations and Stock Redemptions
Stock Redemptions—In General
6-1
6-2
Stock Redemptions—Sale or Exchange
Treatment6-3
Global Tax Issues: Foreign Shareholders Prefer Sale
or Exchange Treatment in Stock Redemptions
Historical Background and Overview
Concept Summary: Summary of the Qualifying Stock
Redemption Rules
Stock Attribution Rules
Concept Summary: Tax Consequences of Stock Redemptions
to Shareholders
Not Essentially Equivalent Redemptions
Disproportionate Redemptions
Complete Termination Redemptions
Partial Liquidations
Redemptions to Pay Death Taxes
Stock Redemptions—Effect on the Corporation
Recognition of Gain or Loss
Effect on Earnings and Profits
Redemption Expenditures
Stock Redemptions—Preferred Stock Bailouts
6-4
6-4
6-5
6-5
6-7
6-7
6-8
6-9
6-9
6-11
6-11
6-12
6-12
6-12
6-12
Background6-13
Tax Consequences
6-13
Section 306 Stock
6-13
Liquidations—In General
The Liquidation Process
Liquidating and Nonliquidating Distributions Compared
19961_fm_hr_i-xxxvi.indd 29
6-14
6-14
6-14
xxix
Liquidations—Effect on the Distributing Corporation
6-15
The General Rule
6-15
Antistuffing Rules
6-16
Concept Summary: Summary of Antistuffing Loss Disallowance Rules 6-19
Liquidations—Effect on the Shareholder
6-20
Ethics & Equity: Transferee Liability for Tax Deficiency
of ­Liquidated Corporation
6-20
Liquidations—Parent-Subsidiary Situations
6-21
Minority Shareholder Interests
Global Tax Issues: Basis Rules for Liquidations of Foreign Subsidiaries
Indebtedness of the Subsidiary to the Parent
Basis of Property Received by the Parent ­
Corporation—The General Rule
Basis of Property Received by the Parent
Corporation—§ 338 Election
Concept Summary: Summary of Liquidation Rules
6-21
6-21
6-22
6-22
6-23
6-23
Tax Planning
6-25
Stock Redemptions
Corporate Liquidations
Parent-Subsidiary Liquidations
Asset Purchase versus Stock Purchase
Refocus on The Big Picture: A Family Attribution Waiver
Is a Valuable Tool in Succession Planning
6-25
6-26
6-27
6-27
6-28
Chapter 7
Corporations: Reorganizations
7-1
The Big Picture: Structuring Acquisitions
7-1
Corporate Reorganizations
7-2
Different Types of Reorganizations
Tax Consequences in a Tax-Free Reorganization
Concept Summary: Gain and Basis Rules for Nontaxable Exchanges
Concept Summary: Basis to Acquiring Corporation of
Property Received
7-2
7-3
7-3
Types of Tax-Free Reorganizations
7-6
Type A
Type B
Type C
Type D
Type E
Financial Disclosure Insights: Offensive versus Defensive
Reorganizations
Concept Summary: Summary of Type A Through Type D
Reorganizations: Advantages and Disadvantages
Type F
Type G
7-6
7-8
7-10
7-12
7-14
Judicial Doctrines
Sound Business Purpose
Continuity of Interest
Continuity of Business Enterprise
Step Transaction
Ethics & Equity: Trafficking in Net Operating Losses
7-5
7-15
7-16
7-17
7-17
7-18
7-18
7-18
7-18
7-19
7-19
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xxx
Contents
Tax Attribute Carryovers
Allowance of Carryovers
Net Operating Loss Carryovers
Earnings and Profits
Concept Summary: Treatment of E & P Carried to Successor
Other Carryovers
Concept Summary: Summary of Carryover Rules
Tax Planning
7-19
7-19
7-19
7-21
7-22
7-23
7-24
7-24
Concept Summary: Comprehensive Summary of Corporate
Reorganizations7-24
Financial Disclosure Insights: Blank Check Companies
7-25
Target Liabilities
7-25
Assessing Restructuring Options
7-25
Refocus on The Big Picture: Structuring Acquisitions
7-28
Chapter 8
Consolidated Tax Returns
The Big Picture: A Corporation Contemplates a Merger
8-1
8-1
The Consolidated Return Rules
8-2
Motivations to Consolidate
Source and Philosophy of Consolidated Return Rules
Ethics & Equity: Delegating Authority to the Nonelected
8-2
8-3
8-4
Assessing Consolidated Return Status
8-4
Financial Disclosure Insights: GAAP and Tax Treatment
of Consolidations
8-5
Electing Consolidated Return Status
8-6
Concept Summary: The Consolidated Return Election
Affiliated Group
Affiliated versus Controlled Group
Eligibility for the Consolidation Election
Compliance Requirements
State Tax Effects
Concept Summary: The Consolidated Tax Return
8-6
8-7
8-7
8-9
8-10
8-14
8-14
Stock Basis of Subsidiary
8-14
Consolidated Taxable Income
8-15
Computational Procedure
Typical Intercompany Transactions
Global Tax Issues: Consolidated Returns and NOLs
Group Items
The Matching Rule
Concept Summary: Consolidated Taxable Income
Tax Planning
Choosing Consolidated Return Partners
Consolidation versus 100 Percent Dividends
Received Deduction
Protecting the Group Members’ Liability for Tax Payments
Short Tax Years
Excess Loss Accounts
Refocus on The Big Picture: Should the Affiliated Group
File a Consolidated Return?
19961_fm_hr_i-xxxvi.indd 30
8-16
8-17
8-19
8-23
8-25
8-26
8-27
8-27
8-27
8-27
8-27
8-27
Chapter 9
Taxation of International Transactions
The Big Picture: Going International
9-1
Overview of International Taxation
9-3
Tax Treaties
9-5
Sourcing of Income and Deductions
9-6
Income Sourcing Rules
Allocation and Apportionment of Deductions
Concept Summary: The Sourcing Rules
Transfer Pricing
Ethics & Equity: The Costs of Good Tax Planning
9-6
9-9
9-10
9-10
9-11
Foreign Currency Gain/Loss
9-14
U.S. Persons with Offshore Income
9-15
Export Property, Licenses, Foreign Branches
Financial Disclosure Insights: Overseas Operations
and Book-Tax Differences
Concept Summary: The Foreign Tax Credit
Tax Havens
Offshore (Foreign) Corporations Controlled by U.S. Persons
Concept Summary: Subpart F Income and a CFC
Concept Summary: Components of Subpart F Income
Movement Toward a More Territorial System
Global Intangible Low-Taxed Income (GILTI)
Concept Summary: The Components of Global Intangible
Low-Taxed Income (GILTI)
Global Tax Issues: Agreement on Global Minimum Corporate
Tax Rate Reached
U.S. Taxation of Nonresident Aliens
and Foreign Corporations
9-15
9-17
9-17
9-18
9-19
9-21
9-23
9-23
9-24
9-24
9-27
9-27
Nonresident Alien Individuals
Foreign Corporations
Foreign Investment in Real Property Tax Act
Expatriation to Avoid U.S. Taxation
9-28
9-29
9-30
9-30
Reporting Requirements
9-31
Tax Planning
9-31
The Foreign Tax Credit Limitation and Sourcing Provisions
Transfer Pricing
Refocus on The Big Picture: Going International
9-31
9-32
9-33
Part 3: Flow-Through Entities
Chapter 10
Partnerships: Formation,
Operation, and Basis
The Big Picture: Why Use a Partnership, Anyway?
Overview of Partnership Taxation
8-28
9-1
What Is a Partnership?
10-1
10-1
10-2
10-2
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Contents
Concept Summary: Comparison of Partnership Types
Key Concepts in Taxation of Partnership Income
10-4
10-4
Formation of a Partnership: Tax Effects
10-6
Contributions to the Partnership
Exceptions to the General Rule of § 721
Other Issues Related to Contributed Property
Concept Summary: Partnership Formation and
Initial Basis Computation
Tax Accounting Elections
Initial Costs of a Partnership
Method of Accounting
Taxable Year of the Partnership
10-6
10-7
10-9
10-11
10-11
10-12
10-12
10-13
Partnership Operations and Reporting
10-14
Partnership Reporting
Measuring Partnership Income
Form 1065 Example
Financial Disclosure Insights: Financial Reporting for Partnerships
Partner Calculations and Reporting
Partner Reporting of Partnership Income
Partner Allocations
Schedule K–1 Example
Concept Summary: Tax Reporting of Partnership Items
Ethics & Equity: Built-In Appreciation on Contributed Property
Partner’s Basis
Effect of Partnership Liabilities
Partner’s Capital Account
Concept Summary: Comparing a Partner’s Tax Basis and
Capital Account
Loss Limitations
Global Tax Issues: Withholding Requirements for non-U.S. Partners
Other Taxes on Partnership Income
Self-Employment Tax
Net Investment Income Tax
Tax Planning
Choosing Partnership Taxation
Formation and Operation of a Partnership
Basis Considerations and Loss Deduction Limitations
Concept Summary: Major Advantages and Disadvantages
of the Partnership Form
Partners' Capital Considerations
Partnership Reporting Requirements
Transactions between Partners and Partnerships
Drafting the Partnership Agreement
Refocus on The Big Picture: Why Use a
Partnership, Anyway?
Chapter 11
Partnerships: Distributions,
Transfer of Interests,
and Terminations
The Big Picture: The Life Cycle of a Partnership
19961_fm_hr_i-xxxvi.indd 31
10-14
10-15
10-18
10-23
10-24
10-24
10-26
10-28
10-30
10-30
10-31
10-32
10-35
10-36
10-36
10-38
10-38
10-39
10-39
10-40
10-40
10-41
10-41
10-41
10-42
10-42
10-42
10-43
10-43
11-1
11-1
Distributions from a Partnership
xxxi
11-2
Distributions in General
11-2
Concept Summary: Hot Assets
11-4
Proportionate Current Distributions
11-5
Ethics & Equity: Arranging Tax-Advantaged
Distributions11-7
Concept Summary: Proportionate Current Distributions
(General Rules)
11-8
Proportionate Liquidating Distributions
11-8
Property Distributions with Special Tax Treatment
11-11
Concept Summary: Proportionate Liquidating
Distributions When the Partnership Also Liquidates
(General Rules)
11-12
Disproportionate Distributions
11-13
Section 736—Liquidating Distributions
to Retiring or Deceased Partners
General Partners in Service-Providing Partnerships
Limited Partners or Capital-Intensive Partnerships
Tax Treatment of § 736 Payments
Concept Summary: Liquidating Distributions of Cash When
the Partnership Continues
Sale of a Partnership Interest
General Rules
Hot Assets and Carried Interests
Concept Summary: Sale of a Partnership Interest
Global Tax Issues: A Partnership Isn’t Always a Partnership—­
Complications of State and International Taxes
Other Dispositions of Partnership Interests
11-14
11-14
11-16
11-16
11-19
11-19
11-19
11-21
11-22
11-23
11-24
Transfers to a Corporation
11-24
Death of a Partner
11-24
Gifts11-24
Section 754—Optional Adjustments
to Property Basis
Adjustment: Sale or Exchange of an Interest
Adjustment: Partnership Distributions
Concept Summary: Basis Adjustments under § 754
Other Issues
11-25
11-26
11-27
11-29
11-29
Termination of a Partnership
11-29
Family Partnerships
11-30
Global Tax Issues: Sale of Global Partnership
Interests11-31
Limited Liability Companies 11-31
Limited Liability Partnerships 11-32
Partnership Administration and Anti-Abuse
11-32
Tax Planning
Planning Partnership Distributions Sales and Exchanges of Partnership Interests
Comparing Sales to Liquidations
Other Partnership Issues Refocus on The Big Picture: The Life Cycle of
a Partnership
11-32
11-32
11-33
11-33
11-34
11-35
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xxxii
Contents
Chapter 12
S Corporations
The Big Picture: Deductibility of Losses and the Choice
of Business Entity
Single versus Double Taxation
12-1
12-1
Choice of Business Entity
12-2
An Overview of S Corporations
12-2
Qualifying for S Corporation Status
Defining an S Corporation
Making the Election
Shareholder Consent
Loss of the Election
12-3
12-3
12-5
12-6
12-7
Operational Rules
12-9
Taxable Income
Qualified Business Income Deduction
Allocation of Income and Loss
Distributions to Shareholders
Concept Summary: Classification Procedures for Distributions
from an S Corporation
Noncash Property Distributions
Concept Summary: Consequences of Noncash Distributions
Shareholder’s Basis in S Stock
Treatment of Losses
Tax on Pre-Election Built-In Gain
LIFO Recapture Tax
Passive Investment Income Penalty Tax
Other Operational Rules
12-9
12-12
12-12
12-13
Tax Planning
When the Election Is Advisable
Concept Summary: Making an S Election
Making a Proper Election
Operation of the S Corporation
Refocus on The Big Picture: Using a Pass-Through
Entity to Achieve Deductibility of Losses
12-14
12-18
12-18
12-19
12-21
12-22
12-23
12-23
12-24
12-25
12-25
12-25
12-26
12-26
12-27
Part 4: Advanced Tax Practice
Considerations
Chapter 13
Comparative Forms of
Doing Business
The Big Picture: Selection of a Tax Entity Form
Overall Effect on Entity and Owners
Alternative Minimum Tax
Global Tax Issues: Tax Rates and Economic Activity
State Taxation
13-8
Favorable Treatment of Certain Fringe Benefits
Minimizing Double Taxation
Considering the Qualified Business Income Deduction
13-9
13-9
13-12
Tax Consequences of Choice of Organizational Form 13-12
Effect on Recognition at Time of Contribution to the Entity
Effect on Basis of Ownership Interest
Ethics & Equity: Income Tax Basis That Does Not Change?
Effect on Results of Operations
Effect on Recognition at Time of Distribution
Effect on Passive Activity Losses
Effect of At-Risk Rules
Effect of Special Allocations
FICA, Self-Employment Taxes, and NIIT
13-18
Disposition of a Business or an ­Ownership
Interest13-20
Sole Proprietorship
Partnership and Limited Liability Company
C Corporation
S Corporation
Converting to Other Entity Types
Sole Proprietorship
C Corporation
Partnership or LLC
Tax Planning
Refocus on The Big Picture: Selection of a Tax Entity Form
13-20
13-21
13-22
13-23
13-24
13-24
13-24
13-24
13-25
13-25
13-29
13-30
Chapter 14
Taxes in the Financial Statements
14-1
14-1
Organizational Forms in Which Business May
be Conducted
13-2
The Big Picture: Taxes in the Financial Statements
Nontax Factors
13-4
Accounting for Income Taxes—Basic Principles
Limited Liability
Other Factors
Capital Formation
13-4
13-4
13-5
19961_fm_hr_i-xxxvi.indd 32
13-12
13-13
13-14
13-14
13-15
13-16
13-16
13-17
FICA13-18
Self-Employment Tax
13-18
Net Investment Income Tax (NIIT)
13-19
Effect on the Entity and Its Owners
13-19
Concept Summary: Tax Attributes of Different Forms of Business
(Assume That Partners and Shareholders Are All Individuals)
13-1
13-6
13-7
13-8
13-8
Controlling the Entity Tax
Overall Comparison of Forms
of Doing Business
13-1
13-6
Book-Tax Differences
Concept Summary: Common Book-Tax Differences
Generally Accepted Accounting Principles and ASC 740
14-2
14-2
14-5
14-5
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Contents
Capturing, Measuring, and Recording Tax Expense
—The Provision Process
Current Tax Expense
Financial Disclosure Insights: The Book-Tax Income Gap
Global Tax Issues: Accounting for Income Taxes under
International Standards
Deferred Tax Expense
The Valuation Allowance
Global Tax Issues: Tax Losses and the Deferred Tax Asset
Tax Disclosures in the Financial Statements
Presentation of Amounts Recognized in the
Financial Statements
The Financial Statement Footnotes
The Effective Tax Rate Reconciliation
Special Issues
The Financial Accounting for Tax Uncertainties
Concept Summary: Recognizing the Tax Benefits
of Uncertain Tax Positions Under ASC 740–10
Ethics & Equity: How Much Uncertainty?
Effects of Statutory Tax Rate Changes
The Corporate Tax Department
Concept Summary: The Income Tax Provision Process
14-7
14-8
14-9
14-9
14-9
14-14
14-15
14-17
14-17
14-18
14-18
14-20
14-20
14-21
14-24
14-24
14-25
14-26
Benchmarking14-26
Methods of Analysis
Tax Rate Sustainability
Uses of Benchmarking Analysis
Concept Summary: Benchmarking Analysis
Tax Planning
14-27
14-28
14-28
14-29
14-29
Releasing Valuation Allowances
14-29
Comparing Tax Savings
14-30
Refocus on The Big Picture: Taxes in the Financial
Statements14-31
CHAPTER 15
Exempt Entities
The Big Picture: Effect of a For-Profit Business on
a Tax-Exempt Entity
15-1
15-1
Types of Exempt Organizations
15-3
Characteristics of Exempt Entities
15-3
Serving the Common Good
Not-for-Profit Entity
Use of Net Earnings
Concept Summary: Consequences of Exempt Status
Taxes on Exempt Entities
Taxable Transactions
Feeder Organizations
Private Foundations and Public Charities
Tax Consequences of Private Foundation Status
19961_fm_hr_i-xxxvi.indd 33
15-3
15-3
15-4
15-5
15-5
15-5
15-8
15-8
15-8
Concept Summary: Exempt Organizations: Classification
Taxes Imposed on Private Foundations
Unrelated Business Income Tax
Unrelated Trade or Business
Unrelated Business Taxable Income
Concept Summary: Unrelated Business Income Tax
Reporting Requirements
Obtaining Exempt Organization Status
Annual Filing Requirements
Disclosure Requirements
Tax Planning
Choosing an Exempt Classification
Maintaining Exempt Status
Private Foundations
Unrelated Business Income Tax
Refocus on The Big Picture: Effect of a For-Profit
Business on a Tax-Exempt Entity
Chapter 16
Multistate Corporate Taxation
The Big Picture: Making a Multistate Location Decision
Corporate State Income Taxation
Computing State Income Tax
State Modifications
The UDITPA and the Multistate Tax Commission
Jurisdiction to Impose Tax: Nexus and Public
Law 86–272
Nexus in Today’s Economy
Concept Summary: Multistate Taxation
xxxiii
15-10
15-11
15-12
15-13
15-16
15-18
15-19
15-19
15-19
15-20
15-21
15-21
15-21
15-22
15-22
15-23
16-1
16-1
16-2
16-2
16-3
16-3
16-6
16-7
16-8
Apportionment and Allocation of Income
16-8
The Apportionment Procedure
Apportionable Income
Apportionment Factors: Elements and Planning
Concept Summary: Apportionable Income
The Sales Factor
The Payroll Factor
The Property Factor
Financial Disclosure Insights: State/Local Taxes
and the Tax Expense
16-9
16-9
16-11
16-12
16-13
16-14
16-16
The Unitary Theory
What Is a Unitary Business?
Tax Effects of the Unitary Theory
Consolidated and Combined Returns
Global Tax Issues: Water’s Edge Is Not a Day
at the Beach
Concept Summary: Using Apportionment Formulas
Taxation of S Corporations
16-17
16-18
16-19
16-19
16-21
16-21
16-22
16-22
Eligibility16-22
State Tax Filing Requirements
16-22
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xxxiv
Contents
Taxation of Partnerships and LLCs
16-23
Other State and Local Taxes
16-23
State and Local Sales and Use Taxes
Local Property Taxes
Other Taxes
Ethics & Equity: Encouraging Economic Development
through Tax Concessions
Tax Planning
Selecting the Optimal State in Which to Operate
Restructuring Corporate Entities
Subjecting the Corporation’s Income to Apportionment
Ethics & Equity: Can You Be a Nowhere Adviser?
Planning with Apportionment Factors
Sales/Use Tax Compliance
Capital Stock Taxation
Refocus on The Big Picture: Making a Multistate
Location Decision
Chapter 17
Tax Practice and Ethics
The Big Picture: A Tax Adviser’s Dilemma
Tax Administration
16-23
16-25
16-26
16-27
16-28
16-28
16-29
16-31
16-32
16-32
16-33
16-33
16-33
17-1
17-1
17-2
Organizational Structure of the IRS
17-3
IRS Procedure—Letter Rulings
17-4
IRS Procedure—Other Issuances
17-4
Ethics & Equity: Tax Compliance Costs
17-5
Administrative Powers of the IRS
17-5
The Audit Process
17-6
Ethics & Equity: Can the IRS Pretend to Be Your Friend?
17-7
The Taxpayer Appeal Process
17-9
Offers in Compromise and Closing Agreements
17-10
Ethics & Equity: Our Taxing System of Self-Assessment
17-11
Interest17-12
Concept Summary: Working with the IRS
17-13
Taxpayer Penalties
17-13
Ethics & Equity: First-Time Tax Violators Can Get Off
with Just a Warning
17-18
Statute of Limitations
17-21
The Tax Profession and Tax Ethics
The Tax Professional
Regulating Tax Preparers
IRS Rules Governing Tax Practice
Preparer Penalties
Privileged Communications
AICPA Statements on Standards for Tax Services
Concept Summary: Tax Profession and Ethics
17-22
17-22
17-23
17-23
17-24
17-26
17-27
17-30
Litigation Considerations
17-32
Penalties17-32
Ethics in the Tax Practice
17-32
Privileged Communications
17-33
Refocus on The Big Picture: A Tax Adviser’s Dilemma
17-33
Part 5: Family Tax Planning
Chapter 18
The Federal Gift and Estate Taxes
The Big Picture: An Eventful and Final Year
Transfer Taxes—In General
Nature of the Taxes
Global Tax Issues: U.S. Transfer Taxes and NRAs
Concept Summary: Formula for the Federal Gift Tax
Concept Summary: Formula for the Federal Estate Tax
Valuation Issues
Key Property Concepts
The Federal Gift Tax
Strategies in Seeking a Letter Ruling
Considerations in Handling an IRS Audit
Statute of Limitations
19961_fm_hr_i-xxxvi.indd 34
18-1
18-2
18-2
18-3
18-4
18-4
18-5
18-6
18-7
General Considerations
18-7
Ethics & Equity: It’s the Thought That Counts
18-7
Transfers Subject to the Gift Tax
18-9
Annual Gift Tax Exclusion
18-10
Deductions18-11
Computing the Federal Gift Tax
18-11
Procedural Matters
18-12
Concept Summary: Federal Gift Tax Provisions
18-13
The Federal Estate Tax
Gross Estate
Concept Summary: Federal Estate Tax Provisions—Gross Estate
Taxable Estate
Estate Tax Credits
Global Tax Issues: Treaty Relief Is Not Abundant!
Procedural Matters
Concept Summary: Federal Estate Tax Provisions—Taxable
Estate and Procedural Matters
The Generation-Skipping Transfer Tax
Inter-Generational Transfers
The Tax on Generation-Skipping Transfers
Tax Planning
Refocus on The Big Picture: An Eventful and Final Year
Chapter 19
Family Tax Planning
The Big Picture: Lifetime Giving—The Good and the Bad
Tax Planning
18-1
18-13
18-14
18-19
18-19
18-23
18-24
18-25
18-25
18-25
18-25
18-26
18-26
18-27
19-1
19-1
17-30
17-30
17-30
17-31
Valuation Concepts
Valuation Issues
Valuation of Specific Assets
19-2
19-2
19-3
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Contents
Ethics & Equity: One Way to Handle Loans to Troublesome In-Laws 19-4
Ethics & Equity: Can IRS Valuation Tables Be Disregarded?
19-5
Real Estate and the Special Use Valuation Method
19-5
Valuation Problems with a Closely Held Business
19-6
Concept Summary: Valuation of Transferred Assets
19-10
Income Tax Concepts
Basis of Property Acquired by Gift
Basis of Property Acquired by Death
Concept Summary: Income Tax Basis of Transferred Assets
Gift Planning
Minimizing Gift Taxes
Minimizing Estate Taxes
Income Tax Considerations
Estate Planning
Probate Costs
Transfer Tax Deductions
Providing Estate Liquidity
Nontax Estate Planning Issues
Concept Summary: Estate and Gift Tax Planning
Refocus on The Big Picture: Lifetime Giving—The Good
and the Bad
Chapter 20
Income Taxation of
Trusts and Estates
The Big Picture: Setting Up a Trust to Protect a Family
Fiduciary Income Taxation
What Is a Trust?
What Is an Estate?
Nature of Trust and Estate Taxation
Concept Summary: Tax Characteristics of Major Pass-Through Entities
Tax Accounting Periods and Methods
Tax Rates and Personal Exemption
Alternative Minimum Tax
Additional Tax on Net Investment Income
19-10
19-10
19-11
19-13
19-13
19-14
19-14
19-15
19-17
19-17
19-17
19-20
19-22
19-22
19-23
20-1
20-1
20-2
20-2
20-5
20-5
20-6
20-6
20-6
20-7
20-8
Taxable Income of Trusts and Estates
20-8
Entity Accounting Income
Gross Income
Ethics & Equity: To Whom Can I Trust My Pet?
Ordinary Deductions
Deductions for Losses
Charitable Contributions
Deduction for Distributions to Beneficiaries
Concept Summary: Uses of the DNI Amount
Tax Credits
Concept Summary: Principles of Fiduciary Income Taxation
20-8
20-11
20-13
20-13
20-15
20-15
20-16
20-17
20-19
20-20
19961_fm_hr_i-xxxvi.indd 35
Taxation of Beneficiaries
xxxv
20-20
Distributions by Simple Trusts
Distributions by Estates and Complex Trusts
Character of Income
20-20
20-20
20-22
Grantor Trusts
20-23
Procedural Matters
20-25
Tax Planning
20-25
A Trust or an Estate as an Income-Shifting Device
Income Tax Planning for Estates
Distributions of In-Kind Property
Ethics & Equity: Who Should Be a Trustee?
Deductibility of Administrative Expenses
Duties of an Executor
Additional Taxes on Capital Gains and Net
Investment Income
Refocus on The Big Picture: Setting Up a Trust
to Protect a Family
20-25
20-26
20-27
20-27
20-27
20-28
20-28
20-29
Appendices
Tax Formulas, Tax Rate Schedules,
and Tables
A-1
Tax Forms
B-1
GlossaryC-1
Table of Code Sections Cited
D-1
Present Value and Future Value Tables
E-1
IndexI-1
Online Appendices
Depreciation and the Accelerated Cost Recovery
System (ACRS)
Affordable Care Act Provisions
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19961_fm_hr_i-xxxvi.indd 36
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1
Introduction
Part
to Taxation and
Business Entities
Chapter
1
Understanding and Working with the Federal Tax Law
Chapter
2
The Deduction for Qualified Business Income for
Noncorporate Taxpayers
The opening chapter of the text is devoted to the “whys and hows” of the tax law, and to the tax
research process as it is used by the tax professional. Chapter 2 begins by discussing the distinctions
between various taxpayer entities, including sole proprietorships, partnerships, and c­ orporations.
Then the chapter explores the deduction for qualified business income available to noncorporate
taxpayers.
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1
C h a p ter
Understanding and
Working with the
Federal Tax Law
L e a r n i n g O b j e c t i v e s : After completing Chapter 1, you should be able to:
LO.1
LO.2
Discuss the importance of revenue needs as an
objective of Federal tax law.
Demonstrate the influence of economic, social,
equity, and political considerations on the
development of the tax law.
LO.3
Explain how the IRS, as the protector of the
revenue, has affected tax law.
LO.4
Recognize the role of the courts in interpreting and
shaping tax law.
LO.5
Identify tax law sources—statutory, administrative,
and judicial.
LO.6
LO.7
LO.8
LO.9
LO.10
List and assess tax law sources.
Demonstrate the ability to conduct tax research.
Assess the validity and weight of tax law sources.
Describe various tax planning procedures.
Explain the role of taxation on the CPA examination.
Chapter Outline
1-1 The Whys of the Tax Law, 1-2
1-1a Revenue Needs, 1-2
1-1b Economic Considerations, 1-2
1-1c Social Considerations, 1-3
1-1d Equity Considerations, 1-4
1-1e Political Considerations, 1-8
1-1f Influence of the Internal Revenue Service, 1-9
1-1g Influence of the Courts, 1-11
1-2 Summary, 1-13
1-3 Reconciling Accounting Concepts, 1-13
1-4 Working with the Tax Law—Tax Sources, 1-13
1-4a Statutory Sources of the Tax Law, 1-14
1-4b Administrative Sources of the Tax Law, 1-17
1-4c Judicial Sources of the Tax Law, 1-20
1-4d Other Sources of the Tax Law, 1-27
1-6 Working with the Tax Law—Tax Research, 1-31
1-6a Identifying the Problem, 1-32
1-6b Locating the Appropriate Tax Law Sources, 1-34
1-6c Assessing the Validity of Tax Law Sources, 1-34
1-6d Arriving at the Solution or at Alternative Solutions, 1-36
1-6e Communicating Tax Research, 1-37
1-7 Working with the Tax Law—Tax Planning, 1-38
1-7a Nontax Considerations, 1-38
1-7b Components of Tax Planning, 1-38
1-7c Follow-Up Procedures, 1-40
1-7d Tax Planning—A Practical Application, 1-40
1-8 Taxation on the CPA Examination, 1-40
1-8a Preparation Blueprints, 1-41
1-8b Regulation Section, 1-41
1-5Working with the Tax Law—Locating and Using
Tax Sources, 1-28
1-5a Commercial Tax Services, 1-28
1-5b Using Electronic (Online) Tax Services, 1-29
1-5c Noncommercial Electronic (Online) Tax Sources, 1-30
19961_ch01_hr_002-049.indd 2
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The Big Picture
STOCKLITE/SHUTTERSTOCK.COM
Importance of Tax Research
Dana Andrews advanced $93,000 to her nephew in 2015 to enable him to attend a private university. Over
the next few years, the nephew repays Dana $16,000 on the loan. However, seven years later Dana comes to
you to determine whether she can claim a bad debt deduction for the $77,000 the nephew has not repaid.
What planning tips might you give to Dana? Were any mistakes made?
Read the chapter and formulate your response.
1-1
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1-2
Part 1
Introduction to Taxation and Business Entities
T
he Federal tax law reflects the three branches of our Federal government. It is
a mixture of laws passed by Congress, explanations provided by the Treasury
Department and the Internal Revenue Service (IRS), and court decisions. Anyone
who has attempted to work with this vast amount of information is familiar with its
complexity. Commenting on his 48-page tax return, author James Michener said, “It is
unimaginable in that I graduated from one of America’s better colleges, yet I am totally
incapable of understanding tax returns.” A person who must sift through this information
to find the solution to a tax problem should recognize that there are reasons behind the
law. Knowing these reasons is helpful in understanding the Federal tax law.
1-1 The Whys of the Tax Law
The primary objective of Federal tax law is the raising of revenue. Despite the importance of the fiscal needs of the government, however, other considerations (e.g.,
economic, social, equity, and political factors) play a significant role. The Treasury
Department, the IRS, and the courts also have significant impacts on the evolution of
Federal tax law. The first part of this chapter focuses on these topics.
LO.1
Discuss the importance of
revenue needs as an objective
of Federal tax law.
LO.2
Demonstrate the influence of
economic, social, equity, and
political considerations on the
development of the tax law.
1-1a Revenue Needs
Raising revenues to fund the cost of government operations is the primary function
of a tax system. In a perfect world, taxes raised by the government would equal the
expenses incurred by government operations. However, this goal has not been the case
in the United States. Over the past century, the national debt has been increasing significantly, reaching more than $28.8 trillion, or about $86,000 per citizen and $230,000
per taxpayer, in November 2021. According to the U.S. National Debt Clock, the U.S.
total unfunded liabilities (including Social Security, Medicare, and Federal employee
and veterans benefits) could be as much as $157 trillion, or about $470,000 per citizen.
When enacting tax legislation, Congress is often guided by the concept of
revenue neutrality so that any changes neither increase nor decrease the net revenues
received by the government. With revenue neutral legislation, there are likely to be both
“winners” (taxpayers who see a reduction in taxes paid) and “losers” (taxpayers who
see an increase in taxes paid).
1-1b Economic Considerations
Using the tax system to attempt to accomplish economic objectives generally involves
changing the Internal Revenue Code1 to help control the economy in some manner or
encourage certain activities and businesses.
Control of the Economy
Congress has used tax depreciation rules as one means of controlling the economy.
Theoretically, shorter asset lives and accelerated methods should encourage additional
investments in depreciable business property. On the other hand, longer asset lives and
the use of straight-line depreciation should discourage capital outlays. Congress also
uses incentives like immediate expensing (§ 179) and bonus depreciation to stimulate
the economy when needed.
A change in tax rates has a more immediate impact on the economy. When tax rates
are lowered, taxpayers retain money that can be used for other purposes (e.g., purchases
or savings). If, however, Congress is using the concept of revenue neutrality, these rate
reductions may be offset by a reduction or elimination of deductions or credits. As a
result, lower rates do not always mean lower taxes.
1
he Internal Revenue Code is a compilation of Federal tax legislation that
T
appears in Title 26 of the U.S. Code.
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Chapter 1 Understanding and Working with the Federal Tax Law
1-3
Encouragement of Certain Activities
Congress uses the tax law to encourage certain types of economic activity or ­segments
of the economy. For example, research and development expenditures can be capitalized and amortized over a period of not less than 60 months.2 And, these expenditures
may generate a tax credit that reduces the taxpayer’s tax liability.
Inventions (including technological innovations) also are encouraged under tax law.
Patents can qualify as capital assets, and under certain conditions, their disposition
automatically carries long-term capital gain treatment.3
Are ecological considerations a desirable objective? This objective explains why pollution control facilities can be amortized over a 60-month period (rather than over the
39-year period required for most business buildings).
Is saving desirable for the economy? Saving leads to capital formation and thus makes
funds available to finance home construction and industrial expansion. The tax law
provides incentives to encourage saving by giving private retirement plans preferential
treatment. Contributions to certain Individual Retirement Accounts (IRAs) and Keogh
(H.R. 10 plans) are deductible, and income from these contributions accumulates on a
tax-free basis.
Encouragement of Certain Industries
Historically, agricultural activities have been favored under Federal tax law. Among the
benefits are the election to expense rather than capitalize certain expenditures for soil
and water conservation and fertilizers and the election to defer the recognition of gain
on the receipt of crop insurance proceeds.
The tax law favors the development of natural resources (like oil and gas and mineral
deposits) by permitting the use of percentage depletion and a write-off (rather than
a capitalization) of certain exploration costs. The railroad and banking industries also
receive special tax treatment.
Encouragement of Small Business
Small business development also is encouraged under the tax law. For example, a
shareholder in a small business corporation can take an ordinary deduction (rather
than a capital loss) for a loss recognized on a stock investment.4 Another provision
permits the shareholders of a small business corporation to make a special election
that allows the profits (or losses) of the corporation to flow through to its shareholders
(avoiding the corporate income tax).5
1-1c Social Considerations
Some of the tax laws, especially those related to the Federal income tax of individuals,
can be explained by social considerations. Here are some notable examples:
• Certain benefits provided to employees through accident and health plans
financed by employers are nontaxable. It is socially desirable to encourage these
plans because they provide medical benefits in the event of an employee’s illness
or injury. Further, insurance companies are paying for these benefits (rather than
the government).
• Most premiums paid by an employer for group term insurance covering the life of
the employee are nontaxable. These funds help the family unit adjust to the loss
of wages caused by the employee’s death.
• A deduction is allowed for contributions to qualified charities. The deduction shifts
some of the financial and administrative burden of socially desirable programs
from the public (the government) to the private sector.
2
If the asset developed has no estimated useful life, no write-off would be
available. Through 2021, these expenses could be expensed immediately
or capitalized and amortized over 60 months.
3
A long-term capital gain has a favorable tax advantage for individuals.
19961_ch01_hr_002-049.indd 3
4
nown as § 1244 stock (and subject to specific annual limitations), this
K
subject is covered in Chapter 4.
5
Known as the S corporation election, this subject is discussed extensively
in Chapter 12.
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1-4
Part 1
Introduction to Taxation and Business Entities
• Various tax credits, deductions, and exclusions are designed to encourage
­taxpayers to obtain additional education.6 To encourage adoptions (and defray the
costs of adopting a child), Congress established the adoption expenses tax credit.
• Certain expenses are deemed to be contrary to public policy and are not
­
deductible. These expenses include fines, penalties, illegal kickbacks, and bribes
to government officials.
1-1d Equity Considerations
The concept of equity (or fairness) is relative. Reasonable persons can, and often
do, disagree about what is fair or unfair. Compare the tax treatment of a corporation
with that of a partnership. The corporation is subject to a separate Federal income
tax; the partnership is not. The tax law can and does make a distinction between
these business forms.
One measure of equity is whether a tax is progressive (e.g., the Federal income tax
on individuals) or regressive (e.g., a gasoline excise tax). The determination is made by
calculating the percentage of a taxpayer’s income that is used to pay a tax.
Equity, then, is not what appears fair or unfair to any one taxpayer or group of taxpayers. It is, instead, what the tax law recognizes. The concept of equity appears in tax
provisions that alleviate the effect of multiple taxation and postpone the recognition
of gain when the taxpayer lacks the ability or wherewithal to pay the tax. Equity also
helps mitigate the effect of the application of the annual accounting period concept and
helps taxpayers cope with the eroding result of inflation.
Alleviating the Effect of Multiple Taxation
The same income earned by a taxpayer may be subject to taxes imposed by different
taxing authorities. If, for example, the taxpayer is situated in New York City, income
might generate Federal, New York state, and New York City income taxes. To compensate for this inequity, the Federal tax law allows a taxpayer to claim a deduction for
some state and local income taxes (with an overall limit of $10,000). The deduction,
however, does not eliminate the effect of multiple taxation; the benefit derived from the
deduction depends on the taxpayer’s Federal income tax rate.7
Equity considerations can explain the Federal tax treatment of income from foreign
sources. Because double taxation results when the same income is subject to both foreign and U.S. income taxes, the tax law permits the taxpayer to choose either a credit
or a deduction for the foreign taxes paid.
Another example is the corporate income tax, which can lead to multiple taxation
of the same income.
Example
1
6
During the current year, Gray Corporation has net income of $100,000, including $5,000 of
­dividends received from stock it owns in IBM Corporation. Assume that Gray Corporation distributes its after-tax income to its shareholders (all individuals).
The shareholder distribution will be subject to two income taxes: the corporate income tax
when the income is earned by Gray Corporation and the individual income tax when it is distributed to the shareholders as a dividend.8
The $5,000 that Gray receives from IBM Corporation fares even worse. Because it is paid from
income earned by IBM, it has been subjected to a third income tax (the corporate income tax
imposed on IBM).9
hese provisions also can be justified under the category of economic
T
considerations since a better educated workforce carries a positive economic impact.
7
A tax credit rather than a deduction would eliminate the effects of multiple
taxation on the same income.
19961_ch01_hr_002-049.indd 4
8
his result materializes because, under the tax law, a corporation is not
T
allowed a deduction for the dividend distributions it makes. In addition to
any income tax assessed on the dividend, a 3.8% Medicare tax also applies
to certain high-income shareholders.
9
This “triple taxation” is mitigated by a dividends received deduction, which
Gray Corporation is allowed.
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Chapter 1 Understanding and Working with the Federal Tax Law
1-5
Congress has moved to mitigate the multiple taxation of corporate profits in several
ways. For corporate shareholders, for whom triple taxation is possible, the law provides
a deduction for dividends received from certain domestic corporations. The deduction,
usually 50 percent of the dividends, would be allowed to Gray Corporation for the
$5,000 it received from IBM Corporation (see the discussion in Chapter 3). For the individual shareholder, the law taxes qualified dividends at lower rates (from 0 percent for
lower tax bracket shareholders to 20 percent for certain high-income shareholders). By
allowing a lower tax rate, this approach mitigates (not eliminates) the effect of multiple
taxation (see the discussion in Chapter 5).
In the area of the Federal estate tax, several provisions reflect attempts to mitigate
the effect of multiple taxation. For example, a limited credit against the estate tax for
foreign death taxes imposed is allowed. Other estate tax credits are available and can
be explained on the same grounds.10
The Wherewithal to Pay Concept
The wherewithal to pay concept recognizes the inequity of taxing a transaction when
the taxpayer lacks the means (i.e., funds) to pay the tax. This concept is typically
applied to transactions where the taxpayer’s economic position has not changed significantly. The following examples illustrate this concept.
Wherewithal to Pay Concept Illustrations
White Corporation holds unimproved land to build a new warehouse. The land has a basis to
White of $60,000 and a fair market value of $100,000. The land is exchanged for a building (worth
$100,000) that White will use in its business.11
White Corporation owns a warehouse that it uses in its business. At a time when the warehouse
has an adjusted basis of $60,000, it is destroyed by fire. White collects the insurance proceeds of
$100,000, and within two years of the end of the year in which the fire occurred, White uses all of
the proceeds to purchase a new warehouse.12
Tom, a sole proprietor, decides to incorporate his business. In exchange for the business’s assets
(adjusted basis of $60,000 and a fair market value of $100,000), Tom receives all of the stock of
Azure Corporation, a newly created corporation.13 The Azure stock is worth $100,000.
Rose, Sam, and Tom want to develop unimproved land owned by Tom. The land has a basis to Tom
of $60,000 and a fair market value of $100,000. The RST Partnership is formed with the following
investments: land worth $100,000 transferred by Tom, $100,000 cash by Rose, and $100,000 cash
by Sam. Each party receives a one-third interest in the RST Partnership.14
Amber Corporation and Crimson Corporation decide to consolidate to form Aqua Corporation.15
Pursuant to the plan of reorganization, Tera exchanges her stock in Amber Corporation (basis of
$60,000 and fair market value of $100,000) for stock in Aqua Corporation worth $100,000.
10
11
See Chapter 18.
Here, White has a gain realized of $40,000 [$100,000 amount realized
(new building) less $60,000 adjusted basis in old building]. But the gain is
deferred (not recognized) since White does not have the wherewithal to
pay tax (White receives no cash as part of the transaction). The nontaxability of like-kind exchanges applies to the exchange of real property held
for investment or used in a trade or business for property to be similarly
held or used (i.e., not held for sale).
19961_ch01_hr_002-049.indd 5
Example
2
Example
3
Example
4
Example
5
Example
6
12
he nontaxability of gains realized from involuntary conversions applies
T
when the proceeds received by the taxpayer are reinvested within a prescribed period of time in property similar or related in service or use to
that converted. Involuntary conversions take place as a result of casualty
losses, theft losses, or condemnations by a public authority.
13
Transfers of property to controlled corporations (§ 351) are discussed in
Chapter 4.
14
The formation of a partnership is discussed in Chapter 10.
15
Corporate reorganizations are discussed in Chapter 7.
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1-6
Part 1
Introduction to Taxation and Business Entities
In all of the preceding examples, White Corporation, Tom, or Tera had a realized
gain of $40,000 [$100,000 (fair market value of the property received) 2 $60,000 (basis
of the property given up)].16 To force a taxpayer to recognize any of this gain is inequitable for two reasons. First, the taxpayer did not end the transaction with any cash
in hand (i.e., the taxpayer does not have the means to pay the tax).17 Second, in each
case, the taxpayer’s economic situation has not changed significantly. In Example 2,
White Corporation owned land before the exchange and owns land after the exchange.
In Example 4, Tom owns a business both before and after the transaction (just in a different business form).
In these examples, recognized gain is merely postponed and not necessarily avoided.
Because basis carries over to the new property or interest acquired in these nontaxable
transactions, the gain element is still present and might be recognized on a subsequent
taxable disposition. In Example 4, suppose Tom later sells his Azure Corporation stock
for $100,000. Tom’s basis in the stock is $60,000 (the same basis as in the assets transferred), and the sale results in a recognized gain of $40,000. Tom now has the funds to
pay the related tax.
Many of these provisions also prevent the recognition of realized losses.
The wherewithal to pay concept, however, is not followed in every situation. The
concept is only applied when the tax law specifically allows it.
Example
7
Alicia exchanges stock in Green Corporation (basis of $60,000 and fair market value of
$100,000) for stock in Purple Corporation (fair market value of $100,000). If the exchange is not
pursuant to a reorganization, Alicia’s realized gain of $40,000 is recognized for Federal income tax
purposes.18
The result reached in Example 7 seems harsh in that the exchange does not place
Alicia in a position to pay the tax on the $40,000 gain. Why does the tax law apply the
wherewithal to pay concept to the exchange of stock pursuant to a corporate reorganization (Example 6) but not to certain other stock exchanges (Example 7)?
The wherewithal to pay concept is typically applied to situations in which the taxpayer’s economic position has not changed significantly. In Example 6, Tera’s stock
investment in Amber Corporation really continues in the form of the Aqua Corporation
stock because Aqua was formed through a consolidation of Amber and Crimson Corporations.19 In Example 7, however, the investment has not continued. Here, Alicia’s
ownership in Green Corporation has ceased, and an investment in an entirely different
corporation has been substituted.
Mitigating the Effect of the Annual Accounting Period Concept
All taxpayers must report their taxable income to the Federal government at regular
intervals. The annual accounting period for the reporting of taxable income (and the
settlement of any tax liability) is one year. Referred to as the annual accounting period
concept, the effect is to divide each taxpayer’s life into equal annual intervals for tax
purposes.
16
ealized gain can be likened to economic gain. However, the Federal
R
income tax is imposed only on that portion of realized gain considered to
be recognized under the law. Generally, recognized (or taxable) gain can
never exceed realized gain.
17
If the taxpayer ends up with other property (boot) as part of the transfer,
gain may be recognized to this extent. The presence of boot, however,
helps solve the wherewithal to pay problem because it provides property
19961_ch01_hr_002-049.indd 6
(other than the property or interest central to the transaction) with which
to pay the tax.
18
The exchange of stock does not qualify for nontaxable treatment as a likekind exchange (refer to Example 2).
19
his is known as the “continuity of interest” concept, which forms the
T
foundation for all nontaxable corporate reorganizations. The concept is
discussed at length in Chapter 7.
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Chapter 1 Understanding and Working with the Federal Tax Law
1-7
This annual accounting period concept sometimes leads to different tax treatment
for taxpayers who are in the same economic position. Consider the following example.
Rena and Samuel are both sole proprietors and report the following results during the past three
years:
8
Profit (or Loss)
Year
Rena
Samuel
2020
2021
2022
$50,000
60,000
60,000
$150,000
60,000
(40,000)
Example
Although Rena and Samuel have the same total profit of $170,000 over the three-year period,
the annual accounting period concept places Samuel at a definite disadvantage for tax purposes.
The net operating loss deduction offers Samuel some relief by allowing him to carry forward (but
not back) some or all of his 2022 loss to any profitable years in the future. With a net operating loss
carryforward, Samuel may obtain a reduction in future taxes.
The reasoning used to support the net operating loss deduction helps explain the
special treatment that excess capital losses and excess charitable contributions receive.
Carryback and carryover procedures help mitigate the effect of limiting a loss or a
deduction to the accounting period in which it is realized. Using these procedures, a
taxpayer can salvage a loss or a deduction that might otherwise be wasted.
Example 9 illustrates how the installment method of recognizing gain on the sale of
property allows a taxpayer to spread tax consequences over the payout period.20 The
installment method is supported by the wherewithal to pay concept; recognition of
gain corresponds to the collection of cash received from the sale of the property. Tax
consequences match the seller’s ability to pay the tax.
In 2020, Tim sold unimproved real estate (cost of $40,000) for $100,000. Under the terms of the
sale, Tim receives two notes from the purchaser, each for $50,000 (plus interest). One note is payable in 2021; the other, in 2022.
Without the installment method Tim would have to recognize and pay a tax on the gain of
$60,000 for the year of the sale (2020). This result is harsh because none of the sale proceeds will
be received until 2021 and 2022.
Using the installment method and presuming the notes are paid when each comes due, Tim
­recognizes half of the gain ($30,000) in 2021 and the remaining half in 2022.
Example
9
The annual accounting period concept has been modified to apply to situations
where taxpayers may have difficulty accurately assessing their tax positions by yearend. Here, the law permits taxpayers to treat transactions taking place in the next year
as having occurred in the prior year.
Monica, a calendar year taxpayer, is a participant in an H.R. 10 (Keogh) retirement plan (see Appendix C
for a definition of a Keogh plan). Under the plan, Monica contributes 20% of her net self-employment
income, and this amount is deductible for Federal income tax purposes. On April 9, 2022, Monica
Example
10
continued
20
nder the installment method, each payment received by the seller repU
resents a return of basis (the nontaxable portion) and profit from the sale
(the taxable portion).
19961_ch01_hr_002-049.indd 7
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1-8
Part 1
Introduction to Taxation and Business Entities
determines that her net self-employment income for calendar year 2021 was $80,000. Consequently,
she contributes $16,000 (20% 3 $80,000) to the plan.
Even though the $16,000 contribution is made in 2022, the law permits Monica to claim this
contribution as a deduction in the 2021 tax year. Requiring Monica to make the contribution by
December 31, 2021, to obtain the deduction for that year would force her to arrive at an accurate
determination of net self-employment income before her income tax return must be prepared
and filed.
Similar exceptions to the annual accounting period concept cover certain charitable
contributions by accrual basis corporations (Chapter 3) and the dividend distributions
by S corporations (Chapter 12).
Coping with Inflation
During periods of inflation, bracket creep can plague a working person. Because of the
progressive nature of the Federal individual income tax, a wage adjustment that merely
compensates for inflation could place the employee in a higher income tax bracket,
and this erodes the taxpayer’s purchasing power. Congress recognized this problem
and began to adjust various income tax components through an indexation procedure.
Indexation, which began in 1985, is based on the rise in the consumer price index
over the prior year.
1-1e Political Considerations
A large segment of the Federal tax law is made up of statutory provisions. Because these
statutes are enacted by Congress, political considerations often influence tax law. The
effect of politics on the tax law includes special interest legislation, political expediency,
and state and local influences.
Special Interest Legislation
Certain provisions of the tax law can be explained largely by the political influence
some groups have had on Congress. For example, prepaid subscription and dues
income is not taxed until earned, but prepaid rents are taxed to the landlord in the
year received. The subscription and dues exception was created because certain
organizations (e.g., the American Automobile Association) convinced Congress that
special tax treatment was needed to cover income received from multiyear dues and
subscriptions. Another provision, sponsored by a senator from Georgia, suspended
the import duties on ceiling fans. The nation’s largest seller of ceiling fans is Atlantabased Home Depot.
Although some special interest legislation can be justified on economic or social
grounds, other special interest legislation cannot. This type of legislation is, however,
an inevitable product of our political system.
Political Expediency
Various tax changes can be tied to the shifting moods of the American public. That
Congress is sensitive to popular feeling is an accepted fact. As a result, certain
provisions of the tax law can be explained by the political climate at the time they
were enacted. Measures that deter more affluent taxpayers from obtaining so-called
preferential tax treatment have always had popular appeal and, consequently, the
support of Congress. Tax provisions like the imputed interest rules, the limitation
on the deductibility of interest on investment indebtedness, the alternative minimum
tax, and gift and estate taxes can be explained on this basis.
19961_ch01_hr_002-049.indd 8
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Chapter 1 Understanding and Working with the Federal Tax Law
1-9
State and Local Government Influences
Political considerations played a major role in providing an exclusion from gross income
for interest received on state and local obligations. Somewhat less apparent has been
the influence state law has had in shaping our present Federal tax law. Of major importance has been the effect of the community property system used by some states.21
At one time, the tax position of the residents of these states was so advantageous that
a number of common law states planned to adopt the community property system.22
The political pressure placed on Congress to correct the disparity in tax treatment was
considerable. To a large extent, this disparity was eliminated by the Revenue Act of
1948, which extended many of the community property tax advantages to residents
of common law jurisdictions.23 The impact of community property law on the Federal
estate and gift taxes is discussed in Chapters 18 and 19.
1-1f Influence of the Internal Revenue Service
The IRS has exerted its influence on many areas of the tax law. As the protector of the
national revenue, the IRS has been instrumental in securing the passage of legislation
designed to curtail aggressive tax avoidance practices (i.e., closing tax loopholes). In
addition, the IRS has sought and obtained law changes to make its job easier (administrative feasibility).
LO.3
Explain how the IRS, as the
protector of the revenue, has
affected tax law.
The IRS as Protector of the Revenue
There are many provisions in the tax law that have resulted from the direct efforts of
the IRS to prevent taxpayers from exploiting a tax loophole. Working within the letter of
existing laws, ingenious taxpayers and their advisers devise techniques that accomplish
indirectly what cannot be accomplished directly. As a result, Congress passes laws to
close the loopholes that taxpayers locate and exploit. Here are some examples (and
where they are discussed in the text):
• The use of a fiscal year by personal service corporations, partnerships, S corporations,
and trusts to defer income recognition to the owners (see Chapters 3, 10, 12, and 20).
• The use of the cash basis method of accounting by certain large corporations (see
Chapter 3).
• The deduction of passive investment losses and expenses against other income
(see Chapters 3 and 10).
• The shifting of income to lower-bracket taxpayers through the use of reversionary
trusts (see Chapter 20).
In addition, Congress has passed laws that enable the IRS to make adjustments
based on the substance of a transaction (rather than the form used by the taxpayer). One provision, for example, authorizes the IRS to establish guidelines on
“thinly capitalized” corporations. Here, the question is whether corporate debt is
recognized as debt for tax purposes or reclassified as equity (see the discussion in
Chapter 4). Another provision allows the IRS to make adjustments to a taxpayer’s
method of accounting when the method used by the taxpayer does not clearly
reflect income. The IRS also has the authority to allocate income and deductions
21
he states with community property systems are Louisiana, Texas, New
T
Mexico, Arizona, California, Washington, Idaho, Nevada, Wisconsin, and
(if elected by the spouses) Alaska. The rest of the states are classified as
common law jurisdictions. The difference between common law and community property systems centers around the property rights possessed by
married persons. In a common law system, each spouse owns whatever
they earn. Under a community property system, one-half of the earnings
of each spouse is considered owned by the other spouse. For example,
assume that Harold and Ruth are married and that their only income is the
$80,000 annual salary Harold receives. If they live in Oklahoma (a common
19961_ch01_hr_002-049.indd 9
law state), the $80,000 salary belongs to Harold. If, however, they live in
Texas (a community property state), the $80,000 salary is divided equally,
in terms of ownership, between Harold and Ruth.
22
Such states included Michigan, Oklahoma, and Pennsylvania.
23
The major advantage extended was the provision allowing married taxpayers to file joint returns and compute the tax liability as if each spouse had
earned one-half of the income. This result is automatic in a community
property state because half of the income earned by one spouse belongs
to the other spouse. The income-splitting benefits of a joint return are
now incorporated as part of the tax rates applicable to married taxpayers.
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1-10
Part 1
Introduction to Taxation and Business Entities
among taxpayers (or businesses owned or controlled by the same interests) when
the allocation is necessary to prevent the evasion of taxes or to correctly reflect
the income of each taxpayer.
Example
11
Gold Corporation is owned entirely by Justin Gold (a single taxpayer), and both use the calendar
year for tax purposes. In 2022, Gold Corporation has taxable income of $335,000; Justin has
taxable income of $185,000. Not included in Justin’s taxable income, h
­ owever, is $10,000
of rent income usually charged Gold Corporation for the use of some property owned by Justin.
Because the related parties have not clearly reflected their taxable income, the IRS can allocate
$10,000 of rent income to Justin. After the allocation, Gold Corporation has taxable income of
$325,000 and Justin has taxable income of $195,000.24
The IRS also has the authority to prevent taxpayers from acquiring corporations to
obtain a tax advantage when the principal purpose of the acquisition is the evasion or
avoidance of the Federal income tax (this rule is discussed briefly in Chapter 7).
Administrative Feasibility
Some tax laws are created in order to simplify the task of the IRS in collecting the
revenue and administering the law. As to collecting revenue, the IRS long ago realized
the importance of placing taxpayers on a pay-as-you-go basis. Withholding procedures
apply to wages, while the tax on other types of income may have to be paid via quarterly estimated tax payments. The IRS has been instrumental in convincing the courts
that accrual basis taxpayers should pay taxes on prepaid income in the year received
and not when earned. This approach may be contrary to generally accepted accounting
principles, but prepayment is consistent with the wherewithal to pay concept.
To help the IRS collect revenues when due, Congress has passed many provisions
that impose interest and penalties on taxpayers if they don’t comply with the tax law.
These provisions include penalties for failure to pay a tax or to file a return that is due
and the negligence penalty for intentional disregard of rules and regulations. Various
penalties for civil and criminal fraud are intended to encourage taxpayers to comply
with tax laws. This aspect of the tax law is discussed in Chapter 17.
The IRS audit process is essential to an effective administration of our tax system. To
carry out this function, the IRS is aided by provisions that reduce the chance of taxpayer
error or manipulation, thus simplifying the audit effort. For example, by increasing the
individual standard deduction amount, the audit function is simplified because there are
fewer returns with itemized deductions needing to be checked.25 The $16,000 annual
gift tax exclusion has the same objective (see Chapter 18). This provision decreases the
number of gift tax returns that must be filed (and also reduces the taxes paid), making
the job of the IRS easier.26
The Big Picture
Example
12
24
Return to the facts of The Big Picture on p. 1–1. The advance of $93,000 to her nephew might be
considered a taxable gift. If so, Dana would have been allowed a $14,000 gift tax exclusion in
2015. Further, if Dana were married, she and her spouse would have been allowed a $28,000 gift
tax exclusion (this is called “gift splitting”). Finally, Dana also could use her lifetime exemption to
eliminate any gift tax, depending on her previous gift history (see Chapter 18).
§ 482. By shifting $10,000 of income to Justin (who is in the 32% bracket),
the IRS gains $3,200 in taxes. Allowing the $10,000 deduction to Gold
Corporation (which is in the 21% bracket) costs the IRS only $2,100. See
Chapter 3 for further discussion of corporate taxable income and taxes.
25
The IRS gave the same administrative justification when it proposed to Congress the $100 per event limitation on personal casualty and theft losses. Imposition of the limitation eliminated many casualty and theft loss deductions
19961_ch01_hr_002-049.indd 10
and, as a consequence, saved the IRS considerable audit time. Also, an additional limitation equal to 10% of adjusted gross income applies to the total
of nonbusiness losses after reduction by the floor of $100 for each loss.
26
Particularly in the case of nominal gifts among family members, taxpayer
compliance in reporting and paying a tax on such transfers would be
questionable. The absence of the gift tax exclusion would create a serious
enforcement problem for the IRS.
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Chapter 1 Understanding and Working with the Federal Tax Law
1-1g Influence of the Courts
1-11
LO.4
In addition to interpreting statutory provisions and the administrative pronouncements
issued by the Treasury Department and the IRS, the Federal courts have influenced tax
law in two other ways.27 First, the courts have developed a number of judicial concepts
that help guide how tax provisions are applied. Second, certain key decisions have led
to changes in the Internal Revenue Code.
Recognize the role of the
courts in interpreting and
shaping tax law.
Judicial Concepts Relating to Tax Law
Although ranking the tax concepts developed by the courts in order of importance is
difficult, the concept of substance over form is certainly near the top of any list. Variously
described as the “telescoping” or “collapsing” process or the “step transaction approach,”
it involves determining the true substance of what happened. In a transaction involving
many steps, any one step may be collapsed (or disregarded) as part of determining the
substance of the event.
In 2022, Mrs. Greer, a widow, wants to give $32,000 to Jean without incurring any gift tax liability.28
She knows that the law permits her to give up to $16,000 each year per person without any tax
consequences (the annual exclusion). With this limitation in mind, the following steps are taken: a
gift by Mrs. Greer to Jean of $16,000 (nontaxable because of the $16,000 annual exclusion), a gift
by Mrs. Greer to Ben of $16,000 (also nontaxable), and a gift by Ben to Jean of $16,000 (nontaxable
because of Ben’s annual exclusion). Considering only the form of what Mrs. Greer and Ben have
done, all appears well from a tax standpoint. In substance, however, what has happened?
By collapsing the steps involving Ben, Mrs. Greer has made a gift of $32,000 to Jean and, therefore, has not avoided the Federal gift tax.
Example
13
The substance over form concept plays an important role in transactions involving
corporations.
Another tax concept developed by the courts deals with the interpretation of statutory
tax provisions that operate to benefit taxpayers. The courts have decided that these relief
provisions are to be applied narrowly. If a taxpayer wants a relief provision to apply, the
taxpayer has the responsibility to meet the provision’s requirements (i.e., no exceptions).
The arm’s length concept is important in the area of corporate-shareholder dealings
(see the discussion of constructive dividends in Chapter 5) and in the resolution of valuation problems for estate and gift tax purposes (see Chapters 18 and 19). Particularly
in dealings between related parties, transactions can be tested by asking the question:
Would unrelated parties have handled the transaction in the same way?
The sole shareholder of a corporation, Arturo, leases property to the corporation for a monthly rental
of $50,000. To test whether the corporation should be allowed a rent deduction for this amount, the
IRS and the courts will apply the arm’s length concept. Would the corporation have paid $50,000 a
month in rent if the same property had been leased from an unrelated party (rather than from the
sole shareholder)?
Example
14
Although the continuity of interest concept originated with the courts, it has, in many
situations, been incorporated into the Internal Revenue Code. If property is transferred
and the taxpayer retains an interest in the property in some form (“continuity of interest”), then the taxpayer should not be subject to tax, since the taxpayer’s position has
not changed. A like-kind exchange (land for land) is an example of a transaction where
27
great deal of case law is devoted to ascertaining congressional intent.
A
The courts, in effect, ask: What did Congress have in mind when it enacted
a particular tax provision?
19961_ch01_hr_002-049.indd 11
28
he example assumes that Mrs. Greer has exhausted her unified tax credit.
T
See Chapter 18.
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1-12
Part 1
Introduction to Taxation and Business Entities
this concept applies. This concept also applies to transfers to controlled corporations
(see Chapter 4), corporate reorganizations (see Chapter 7), and transfers to partnerships
(see Chapter 10).29
The court-developed business purpose concept, discussed in Chapter 7, principally
applies to corporate transactions. Under this concept, there must be a sound business
reason motivating a transaction in order for the tax treatment to result. The avoidance
of taxation is not considered a sound business purpose.
Example
15
Beth and Charles are equal shareholders in Brown Corporation. They have recently disagreed about
the company’s operations, and they are at an impasse about the future of Brown Corporation. This
shareholder disagreement on corporate policy constitutes a sound business purpose and would
justify a division of Brown Corporation that will permit Beth and Charles to go their separate ways.
Whether the division of Brown would be nontaxable to the parties depends on their compliance
with the statutory provisions dealing with corporate reorganizations. The point is that compliance
with statutory provisions is not enough to ensure nontaxability without a business purpose for
the transaction.
Judicial Influence on Statutory Provisions
Some court decisions have been so important that Congress has incorporated them into
the Internal Revenue Code. Example 16 illustrates this influence.
Example
16
In 1983, Brad claimed a capital loss of $100,000 for Tan Corporation stock that became worthless during the year. In the absence of any offsetting gains, the capital loss deduction produced no income tax
savings for Brad either in 1983 or in future years. Brad instituted a lawsuit against the former officers of
Tan Corporation for their misconduct that resulted in the corporation’s failure and thereby led to Brad’s
$100,000 loss. In settlement of the suit, the officers paid $50,000 to Brad in 1986. The IRS argued that
the full $50,000 should be taxed as gain to Brad. The Tan stock was written off in 1983 and had a zero
basis for tax purposes. The $50,000 recovery that Brad received on the stock was, therefore, all gain.
The IRS’s position was logical but not equitable. The court stated that Brad should not be taxed on
the recovery of an amount previously deducted unless the deduction produced a tax savings. Because
the $100,000 capital loss deduction in 1983 produced no tax benefit, none of the $50,000 received
in 1986 resulted in gain.
The decision reached by the courts in Example 16, known as the tax benefit rule , is
now part of the Internal Revenue Code.
Court decisions sometimes create uncertainty about the tax law. These decisions
may reach the right result, but they do not produce the guidelines necessary to enable
taxpayers to comply. In many situations, Congress may be compelled to add certainty
to the law by revising the Internal Revenue Code. The following are examples of this
type of judicial “cause” and the statutory “effect”:
• When a stock redemption will be treated as an exchange or as a dividend (see
Chapter 6).
• What basis a parent corporation will have in the assets received from a subsidiary
that is liquidated shortly after its acquisition (see Chapter 6).
Some statutory provisions can be explained by congressional reactions to a particular court decision. One decision, for example, held that the transfer of a liability to a
controlled corporation should be treated as boot received by the transferor, creating
a taxable gain (see Chapter 4). Congress disagreed with this treatment and promptly
enacted legislation to change the result.
29
lso see Examples 4 (forming a corporation), 5 (forming a partnership),
A
and 6 (reorganizing corporations) of this chapter.
19961_ch01_hr_002-049.indd 12
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Chapter 1 Understanding and Working with the Federal Tax Law
1-13
1-2 Summary
In addition to raising revenues, other factors have influenced the development of Federal tax law:
• Economic considerations. Congress uses the tax law to help regulate the economy
and encourage certain activities and types of businesses.
• Social considerations. Some tax provisions encourage or discourage certain
socially desirable or undesirable practices.
• Equity considerations. The tax law can be designed to alleviate the effect of multiple taxation, recognize the wherewithal to pay concept, mitigate the effect of the
annual accounting period concept, and recognize the eroding effect of inflation.
• Political considerations. Some tax law represents special interest legislation,
reflects political expediency, and illustrates the effect of state law.
• Influence of the IRS. Laws are enacted to aid the IRS in collecting revenue and
administering the tax law.
• Influence of the courts. Court decisions have established a body of judicial concepts relating to tax law and have, on occasion, led Congress to enact laws that
either clarify or negate their effect.
These factors help us understand how tax law develops (and why some provisions
exist). We also must learn to work with the tax law.
1-3 Reconciling Accounting Concepts
The vast majority of an entity’s business transactions receive the same treatment for
financial accounting purposes as they do under Federal and state tax law. But “book-tax
differences” exist. When there are differences between Generally Accepted ­Accounting
Principles (GAAP) or International Financial Reporting Standards (IFRS) and tax rules,
they are highlighted and discussed in a special feature used throughout the text titled
Financial Disclosure Insights.
1-4 Working with the Tax Law—Tax Sources
Understanding taxation requires a strong understanding of the sources of tax law. These
sources include laws passed by Congress, which are contained in the Internal Revenue
Code and also congressional Committee Reports, Regulations, Treasury Department and
IRS pronouncements, and court decisions. As a result, the primary sources of tax law
include information from all three branches of government: legislative (or statutory),
executive, and judicial.30
The law is of little significance, however, until it is applied to a set of facts and circumstances. A tax researcher not only must be able to read and interpret the sources
of the law but also must understand the relative weight of authority that each source
carries. Learning to work with the tax law involves three basic steps:
1. Familiarity with the sources of the law.
2. Application of research techniques.
3. Effective use of planning procedures.
30
S econdary sources also are used by tax practitioners. These sources are
not part of the tax law and include items like tax articles from professional tax journals, newsletters, and textbooks. Commentary contained in
19961_ch01_hr_002-049.indd 13
various tax research services (like Thomson Reuters Checkpoint) also are
secondary sources.
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1-14
Part 1
Introduction to Taxation and Business Entities
The remainder of this chapter introduces the sources of tax law and explains how
the law is applied to problems and conditions of individual and business transactions.
Statutory, administrative, and judicial sources of the tax law are considered first.
LO.5
Identify tax law sources—
statutory, administrative, and
judicial.
1-4a Statutory Sources of the Tax Law
Statutory sources of law include the Constitution (Article I, Sections 7, 8, and 10), the
Internal Revenue Code, and tax treaties (agreements between countries to mitigate the
double taxation of taxpayers subject to the tax laws of those countries). The Constitution
grants Congress the power to impose and collect taxes and also authorizes the creation
of treaties with other countries. The power of Congress to implement and collect taxes
is summarized in the Internal Revenue Code, the official title of U.S. tax law, and the
Code is the basis for arriving at solutions to all tax questions.
Origin of the Internal Revenue Code
Before 1939, the statutory provisions relating to taxation were contained in the individual revenue acts enacted by Congress. The inconvenience and confusion that resulted
from dealing with many separate acts led Congress to codify all of the Federal tax laws.
Known as the Internal Revenue Code of 1939, the codification arranged all Federal tax
provisions in a logical sequence and placed them in a separate part of the Federal statutes. A further rearrangement took place in 1954 and resulted in the Internal Revenue
Code of 1954.
Perhaps to emphasize the magnitude of the changes made by the Tax Reform Act
(TRA) of 1986, Congress redesignated the Internal Revenue Code of 1954 as the Internal
Revenue Code of 1986.31
The Legislative Process
Exhibit 1.1 illustrates the legislative process for enacting changes to the Internal Revenue
Code of 1986. Federal tax legislation generally originates in the House of Representatives, where it is first considered by the House Ways and Means Committee.32 Once
approved by the House Ways and Means Committee, the proposed bill is referred to the
entire House of Representatives for approval or disapproval. Approved bills are sent to
the Senate, where they are considered by the Senate Finance Committee.
After approval by the Senate Finance Committee, the bill is sent to the entire Senate.
Assuming no disagreement between the House and the Senate, a bill passed by the
Senate is referred to the President for approval or veto. If the bill is approved or if
the President’s veto is overridden by a two-thirds vote, the bill becomes law and part
of the Internal Revenue Code.
When the Senate version of the bill differs from that passed by the House, the Joint
Conference Committee resolves these differences. The Joint Conference Committee
includes members of the House Ways and Means Committee and the Senate Finance
Committee.
The House Ways and Means Committee, the Senate Finance Committee, and the Joint
Conference Committee each produce a Committee Report. These Committee Reports
explain the provisions of the proposed legislation and are therefore a valuable source
in ascertaining the intent of Congress. What Congress has in mind when it considers
and enacts tax legislation is, of course, the key to interpreting that legislation. Because
it takes time to develop other primary authority (e.g., from the Treasury Department,
the IRS, and the courts), tax researchers rely heavily on Committee Reports to interpret
and apply new tax laws.
31
ongress enacts tax legislation virtually every year, and each piece of legC
islation contains changes to the Internal Revenue Code of 1986.
32
lthough rare, a tax bill can originate in the Senate when it is attached
A
as a rider to a different legislative proposal. The Tax Equity and Fiscal
19961_ch01_hr_002-049.indd 14
Responsibility Act of 1982 originated in the Senate; its constitutionality was
upheld by the courts.
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Chapter 1 Understanding and Working with the Federal Tax Law
E x h i b i t 1.1
1-15
Legislative Process for Tax Bills
House
Ways and Means
Committee
Consideration by
the House of
Representatives
Senate Finance
Committee
Consideration by
the Senate
Joint Conference Committee
(if the House and Senate differ)
Consideration by the
House and Senate
Approval or Veto
by the President
Incorporation into the
Internal Revenue Code
(if approved by the President or if
the President’s veto is overridden)
The role of the Joint Conference Committee indicates the importance of compromise
in the legislative process. Exhibit 1.2 illustrates what happened in the Tax Cuts and Jobs
Act (TCJA) of 2017 regarding corporate tax rates and a new qualified business income
deduction for noncorporate taxpayers.
Arrangement of the Internal Revenue Code
In working with the Internal Revenue Code, it helps to understand the format. Here is
a partial table of contents:
Subtitle A. Income Taxes
Chapter 1. Normal Taxes and Surtaxes
Subchapter A. Determination of Tax Liability
Part I. Tax on Individuals
Sections 1–5
Part II. Tax on Corporations
Sections 11–12
***
19961_ch01_hr_002-049.indd 15
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1-16
Part 1
Introduction to Taxation and Business Entities
Example of Compromise in the Joint Conference
Committee
E x h i b i t 1.2
House Version
Applies a flat corporate tax rate of 20% (25%
for personal service corporations). Taxes an
individual's "qualified business income"
from flow-through entities (including sole
proprietorships) at maximum rate of 25%.
Both provisions effective in 2018.
Senate Version
Applies a flat corporate tax rate of 20%
(including for personal service corporations)
effective in 2019. Allows taxpayers other than
corporations to deduct 23% of "qualified
business income" from flow-through entities
(including sole proprietorships) effective in 2018.
Joint Conference Committee Result
Applies a flat corporate tax rate of 21% (including
for personal service corporations). Allows
taxpayers other than corporations to deduct 20%
of "qualified business income" from flow-through
entities (including sole proprietorships).
Both provisions effective in 2018.
In referring to a provision of the Code, the key is usually the Section number. In citing a Section number, identifying the related Subtitle, Chapter, Subchapter, and Part is
not necessary. Merely mentioning Section 2(a) is sufficient because the Section numbers
run consecutively and do not begin again with each new Subtitle, Chapter, Subchapter,
or Part.33
Tax researchers often refer to a specific area of income taxation by Subchapter designation. Some of the more common Subchapter designations include Subchapter C
(Corporate Distributions and Adjustments), Subchapter K (Partners and Partnerships),
and Subchapter S (Tax Treatment of S Corporations and Their Shareholders).
Citing the Code
Code Sections often are broken down into subparts.34 Code § 2(a)(1)(A) serves as an
example.
§
2
(a)
(1)
(A)
Abbreviation for “Section”
Section number
Subsection designation35
Paragraph designation
Subparagraph designation
33
hen the 1954 Code was drafted, some section numbers were intentionW
ally omitted. This omission provided flexibility to incorporate later changes
into the Code without disrupting its organization. When Congress does
not leave enough space, subsequent Code Sections are given A, B, C, etc.,
designations. A good example is the treatment of §§ 280A through 280H.
19961_ch01_hr_002-049.indd 16
34
Some Code Sections do not have subparts. See, for example, § 482.
Some Code Sections omit the subsection designation and use, instead,
the paragraph designation as the first subpart. See, for example, §§ 212(1)
and 1222(1).
35
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Chapter 1 Understanding and Working with the Federal Tax Law
1-17
Broken down as to content, § 2(a)(1)(A) becomes:
§2
Definitions and special rules (relating to
the income tax imposed on individuals).
(a)
Definition of a surviving spouse.
(1)
For purposes of § 1 (the determination of
the applicable rate schedule), a surviving
spouse must meet certain conditions.
(A)
One of the conditions necessary to qualify
as a surviving spouse is that the taxpayer’s
spouse must have died during either of
their two taxable years immediately
preceding the present taxable year.
Throughout this text, references to Code Sections are in the form just given. The
symbols “§” and “§§” are used in place of “Section” and “Sections,” respectively. The following table summarizes the format that we use:
Complete Reference
Text Reference
Section 2(a)(1)(A) of the Internal Revenue Code of 1986
Sections 1 and 2 of the Internal Revenue Code of 1986
Section 2 of the Internal Revenue Code of 1954
§ 2(a)(1)(A)
§§ 1 and 2
§ 2 of the Internal Revenue
Code of 1954
§ 12(d) of the Internal Revenue
Code of 1939
Section 12(d) of the Internal Revenue Code of 193936
1-4b Administrative Sources of the Tax Law
The administrative sources of the Federal tax law include Treasury Department Regulations, Revenue Rulings and Procedures, and various other administrative pronouncements (see Exhibit 1.3). All are issued by either the U.S. Treasury Department or the IRS.
The role played by the IRS in this process is considered in greater depth in Chapter 17.
Treasury Department Regulations
Regulations are issued by the U.S. Treasury Department under authority granted by
Congress (§ 7805). Interpretative by nature, they provide taxpayers with considerable
guidance on the meaning and application of the Code. Regulations, which carry considerable authority as the official interpretation of tax law, may be issued in proposed,
temporary, or final form.
Because Regulations interpret the Code, they are arranged in the same sequence.
Regulations are, however, prefixed by a number that indicates the type of tax or
administrative, procedural, or definitional matter to which they relate.37 For example,
the prefix 1 designates the Regulations under the income tax law. As a result, the Regulations under Code § 2 would be cited as Reg. § 1.2, with subparts added for further
identification. The numbering pattern of these subparts often has no correlation with
the Code subsections.
New Regulations and changes in existing Regulations usually are issued in proposed
form before they are finalized. The time interval between the proposal of a Regulation
and its finalization permits taxpayers and other interested parties to comment on the
propriety of the proposal. Proposed Regulations under Code § 2, for example, would
be cited as Prop.Reg. § 1.2.
Sometimes the Treasury Department issues Temporary Regulations relating to elections and other matters where immediate guidance is critical. These Regulations often are
needed for recent legislation that takes effect immediately. Temporary Regulations, cited
36
ode § 12(d) of the Internal Revenue Code of 1939 is the predecessor to
C
§ 2 of the Internal Revenue Code of 1954. Keep in mind that the 1954 Code
superseded the 1939 Code.
19961_ch01_hr_002-049.indd 17
37
he prefix 20 designates estate tax Regulations, 25 covers gift tax RegulaT
tions, 31 relates to employment taxes, and 301 refers to procedure and
administration.
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1-18
Part 1
Introduction to Taxation and Business Entities
E x h i b i t 1.3
Administrative Sources
Source
Location
Authority
Regulations
Federal Register
Force and effect of law.
Temporary Regulations
Federal Register
Internal Revenue Bulletin (IRB)
Cumulative Bulletin*
May be cited as a precedent.
Proposed Regulations
Federal Register
Internal Revenue Bulletin
Cumulative Bulletin*
Preview of Final Regulations. Not yet a precedent.
Revenue Rulings
Internal Revenue Bulletin
Cumulative Bulletin*
IRS interpretation only. Items published in the IRB are
binding on the IRS. Taxpayers can rely on these items.**
Weak precedent.
Revenue Procedures
Notices
Internal Revenue Bulletin
Cumulative Bulletin*
Chief Counsel Advice
Technical Advice Memoranda
Actions on Decisions
Tax Analysts’ Tax Notes;
Thomson Reuters Checkpoint***;
CCH IntelliConnect;
May not be cited as a precedent.
IRS website
Letter Rulings
Tax services from Thomson Reuters,
CCH Wolters Kluwer, and
Bloomberg Law; IRS website
Applicable only to taxpayer addressed.
May not be cited as precedent by others, but can be used as
authority to avoid certain tax penalties on audit.
Frequently Asked Questions
(FAQs)
IRS website****
FAQs have no precedential value. However, if relied upon in good
faith, a taxpayer will have a “reasonable cause” defense against
any negligence penalty or accuracy-related penalty.
Note: All Administrative Sources can be accessed electronically through Thomson Reuters Checkpoint (and other commercial tax services).
*Through 2008, the contents of Internal Revenue Bulletins were consolidated semiannually into a Cumulative Bulletin. The IRS no longer produces a Cumulative
Bulletin because Internal Revenue Bulletins from mid-2003 are available electronically on the IRS website (irs.gov/irb).
**Internal Revenue Manual (IRM) 4.10.7.2.4 (01-10-2018).
***Thomson Reuters Checkpoint includes a wide variety of tax resources. The most significant are materials produced by the Research Institute of America (RIA),
including the Federal Tax Coordinator 2d.
****Starting after October 15, 2021, FAQs on newly enacted tax legislation are announced in a news release and posted on the IRS website as a Fact Sheet. FAQs on
other topics are posted on the website and not announced in a news release (IR-2021-202).
as Temp.Reg. §, have the same authoritative value as Final Regulations and may be cited
as precedent for three years. However, Temporary Regulations also must be issued as
Proposed Regulations and automatically expire within three years after the date of issuance.38 The Tax Court indicates that Proposed Regulations carry little weight.39
Proposed, Final, and Temporary Regulations are published in the Federal Register
(now online) and are reproduced in major tax services. Final Regulations are issued as
Treasury Decisions (TDs) and carry the force and effect of law.
Revenue Rulings, Revenue Procedures, and Notices
Revenue Rulings are official pronouncements of the National Office of the IRS. Like
Regulations, Revenue Rulings are designed to provide interpretation of the tax law.
Although they do not carry the same legal force and effect as Regulations, because they
are focused on a specific fact pattern, they provide a more detailed analysis of the law.
A Revenue Ruling often results from a specific taxpayer’s request for a letter ruling
(discussed below). If the IRS believes that a letter ruling request has widespread impact,
the letter ruling will be converted into a Revenue Ruling and issued. Revenue Rulings
also can be issued in response to technical advice to District Offices of the IRS, court
decisions, and suggestions from tax practitioner groups.
Revenue Procedures deal with the internal management practices and procedures
of the IRS. For example, Rev.Proc. 2022–1 provides general instructions for taxpayers
requesting letter rulings or determination letters from the IRS.
38
§ 7805(e).
19961_ch01_hr_002-049.indd 18
39
. W. Woolworth Co., 54 T.C. 1233 (1970); Harris M. Miller, 70 T.C. 448
F
(1978); and James O. Tomerlin Trust, 87 T.C. 876 (1986).
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Chapter 1 Understanding and Working with the Federal Tax Law
1-19
Notices are issued when immediate guidance is needed by taxpayers and tax
practitioners. Typically, this guidance is transitional while the IRS works on permanent guidance on the particular topic. For example, Notice 2021–48 provides
guidance on the changes to the funding rules for single employer-defined benefit
pension plans.
Revenue Rulings, Revenue Procedures, and Notices serve an important function in
that they provide guidance to both IRS personnel and taxpayers in handling routine
tax matters. Revenue Rulings and Revenue Procedures generally apply retroactively and
are binding on the IRS until revoked or modified by subsequent rulings or procedures,
Regulations, legislation, or court decisions.
Revenue Rulings, Revenue Procedures, and Notices are published weekly by the U.S.
Government in the Internal Revenue Bulletin (I.R.B.).
The proper form for citing Revenue Rulings is shown below. Revenue Procedures and
Notices are cited in the same manner, except that “Rev.Proc.” or “Notice” is substituted
for “Rev.Rul.”
Rev.Rul. 2021–2, 2021–4 I.R.B. 495.
Explanation: Revenue Ruling Number 2, appearing on page 495 of the 4th
weekly issue of the Internal Revenue Bulletin for 2021.
Internal Revenue Bulletins can be found at the IRS website: irs.gov/irb.40
Other Administrative Pronouncements
Letter rulings are issued for a fee by the National Office of the IRS upon a taxpayer’s
request and describe how the IRS will treat a proposed transaction for tax purposes.
Issued by the National Office of the IRS, they apply only to the taxpayer who asks
for and obtains the ruling.41 Letter rulings can be useful to taxpayers who want to be
certain of how a transaction will be taxed before proceeding with it. Letter rulings
also allow taxpayers to avoid unexpected tax costs and may be the most effective
way to carry out tax planning. However, the IRS limits the issuance of letter rulings to
restricted, pre-announced areas of taxation.42
The IRS must make letter rulings available for public inspection after identifying
details are deleted.43 Published digests of private letter rulings can be found in a variety
of sources, including IRS Private Letter Rulings Reports (published by CCH), Bloomberg
BNA Daily Tax Reports, and Tax Analysts’ Tax Notes, and in electronic (online) tax
research services (like Thomson Reuters Checkpoint).
The National Office of the IRS releases Technical Advice Memoranda (TAMs) weekly.
TAMs resemble letter rulings in that they give the IRS’s determination of an issue. However, they differ in several respects. Letter rulings deal with proposed transactions and
are issued to taxpayers at their request. In contrast, TAMs deal with completed (rather
than proposed) transactions. TAMs are issued by the National Office of the IRS in
response to questions raised by taxpayers or IRS field personnel during audits. TAMs
are not officially published and may not be cited or used as precedent.44
Both letter rulings and TAMs are issued with multi-digit file numbers. Consider, for
example, Ltr.Rul. 202124008, which concluded that an exchange of Bitcoin for another
cryptocurrency (Ether) does not qualify for like-kind exchange treatment. Broken down
by digits, the file number reveals the following information:
2021
24
008
Year 2021
Issued during the 24th week of 2021
8th ruling issued during the 24th week
40
ommercial sources for Revenue Rulings and Procedures are available,
C
usually requiring a subscription fee. Older Revenue Rulings and Procedures
often are cited as being published in the Cumulative Bulletin (C.B.) rather
than the Internal Revenue Bulletin (I.R.B.).
41
ost-1984 letter rulings may be substantial authority for purposes of the
P
accuracy-related penalty; see Notice 90–20.
19961_ch01_hr_002-049.indd 19
42
ev.Proc. 2022–3 contains a list of areas in which the IRS will not issue
R
advance rulings. According to the IRS, the main reason they will not rule
in certain areas is that specific fact-oriented situations are involved. As a
result, a ruling may not be obtained on many of the problems that are
particularly troublesome for taxpayers.
43
§ 6110.
44
§ 6110(k)(3). Post-1984 TAMs may be substantial authority for purposes of
avoiding the accuracy-related penalty. Notice 90–20.
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Introduction to Taxation and Business Entities
Letter rulings and TAMs issued before 2000 are often cited with only two-digit years
(e.g., Ltr.Rul. 9933108).
Like letter rulings, determination letters are issued at the request of taxpayers and
provide guidance concerning the application of the tax law. They differ from individual
rulings in that the issuing source is an IRS Area Director (rather than the National Office
of the IRS). Also, determination letters usually involve completed (as opposed to proposed) transactions. Determination letters are not published by the government and are
made known only to the party making the request.
The following examples illustrate the distinction between individual rulings and
determination letters.
Difference between Letter Rulings and Determination Letters
Example
17
Example
18
The shareholders of Black Corporation and White Corporation want assurance that the
consolidation of the corporations into Gray Corporation will be a nontaxable reorganization (see
Chapter 7). The proper approach is to request from the National Office of the IRS an individual
ruling concerning the income tax effect of the proposed transaction.
The tax director of Bends Corporation wants confirmation that its retirement plan meets all
requirements for optimal tax treatment for the employer and employees. The proper procedure
is to request a determination letter from the IRS.
1-4c Judicial Sources of the Tax Law
Five Federal courts have jurisdiction over tax disputes between the IRS and taxpayers:
the U.S. Tax Court, the U.S. District Court, the U.S. Court of Federal Claims, the U.S.
Court of Appeals, and the U.S. Supreme Court.
The Judicial Process in General
Once a taxpayer has exhausted the remedies available within the IRS (i.e., no satisfactory settlement has been reached at the agent or at the Independent Office of Appeals
level), the dispute can be taken to the Federal courts. The trial and appellate court
system for Federal tax litigation is illustrated in Exhibit 1.4.
A trial court, also known as a court of original jurisdiction , initially hears the case.
Appeals (either by the taxpayer or the IRS) are heard by the appropriate appellate
court. A taxpayer has a choice of three trial courts: a U.S. District Court, the U.S. Court
of Federal Claims, or the U.S. Tax Court.
The U.S. Tax Court contains a Small Cases Division that only hears cases involving
amounts of $50,000 or less. The ruling of the judge is final (no appeal is available), and
these rulings are not precedent for any other cases (i.e., they are not primary authority
and are not citable as substantial authority). Proceedings of the Small Cases Division
are informal, and because there is no requirement that a taxpayer be represented by an
attorney, they can be less costly for a taxpayer (the filing fee is $60). The typical small case
lasts one to two hours, and the taxpayer only needs to tell the judge their story and present
any supporting evidence. Special trial judges, rather than Tax Court judges, often preside
over these hearings. Some of these cases can be found on the U.S. Tax Court website.
Several other terms are important to understand. The plaintiff is the party requesting
action in a court, and the defendant is the party against whom the suit is brought. Sometimes
a court uses the terms petitioner and respondent. In general, petitioner is a synonym for
plaintiff, and respondent is a synonym for defendant. At the trial court level, a taxpayer usually is the petitioner and the government is the respondent. If the taxpayer wins and the government appeals as the new petitioner (or appellant), the taxpayer now is the respondent.
American law, following English law, is frequently created by judicial decisions.
Under the doctrine of stare decisis (“let the decision stand”), each case has precedential
value for future cases with the same controlling set of facts.
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Chapter 1 Understanding and Working with the Federal Tax Law
E x h i b i t 1.4
1-21
Federal Judicial Tax Process
U.S.
Supreme Court
U.S. Court of
Appeals
(Regional Circuit)
U.S. Tax
Court
U.S. Court of
Appeals
(Federal Circuit)
U.S. District
Court
Small Cases
Division*
U.S. Court
of Federal
Claims
Appellate
Courts
Trial Courts
(Courts of
Original
Jurisdiction)
* No appeal from this division of the U.S. Tax Court.
Judges are not required to follow judicial precedent beyond their own jurisdiction.
For example, the decisions of an appellate court are binding only on the trial courts
within its jurisdiction and not on other trial courts. Different appellate courts may reach
different opinions about the same issue. Further, the doctrine of precedential authority
requires a court to follow prior cases only when the issues and material facts of the
current case are essentially the same as those involved in the prior decisions.
Most Federal and state appellate court decisions and some decisions of trial courts
are published. Published court decisions are organized by jurisdiction (Federal or state)
and level of court (appellate or trial).
Trial Courts
Here are some differences between the various trial courts (courts of original jurisdiction):
• Number of courts. There is only one Court of Federal Claims and only one Tax
Court, but there are many U.S. District Courts. District Courts hear cases based on
where the taxpayer lives (so a taxpayer in Atlanta would have her case heard by
the Atlanta U.S. District Court).
• Number of judges. District Courts have a number of judges, but only one judge
hears a case. The Court of Federal Claims has 16 judges, and the Tax Court has
19 regular judges. Typically, Tax Court cases are heard and decided by only one
of the 19 regular judges. However, if the case is viewed as important, or novel tax
issues are raised, the entire Tax Court might hear the case. If a case is reviewed
by the full Tax Court, such an en banc decision has compelling authority.
• Location. The Court of Federal Claims meets most often in Washington, D.C.
Each state has at least one District Court, and the more populous states have more
than one. The Tax Court is officially based in Washington, D.C., but its judges travel
to different parts of the country and hear cases at predetermined locations and dates.
• Jurisdiction of the Tax Court and District Courts. The Tax Court hears only Federal tax
cases and is the most frequently used forum for tax cases since its judges have more tax
expertise; many had careers in the IRS or Treasury Department before being appointed
to the Tax Court. The District Courts hear a wide variety of nontax cases as well. As a
result, these judges are viewed as generalists (rather than s­ pecialists) in tax law.
19961_ch01_hr_002-049.indd 21
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• Jurisdiction of the Court of Federal Claims. The U.S. Court of Federal Claims has
jurisdiction over any claim against the United States. As a result, the Court of Federal
Claims hears nontax litigation as well as tax cases. Court of Federal Claims judges
are tax law generalists. This court is viewed as a stronger option when equity is an
issue (as opposed to purely technical issues) or when the case requires extensive
discovery of evidence. It is considered by some to have a pro-business orientation.45
• Jury trial. A jury trial is available only in a District Court. However, because juries
can decide only questions of fact (and not questions of law), taxpayers who
choose a District Court often do not request a jury trial. In that event, the judge
decides all issues in a bench trial. A District Court decision carries precedential
value only in its district.
• Payment of deficiency. Before the Court of Federal Claims or a District Court will
hear a case, the taxpayer must pay any taxes assessed by the IRS and then sue for
a refund. This is not the case with the Tax Court. Here, a taxpayer may request
a hearing without making any payments to the IRS. As a result, whether to pay
the tax in advance (and limit further interest and penalties) or wait to pay the tax
(and risk additional interest and penalties) becomes part of the decision-making
process of selecting a trial court.
• Appeals. Appeals from a District Court or a Tax Court decision go to the appropriate U.S. Court of Appeals (i.e., the circuit in which the taxpayer resides). Appeals
from the Court of Federal Claims go to the Court of Appeals for the Federal Circuit.
• Gray areas. Because there are “gray areas” in the tax laws, courts may disagree as
to the proper tax treatment of an item. With these differences in judicial authority,
a taxpayer must consider how a specific court might rule when choosing the most
favorable forum to hear the case.
Some of the characteristics of the judicial system just described are summarized in
Concept Summary 1.1.
Concept Summary 1.1
Federal Judicial System
Issue
U.S. Tax Court
U.S. District Court
U.S. Court of Federal Claims
Number of judges per court
19*
1
16
Payment of deficiency before
trial
No
Yes
Yes
Jury trial available
No
Yes
No
Types of disputes
Tax cases only
Most criminal/civil cases
Claims against the United States
Jurisdiction
Nationwide
Location of taxpayer
Nationwide
IRS acquiescence policy
Yes
Yes
Yes
Appeal route
U.S. Court of Appeals
U.S. Court of Appeals
U.S. Court of Appeals for the
Federal Circuit
*Some positions may be unfilled at any time. Senior judges and special trial judges may be used to manage the caseload.
Appellate Courts
A trial court can be appealed to the appropriate U.S. Court of Appeals. The 11 geographic circuits, the circuit for the District of Columbia, and the Federal Circuit 46 appear
45
.D. Peyser, “The Case for Selecting the Claims Court to Litigate a Federal
T
Tax Liability,” The Tax Executive (Winter 1988): 149.
19961_ch01_hr_002-049.indd 22
46
he Court of Appeals for the Federal Circuit was created effective
T
October 1, 1982, by P.L. 97–64 (4/2/82) to hear decisions appealed from
the Claims Court (now the Court of Federal Claims).
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Chapter 1 Understanding and Working with the Federal Tax Law
The Federal Courts of Appeals
E x h i b i t 1.5
WASHINGTON
WASHINGTON
WESTERN
EASTERN
ALASKA
MAINE
NORTH DAKOTA
MONTANA
VERMONT
MINNESOTA
MICHIGAN WESTERN
OREGON
NEW YORK
NORTHERN
IDAHO
WISCONSIN
WESTERN
WISCONSIN
EASTERN
SOUTH DAKOTA
WYOMING
F OR
C AL I
HAWAII
IOWA
NORTHERN
N IA
NEVADA
ILLINOIS
CENTRAL
CALIFORNIA
EASTERN
COLORADO
TH E R
KANSAS
MISSOURI
WESTERN
N
GUAM
ILLINOIS
NORTHERN
IOWA
SOUTHERN
UTAH
NO R
NORTHERN
MARIANA
ISLANDS
NEBRASKA
CALIFORNIA
SOUTHERN
OKLAHOMA
WESTERN
ARIZONA
NEW MEXICO
TEXAS
NORTHERN
MISSOURI
EASTERN
TENNESSEE
WESTERN
ARKANSAS
EASTERN
OKLAHOMA
EASTERN ARKANSAS
MISSISSIPPI
WESTERN
NORTHERN
PUERTO RICO
TEXAS
EASTERN
VIRGIN ISLANDS
LEGEND
Circuit Boundaries
State Boundaries
District Boundaries
LOUISIANA
WESTERN
INDIANA
NORTHERN
INDIANA
SOUTHERN
KENTUCKY
WESTERN
TENNESSEE
MIDDLE
OHIO
NORTHERN
RHODE
NEW YORK CONN
ISLAND
SOUTH
PENNSYLVANIA
MIDDLE
NEW YORK EASTERN
PENNSYLVANIA
PENN
WESTERN
NEW JERSEY
EASTERN
DISTRICT OF COLUMBIA
DELAWARE
OHIO
SOUTHERN W. VIRGINIA
NORTHERN
KENTUCKY
EASTERN
W. VIRGINIA
SOUTHERN
VIRGINIA
WESTERN
TENNESSEE
EASTERN
GEORGIA
NORTHERN
ALABAMA
NORTHERN
ALABAMA
MISSISSIPPI ALABAMA MIDDLE
SOUTHERN SOUTHERN
LOUISIANA
MIDDLE
LOUISIANA
EASTERN
TEXAS WESTERN
MASSACHUSETTS
MICHIGAN
EASTERN
MICHIGAN
WESTERN
ILLINOIS
SOUTHERN
OKLAHOMA
NORTHERN
CALIFORNIA CENTRAL
NEW HAMPSHIRE
NEW YORK
WESTERN
MARYLAND
VIRGINIA
EASTERN
NORTH
NORTH
NORTH CAROLINA CAROLINA
CAROLINA MIDDLE EASTERN
EASTERN
SOUTH
CAROLINA
GEORGIA
GEORGIA
MIDDLE
SOUTHERN
Washington, D.C.
FLORIDA NORTHERN
TEXAS
SOUTHERN
FLORIDA
MIDDLE
FLORIDA
SOUTHERN
Washington, D.C.
ADMINISTRATIVE OFFICE OF THE UNITED STATES SUPREME COURT
APRIL 1988
in Exhibit 1.5. Generally, a three-judge panel hears a Court of Appeals case, but occasionally the full court decides more controversial cases.
If the Government loses at the trial court level (District Court, Tax Court, or Court of
Federal Claims), it may decide not to appeal. However, the fact that the IRS does not
appeal does not mean that the IRS agrees with the result (and it may litigate similar
issues in the future).
The IRS may decide not to appeal for a number of reasons. First, the IRS may decide
that available personnel should be assigned to other more important cases. Second,
the IRS may decide that the taxpayer has a sympathetic position or the facts may be
particularly strong in their favor. In this event, the IRS may wait to test the legal issues
with a different taxpayer (who might have a weaker case). Third, the Court of Appeals
of jurisdiction might matter. Based on past experience and precedent, the IRS may
decide that the chance for success on a particular issue might be more promising in a
different Court of Appeals.
District Courts, the Tax Court, and the Court of Federal Claims must abide by the
precedents set by a Court of Appeals of jurisdiction. A particular Court of Appeals need
not follow the decisions of another Court of Appeals. All courts, however, must follow
the decisions of the U.S. Supreme Court.
The role of appellate courts is usually limited to a review of whether the trial court
applied the proper law in arriving at its decision. Rarely does an appellate court question a lower court’s fact-finding determination.
An appeal can have a number of possible outcomes. The appellate court may approve
(affirm) or disapprove (reverse) the lower court’s finding, or it may send the case back
to the trial court for further consideration (remand). When many issues are involved,
a taxpayer may encounter a mixed result. As a result, the lower court may be affirmed
(aff’d) on Issue A and reversed (rev’d) on Issue B, while Issue C is remanded (rem’d)
for additional fact finding.
19961_ch01_hr_002-049.indd 23
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When more than one judge is involved in the decision-making process, disagreements are common. In addition to the majority view, one or more judges may concur
(agree with the result reached but not with some or all of the reasoning) or dissent
(disagree with the result). In any decision, of course, the majority controls. But concurring and dissenting views can have influence on future cases or other courts.
Appealing from the Tax Court The Tax Court is a national court, meaning that it
hears and decides cases from all parts of the country.
Under a policy known as the Golsen rule, the Tax Court decides a case as it believes
the law should be applied only if the Court of Appeals of appropriate jurisdiction has
not yet ruled on the issue or has previously affirmed the Tax Court’s rationale. If the
Court of Appeals has ruled on a case similar to the one being heard by the Tax Court,
the Tax Court will conform to the Appeals Court decision under the Golsen rule even
though it disagrees with the decision.47
Example
19
Gene lives in Texas and sues in the Tax Court on Issue A. The Fifth Circuit Court of Appeals is the appropriate appellate court for Texas. The Fifth Circuit has already decided, in a case involving similar facts but
a different taxpayer, that Issue A should be resolved in favor of the taxpayer. Although the Tax Court
believes that the Fifth Circuit Court of Appeals is wrong, under the Golsen rule, it will rule in favor of Gene.
Shortly thereafter, Beth, a resident of New York, in a comparable case, sues in the Tax Court on Issue
A. The Second Circuit Court of Appeals, the appellate court that would hear a Tax Court appeal from
New York, has never expressed itself on Issue A. As a result, the Tax Court will decide against Beth.
As a result, it is possible for two taxpayers, both having their cases heard by the Tax Court, to end
up with opposite results merely because they live in different parts of the country.
Appeal to the U.S. Supreme Court Appeal to the U.S. Supreme Court is by Writ of
Certiorari . If the Court agrees to hear the case, it will grant the Writ (cert. granted). Since
the Supreme Court rarely hears tax cases, most often it denies jurisdiction (cert. denied).
The Court usually grants certiorari when it must resolve a conflict among the Courts
of Appeals (e.g., two or more appellate courts have assumed opposing positions on a
particular issue) or when the tax issue is extremely important. The granting of a Writ of
Certiorari indicates that at least four of the nine members of the Supreme Court believe
that the issue is of sufficient importance to be heard by the full Court.
Judicial Citations
Court decisions are an important source of tax law, and the ability to cite and locate a
case is a critical skill when working with the tax law. Judicial citations usually follow
a standard pattern: case name, volume number, reporter series, page or paragraph
number, court (where necessary), and year of the decision (see Concept Summary 1.2).
These conventions are based on the legacy of publishing court decisions in books, but
they carry on even in today’s electronic research environment.
Judicial Citations—The U.S. Tax Court The U.S. Tax Court issues two types of decisions: Regular decisions and Memorandum decisions based on the Chief Judge’s determination. They differ in both substance and form. In terms of substance, Memorandum
decisions deal with cases that involve only the application of established principles of
law. Regular decisions involve novel issues not previously resolved by the Tax Court.
In actual practice, however, both Regular and Memorandum decisions represent the
position of the Tax Court and, as such, can be relied upon.48
The Regular and Summary decisions issued by the Tax Court also differ in form.
Regular decisions are published by the U.S. Government in a series called Tax Court of
the United States Reports (T.C.). Each volume of these reports covers a six-month period
( January 1 through June 30 and July 1 through December 31) and is given a succeeding
47
Jack E. Golsen, 54 T.C. 742 (1970); see also John A. Lardas, 99 T.C. 490
(1992).
19961_ch01_hr_002-049.indd 24
48
In contrast, U.S. Tax Court Small Cases Division Summary Opinions carry
no precedential value. Summary Opinions issued after January 9, 2001, are
available on the U.S. Tax Court website.
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Chapter 1 Understanding and Working with the Federal Tax Law
1-25
Concept Summary 1.2
Judicial Sources
Court
U.S. Supreme Court
Location
Authority
S.Ct. Series (West)
Highest authority
U.S. Series (U.S. Gov’t.)
L.Ed.2d (Lawyer’s Co-op.)
AFTR (RIA)
USTC (CCH)
U.S. Courts of Appeal
Federal 3d (West)
Next highest appellate court
AFTR (RIA)
USTC (CCH)
Tax Court (Regular decisions)
U.S. Gov’t. Printing Office
Highest trial court*
RIA/CCH separate services
Tax Court (Memorandum decisions)
RIA T.C.Memo. (RIA)
Less authority than Regular T.C. decision
TCM (CCH)
U.S. Court of Federal Claims**
Federal Claims Reporter (West)
Similar authority as Tax Court
AFTR (RIA)
USTC (CCH)
U.S. District Courts
F.Supp.2d Series (West)
Lowest trial court
AFTR (RIA)
USTC (CCH)
Small Cases Division of Tax Court
U.S. Tax Court website***
No precedent value
ote: All Judicial Sources can be accessed electronically through Thomson Reuters Checkpoint (and other commercial tax services).
N
*Theoretically, the Tax Court, Court of Federal Claims, and District Courts are on the same level of authority. But some people believe that because the Tax Court
hears and decides tax cases from all parts of the country (i.e., it is a national court), its decisions may be more authoritative than a Court of Federal Claims or
District Court decision.
**Before October 29, 1992, the U.S. Claims Court.
***Starting in 2001.
volume number. Usually there is a time lag between the date a decision is rendered and
the date it is published. A temporary citation may be necessary to help the researcher
locate a recent Regular decision. Consider, for example, the temporary and permanent
citations for Wiley Ramey, a decision filed on January 14, 2021:
Temporary Citation
Permanent Citation
{
{
Wiley Ramey 156 T.C. –––––, No. 1 (2021).
Explanation: Page number left blank because not yet known.
Wiley Ramey , 156 T.C. 1 (2021).
Explanation: Page number now available.
Both citations tell us that the case ultimately will appear in Volume 156 of the Tax
Court of the United States Reports. But until this volume is made available, the page number must be left blank. Instead, the temporary citation identifies the decision as being the
first Regular decision issued by the Tax Court since Volume 155 ended. With this information, the decision can be easily located in the special Tax Court services published
by Commerce Clearing House (CCH) and Research Institute of America (RIA). Once
Volume 156 is released, the permanent citation can be substituted and the number of
the case dropped. Starting in 1995, both Regular and Memorandum decisions are issued
on the U.S. Tax Court website (ustaxcourt.gov). Memorandum decisions, although
available on the U.S. Tax Court website, are not published by the U.S. Government.
19961_ch01_hr_002-049.indd 25
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1-26
Part 1
Introduction to Taxation and Business Entities
Before 1943, the Tax Court was called the Board of Tax Appeals, and its decisions were published as the United States Board of Tax Appeals Reports (B.T.A.). These
47 ­volumes cover the period from 1924 to 1942. For example, the citation Karl Pauli,
11 B.T.A. 784 (1928) refers to the 11th volume of the Board of Tax Appeals Reports,
page 784, issued in 1928.
Memorandum decisions are published by both CCH and RIA. Consider, for example,
the three different ways the Nick R. Hughes case can be cited:
Nick R. Hughes, T.C.Memo. 2009–94.
Explanation: The 94th Memorandum decision issued by the Tax Court in 2009.
Nick R. Hughes, 97 TCM 1488.
Explanation: Page 1488 of Vol. 97 of the CCH Tax Court Memorandum Decisions.
Nick R. Hughes, 2009 RIA T.C.Memo. ¶2009,094.
Explanation: Paragraph 2009,094 of the RIA T.C. Memorandum Decisions.
Note that the third citation contains the same information as the first. As a result,
¶2009,094 indicates both the year and decision number of the case.49
U.S. Tax Court Summary Opinions relate to decisions of the Tax Court’s Small Cases
Division and may not be treated as precedent. For example, Maria Claudia Ginos, decision entered on May 21, 2021, is cited as follows:
Maria Claudia Ginos, T.C. Summary 2021–14.
If the IRS loses a decision, it may indicate whether it agrees or disagrees with
the results reached by the court by publishing an acquiescence (“A” or “Acq.”) or
­nonacquiescence (“NA” or “Nonacq.”), respectively. The acquiescence or nonacquiescence
is published in the Internal Revenue Bulletin (and as an Action on Decision). The IRS
can revoke an acquiescence or a nonacquiescence retroactively.
Judicial Citations—The U.S. District Courts, Court of Federal Claims, and
Courts of Appeals District Court, Court of Federal Claims, Court of Appeals, and
Supreme Court decisions dealing with Federal tax matters are reported in both
the CCH U.S. Tax Cases (USTC) and the RIA American Federal Tax Reports (AFTR)
series.
U.S. District Court decisions, dealing with both tax and nontax issues, also are
published by West in its Federal Supplement (F.Supp.) series. The following examples
illustrate three different ways to cite a District Court case:
Turner v. U.S., 2004–1 USTC ¶60,478 (D.Ct. Tex., 2004).
Explanation: Reported in the first volume of the U.S. Tax Cases, published
by Commerce Clearing House for calendar year 2004 (2004–1) and located at
paragraph 60,478 (¶60,478).
Turner v. U.S., 93 AFTR 2d 2004–686 (D.Ct. Tex., 2004).
Explanation: Reported in the 93rd volume of the second series of the American
Federal Tax Reports (AFTR 2d), published by RIA and beginning on page 686.
Turner v. U.S., 306 F.Supp.2d 668 (D.Ct. Tex., 2004).
Explanation: Reported in the 306th volume of the second series of the ­Federal
Supplement (F.Supp.2d), published by West and beginning on page 668.
The case name, the reference to the U.S. District Court of Texas (D.Ct. Tex.), and the
year the decision was rendered (2004) appear in each of the citations.50
49
In this text, the Research Institute of America (RIA) citation for Memorandum decisions of the U.S. Tax Court is omitted. As a result, Nick R. Hughes
is cited as 97 TCM 1488, T.C.Memo. 2009–94.
19961_ch01_hr_002-049.indd 26
50
In the text, the case is cited in the following form: Turner v. U.S., 2004–1
USTC ¶60,478, 93 AFTR 2d 2004–686, 306 F.Supp.2d 668 (D.Ct.Tex., 2004).
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Chapter 1 Understanding and Working with the Federal Tax Law
1-27
Decisions of the Court of Federal Claims are published in the USTCs, the AFTRs, and
in a West reporter, the Federal Claims Reporter, abbreviated as Fed.Cl.
Apollo Computer, Inc. v. U.S.
(Fed.Cl., 1994)
95–1 USTC ¶50,015 (CCH citation)
74 AFTR 2d 94–7172 (RIA citation)
32 Fed.Cl. 334 (West citation)
Decisions of the Courts of Appeals are published in a West reporter designated as
the Federal Third (F.3d) series, which began in October 1993, in addition to USTCs and
AFTRs. Illustrations of the different forms follow:
Estate of Gribaukas v. Comm.
(CA–2, 2003)
2003–2 USTC ¶60,466 (CCH citation)
92 AFTR 2d 2003–5914 (RIA citation)
342 F.3d 85 (West citation)
Judicial Citations—The U.S. Supreme Court Supreme Court decisions are published
by CCH in the USTCs and by RIA in the AFTRs. The U.S. Government Printing Office
also publishes these decisions in the United States Supreme Court Reports (U.S.), as does
West in its Supreme Court Reporter (S.Ct.), and the Lawyer’s Co-operative Publishing
Company in its United States Reports, Lawyer’s Edition (L.Ed.). The following illustrates
the different ways the same decision can be cited:
U.S. v. The Donruss Co.
(USSC, 1969)
69–1 USTC ¶9167 (CCH citation)
23 AFTR 2d 69–418 (RIA citation)
89 S.Ct. 501 (West citation)
393 U.S. 297 (U.S. Government Printing Office citation)
21 L.Ed.2d 495 (Lawyer's Co-operative Publishing Co. citation)
The parenthetical reference (USSC, 1969) identifies the decision as having been rendered by the U.S. Supreme Court in 1969. In this text, Supreme Court decision citations
are limited to the CCH (USTC), the RIA (AFTR), and the West (S.Ct.) versions.
1-4d Other Sources of the Tax Law
Other sources of the tax law include tax treaties and tax periodicals.
Tax Treaties
The United States signs certain tax treaties (sometimes called tax conventions) with foreign
countries to assist in tax enforcement and to avoid double taxation. These treaties affect
transactions involving U.S. persons and entities operating or investing in a foreign country, as
well as persons and entities of a foreign country operating or investing in the United States.
Although these bilateral agreements are not codified in any one source, they are available
from the IRS at tinyurl.com/taxtreaties, as well as in various commercial tax services.
Neither a tax law nor a tax treaty automatically takes legal precedence. When there is
a direct conflict between a treaty and the Code, the most recent item takes precedence. A
taxpayer must disclose on the tax return any position where a treaty overrides a tax law.51
Tax Periodicals
The use of tax periodicals can often shorten the research time needed to resolve a tax
problem. An article relevant to the issue at hand may provide the references needed
to locate the primary sources of the tax that apply (e.g., citations to judicial decisions,
Regulations, and other IRS pronouncements).
Several indexes are available for locating tax articles, including Federal Tax Articles
(published by CCH) and Index to Federal Tax Articles (published by Thomson Reuters).
Both of these indexes are available by subscription.
51
§ 7852(d).
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1-28
Part 1
Introduction to Taxation and Business Entities
Here are some of the more useful tax periodicals:
Journal of Taxation
Journal of International Taxation
Practical Tax Strategies
Estate Planning
Corporate Taxation
Business Entities
Taxation of Exempts
Real Estate Taxation
store.tax.thomsonreuters.com
The Tax Executive
tei.org
The Tax Adviser (AICPA)
thetaxadviser.com
Journal of the American Taxation
Association
aaajournals.org/loi/atax
Oil, Gas & Energy Quarterly
faculty.tamucc.edu/dcrumbley/
index.html
Trusts & Estates
wealthmanagement.com/
trusts-estates
Journal of Passthrough Entities
TAXES—The Tax Magazine
taxna.wolterskluwer.com
Tax Notes
Tax Notes State
Tax Notes International
taxnotes.com
Tax Law Review
law.nyu.edu/tax/
taxlawreview/index.htm
The ATA Journal of Legal Tax Research
aaajournals.org/loi/jltr
LO.6
List and assess tax law
sources.
1-5 Working with the Tax Law—Locating
and Using Tax Sources
Tax law consists of a body of legislative (e.g., Code Sections and tax treaties), administrative
(e.g., Regulations and Rulings), and judicial (e.g., court cases) pronouncements. Working
with the tax law requires being able to locate and effectively use these sources. A major
consideration is the time required to find relevant information related to the issues identified.
Unless the problem is simple (e.g., the Code Section is known and there is a Regulation on point), the research process begins with a tax service.
1-5a Commercial Tax Services
In the past, commercial tax services could be classified as annotated (i.e., organized
by Internal Revenue Code) or topical (i.e., organized by major topics). However, as tax
research has become electronic, this classification system is no longer appropriate. For
example, Thomson Reuters Checkpoint includes both the Federal Tax Coordinator 2d
(topical) and the United States Tax Reporter (annotated).
Here is a partial list of the available commercial tax services:
• CCH IntelliConnect and CCH AnswerConnect, CCH/Wolters Kluwer. Includes the
Standard Federal Tax Reporter (along with other CCH materials).
• Thomson Reuters Checkpoint, Research Institute of America. Includes RIA’s Federal
Tax Coordinator 2d and United States Tax Reporter.
• Practical Tax Expert, CCH/Wolters Kluwer.
• Tax Management Portfolios, Bloomberg BNA.
• Parker Tax Pro Library.
• Mertens Law of Federal Income Taxation, Thomson Reuters.
• Thomson Reuters Westlaw and WestlawNext—compilations include access to Tax
Management Portfolios, Federal Tax Coordinator 2d, and Mertens.
• LexisNexis Tax Center—a compilation of primary sources and various materials
taken from CCH, Matthew Bender, Kleinrock, and Bloomberg BNA.
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Chapter 1 Understanding and Working with the Federal Tax Law
1-29
Financial Disclosure Insights Where Does GAAP Come From?
Tax law has many sources, including Congress
and the legislators of other countries, the courts, and the IRS.
Similarly, accounting principles also have many sources. In
reconciling the tax and financial accounting reporting of a
transaction, the tax professional needs to know the hierarchy
of authority of accounting principles so that the proper level of
importance can be assigned to a specific GAAP document. The
diagram shown below presents the sources of GAAP listed in
general order of authority from highest to lowest.
Highest
Authority
Professional research is conducted to find and analyze
the sources of accounting reporting standards in much the
same way tax professionals conduct research into open
tax questions. In fact, many of the publishers that provide
tax research materials also can be used to find GAAP and
IFRS documents. The Financial Accounting Standards Board
(FASB) also makes its standards and interpretations available
by subscription.
• Financial Accounting Standards and Interpretations of the FASB.
• Pronouncements of bodies that preceded the FASB, such as the Accounting Principles Board (APB).
• FASB Technical Bulletins.
• Audit and Accounting Guides, prepared by the American Institute of CPAs (AICPA) and cleared by the FASB.
• Practice Bulletins, prepared by the AICPA and cleared by the FASB.
•
•
•
•
•
Interpretation Guides of the FASB Staff.
Accounting Interpretations of the AICPA.
IASB Accounting Standards.
FASB Concepts Standards.
Widely accepted accounting practices, professional journals, accounting textbooks, and treatises.
1-5b Using Electronic (Online) Tax Services
A competent tax professional must become familiar and proficient with electronic
research services and be able to use them to complete research projects efficiently.
Following certain general procedures, however, can simplify the research process. The
following suggestions may be helpful:52
• Carefully choose keywords for the search. Words with a broad usage, such as
income, are of limited value. If the researcher is interested in a specific type
of dividend income, the search phrase dividend income is too broad because
it finds a variety of topics including stock dividends, constructive dividends,
and liquidating dividends (drawing about 2,000 hits in Thomson Reuters
Checkpoint). Searching for qualified dividend income, stock dividend income,
cash dividend income, or property d
­ ividend income narrows the number of items
found.
• Take advantage of connectors to place parameters on the search and further restrict
the output. Although each tax service has its own set of connectors, many are
similar. Enclosing words in quotation marks (e.g., “personal service corporation”)
means “exact phrase” in both Thomson Reuters Checkpoint and CCH IntelliConnect.
• Be selective in choosing the data to search. For example, if the research project
does not involve case law, do not include judicial decisions in the search.
52
or a more complete discussion of the use of Thomson Reuters Checkpoint
F
and CCH IntelliConnect, as well as internet research in taxation in general,
19961_ch01_hr_002-049.indd 29
see Sawyers and Gill, Federal Tax Research, 12th ed. (Cengage Learning,
2021), Chapters 6 and 7.
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1-30
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Introduction to Taxation and Business Entities
• Use a table of contents, an index, or a citation when appropriate. Although the
keyword approach is used most frequently, there are other ways to search tax
databases. Using the table of contents or index may narrow the information that
needs to be examined. Citations may be used to search for statutory (e.g., Code
Section), administrative (e.g., Rev.Rul.), or judicial (e.g., Tax Court) sources and
also can provide access to the tax service’s annotations.
• Always check for current developments. Tax services are updated several times a
day, and tax newsletters often feature highlights of recent tax law developments.
In addition, there is no substitute for the original source. Do not base a conclusion solely on a tax service’s commentary. If a Code Section, Regulation, or case
is vital to the research, read it.
1-5c Noncommercial Electronic (Online) Tax Sources
The internet provides a wealth of tax information in several popular forms, sometimes
at no cost to the researcher. A tax professional can access a significant amount of information that can aid the research process.
• Websites are provided by accounting and consulting firms, publishers, tax academics, libraries, and governmental bodies as a means of making information widely
available. One of the best sites available to the tax professional is the Internal
Revenue Service’s home page, illustrated in Exhibit 1.6. This site offers downloadable forms and instructions, interpretations of Regulations, and news update items.
Exhibit 1.7 lists some of the websites that may be most useful to tax researchers.
• Blogs and RSS sites provide a means by which information related to the tax law can
be exchanged among taxpayers, tax professionals, and others who subscribe to the
group’s services. Individuals can read the exchanges and offer replies and suggestions to inquiries. Discussions address the interpretation and application of existing
law, analysis of proposals and new pronouncements, and reviews of tax software.
Although tax information on the internet is plentiful, information in the public domain
should not be relied upon without referring to other sources. Anyone can set up a website, and the quality of the information can be difficult for a tax professional to ascertain.
The IRS’s Home Page
© IRS-Internal Revenue Service
E x h i b i t 1.6
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1-31
Chapter 1 Understanding and Working with the Federal Tax Law
E x h i b i t 1.7
Tax-Related Websites
Website
Web Address
Description
Accounting firms and
­professional organizations
For instance, the AICPA’s page is at
aicpa.org, Ernst & Young is at ey.com, Deloitte
is at deloitte.com, KPMG is at kpmg.com, and
PricewaterhouseCoopers is at pwc.com
Tax planning newsletters, descriptions of services
offered and career opportunities, and exchange
of data with clients and subscribers
Cengage Learning
cengage.com
Informational updates, newsletters, support
materials for students and adopters, and
continuing education
Commercial tax publishers
For instance, taxnotes.com, taxna.wolterskluwer
.com, tax.thomsonreuters.com, and
pro.bloombergtax.com
Information about products and services available
for subscription and newsletter excerpts
Court opinions
The site at law.justia.com covers state,
Federal, and Supreme Court decisions
(but not Tax Court)
A synopsis of result reached by the court
Federal Register
federalregister.gov
Releases from the IRS (e.g., Regulations)
Internal Revenue Service
irs.gov
News releases, downloadable forms and
instructions, tables, Circular 230, and e-mail
Tax Almanac
taxalmanac.org
Smorgasbord of tax research resources
Tax Analysts
taxnotes.com
Policy-oriented readings on the tax law and
proposals to change it and articles on various
tax subjects
taxnotes.com/research/federal
Tax-related laws, regulations, rulings, procedures,
and other documents.
Tax Foundation
taxfoundation.org
Nonprofit educational organization that promotes
sound tax policy and measures tax burdens
Tax laws online
Regulations are at law.cornell.edu/cfr,
and the Code is at uscode.house.gov
U.S. Tax Court decisions
ustaxcourt.gov
Recent U.S. Tax Court decisions
Caution: Web addresses change frequently.
1-6 Working with the Tax Law—Tax Research
Tax research is the process of finding a competent and professional conclusion to a tax
problem. The problem may originate from either completed or proposed transactions. In
the case of a completed transaction, the objective of the research is to determine the tax
result of what has already taken place. For example, is a taxpayer expense ­deductible?
When dealing with proposed transactions, tax research has a different ­objective: effective
tax planning by determining the tax consequences of various alternatives. A large part
of a tax professional’s career is spent on this type of tax research.
Tax research involves the following steps:
LO.7
Demonstrate the ability to
conduct tax research.
•
•
•
•
Identifying and refining the problem.
Locating the appropriate tax law sources.
Assessing the validity of the tax law sources.
Arriving at the solution or at alternative solutions (including consideration of
nontax factors).
• Effectively communicating the solution to the taxpayer.
• Updating the solution (where appropriate) in light of new developments.
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1-32
Part 1
Introduction to Taxation and Business Entities
The tax research process is illustrated in Exhibit 1.8. The broken lines indicate steps
of particular interest when tax research is directed toward proposed rather than completed transactions.
1-6a Identifying the Problem
Problem identification starts by documenting the relevant facts involved with the issue.
All of the facts that might have a bearing on the problem must be gathered; if any facts
are omitted, the solution provided will likely change. To illustrate, refer to the facts of
The Big Picture on p. 1-1. Is Dana entitled to a bad debt deduction?
Refining the Problem
Before a bad debt deduction is allowed, it must be proven that a debt really existed.
In a related-party setting (e.g., aunt and nephew), the IRS may argue that the original
advance was not a loan but was, in reality, a gift. A key factor is whether the lender (the
aunt) had an honest and real expectation of payment by the borrower (the nephew).53
An expectation of repayment could be established by the following:
•
•
•
•
The borrower issued a written instrument evidencing the obligation.
The loan arrangement provided for interest.
The note specified a set due date.
Collateral was available to the lender in the event of default by the borrower.54
E x h i b i t 1.8
Tax Research Process
Preliminary
Problem
Identification
Legislative
Sources
Administrative
Sources
Tax
Research
Judicial
Sources
Problem
Refinement and
Discovery of
New Problem
Areas
Unofficial
Sources
Nontax
Considerations
Solution
Communication
53
illiam F. Mercil, 24 T.C. 1150 (1955), and Evans Clark, 18 T.C. 780 (1952),
W
aff’d 53–2 USTC ¶9452, 44 AFTR 70, 205 F.2d 353 (CA–2, 1953).
19961_ch01_hr_002-049.indd 32
New
Developments
54
Arthur T. Davidson, 37 TCM 725, T.C.Memo. 1978–167.
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Chapter 1 Understanding and Working with the Federal Tax Law
1-33
The presence of some (or all) of these items does not, however, guarantee that a
loan exists. And the absence of some or all of these items does not make the advance
a gift. Although The Big Picture on p. 1-1 does not provide all of the facts (e.g., was
a written note created and signed?), several items appear to indicate that a loan was
created:
• It appears that the nephew has repaid $16,000 of the $93,000 that he borrowed. If
both parties intended the advance to be a gift, why was a partial repayment made?
• Although a nephew on his way to college would likely have limited assets to serve
as collateral for a loan, the fact that he was obtaining additional education could
reinforce an expectation of repayment. In general, the earning potential of an
individual increases as a result of a college education. By obtaining the education,
the nephew will increase earning power and his financial ability to repay the loan.
Further Refinement of the Problem
Without additional facts, it may be impossible to conclude whether the advance was
a loan or a gift. However, it is possible to document the tax consequences of each
outcome.
If the advance is determined to be a gift, it is subject to the Federal gift tax.55
Whether a gift tax results depends on the aunt’s available unified tax credit. Absent a
unified credit, there will be a gift tax on $79,000 [$93,000 (total gift) − $14,000 (annual
exclusion in 2015)].56 Whether the transfer results in a gift tax, it must be reported on
Form 709 (United States Gift Tax Return) because the amount of the gift exceeds the
annual exclusion.
Even if it is assumed that Dana made a gift to her nephew in 2015, will the intervening seven years preclude the IRS from assessing any gift tax that might be due as a result
of the transfer?57 Further research indicates that the statute of limitations on assessments
does not begin to run when a tax return is not filed.58
What are the tax consequences if the advance is treated as a loan? Aside from the
bad debt deduction aspects (covered later in the chapter), the tax law identifies several
immediate implications:59
• If the loan did not provide for interest (or if the interest was at a below-market
rate), interest will be imputed (i.e., “created”).
a. The lender (the aunt) will be required to include any imputed interest in her
income.
b. She also is deemed to have made a gift of the interest to the borrower.
c. The borrower (nephew) may be entitled to deduct (as an itemized deduction)
a portion of the interest deemed paid to the lender (aunt).
• If the stated interest is at a below-market rate, the difference is treated as noted
above.
• For gift loans of $100,000 or less, the imputed element cannot exceed the net
investment income of the borrower.
55
he transfer does not come within the unlimited gift tax exclusion of
T
§ 2503(e)(2)(A) because the aunt did not pay the amount directly to an
educational institution. Besides, the exclusion covers only tuition payments
and not other costs attendant on going to college (e.g., room and board).
56
he tax, in turn, depends on the amount of taxable gifts the aunt has
T
made in the past. For a discussion of the mechanics of the Federal gift
tax, see Chapter 18.
19961_ch01_hr_002-049.indd 33
57
hroughout the discussion of The Big Picture on p. 1-1, the assumption has
T
been made that if a gift occurred, it took place in 2015. That assumption
need not be the case. Depending on the aunt’s intent, she could have
decided to make a gift of the unpaid balance anytime after the loan was
made (e.g., 2016 or 2017).
58
See § 6501(c)(3) and the discussion of the statute of limitations in Chapter 17.
59
§ 7872.
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1-34
Part 1
Introduction to Taxation and Business Entities
1-6b Locating the Appropriate Tax Law Sources
Once a problem is clearly defined, what is the next step? Although the next step is a
matter of individual judgment, most tax research begins with a keyword search using an
electronic tax service. If the problem is not complex, the researcher may turn directly
to the Internal Revenue Code and the Treasury Regulations. The Code and Regulations
are available in print form (and accessible electronically).
LO.8
Assess the validity and weight
of tax law sources.
1-6c Assessing the Validity of Tax Law Sources
After a source has been located, the next step is to assess the source in light of the
problem at hand. Proper assessment involves careful interpretation of the tax law and
consideration of the law’s relevance and validity.
Interpreting the Internal Revenue Code
The language of the Code can be extremely difficult to comprehend. Some of this difficulty is due to its structure (the Code follows the structure of all U.S. law), so getting
used to reading (and interpreting) the Code can take time.
The Code must be read carefully for restrictive language such as “at least 80 percent”
and “more than 80 percent” or “less than 50 percent” and “exceeds 50 percent.” Whether
two or more clauses are connected by “or” or by “and” makes a great deal of difference.
Sometimes the Code directs the researcher elsewhere for the answer. For example,
§ 162(c) refers to the Foreign Corrupt Practices Act for purposes of determining when
payments to foreign officials are deductible.
Definitions vary from one Code Section to another. For example, § 267 disallows
losses between related parties. Brothers and sisters are included in this definition of
related parties. This is not the case with § 318, which deals with the definition of related
parties for certain stock redemptions. Research has shown that in one-third of the conflicts reaching the Tax Court, the court could not discern the intent of Congress by simply
reading the statute (the Court had to look to Committee Reports to understand intent).60
If an answer is not in the Code, it may be necessary to look to other tax law, including Regulations and judicial decisions.
Assessing the Validity of a Treasury Regulation
Treasury Regulations are the official interpretation of the Code and have the force and
effect of law. Occasionally, however, a court invalidates a Regulation (or a portion of it)
because the Regulation is contrary to the intent of Congress.
Keep the following things in mind when you assess the validity of a Regulation:
• IRS agents must give the Code and any related Regulations equal weight when
dealing with taxpayers and their representatives.
• Taxpayers have the burden of proof to show that a Regulation varies from the
language of the statute and is not supported by the related Committee Reports.
• If the taxpayer challenges a Regulation and loses, a 20 percent accuracy-related
penalty may apply. This accuracy-related penalty deals with the “intentional
disregard of rules and regulations” discussed in Chapter 17.
• Some Regulations merely rephrase what Congress has stated in its Committee
Reports issued when the tax legislation was enacted. These Regulations are almost
impossible to overturn because they clearly reflect the intent of Congress.
• In some Code Sections, Congress has given to the “[Treasury] Secretary or his delegate” the authority to prescribe Regulations to carry out the details of administration
or to otherwise complete the operating rules. In these cases, Congress is delegating
60
. L. Kirkpatrick and W. B. Pollard, “Reliance by the Tax Court on the LegT
islative Intent of Congress,” The Tax Executive (Summer 1986): 358–359.
19961_ch01_hr_002-049.indd 34
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Chapter 1 Understanding and Working with the Federal Tax Law
1-35
its legislative powers to the Treasury Department. Regulations issued under this
type of authority truly possess the force and effect of law and are often called “legislative” Regulations. They are to be distinguished from “interpretative” Regulations,
which are issued to explain the meaning of a particular Code Section.61
• Courts tend to apply a legislative reenactment doctrine. A particular interpretive
Regulation is assumed to have achieved congressional approval if the Regulation
was finalized many years earlier and Congress has not amended the related Code
Section.
Ethics & Equity Choosing Cases for Appeal
The U.S. Government loses a tax case against a
prominent citizen in the U.S. District Court of Iowa. The taxpayer, a minister, had set up three separate trusts for each of
his three children (i.e., a total of nine trusts). The Government
argued that these trusts should be consolidated and treated
as three trusts (one for each child) to stop the taxpayer from
mitigating the progressive individual tax rate structure.
The IRS has decided to appeal a case in this multiple trust
area. As one of the attorneys for the Government, you must
choose between the Iowa case and a similar multiple trust
case decided by the U.S. District Court of Virginia, also in
favor of the taxpayer. In this case, the taxpayer is a CPA who
established four separate trusts for her two children (i.e., a
total of eight trusts).
Factors you are considering are the potential sympathy associated with the minister’s profession (and a lack
thereof associated with the CPA), the facts indicating that
the attempt at tax avoidance is more egregious in the Iowa
case, and a colleague’s opinion that the Virginia case is winnable. Which case will you select? Comment on the fairness
of the Government’s ability and willingness to select a case
to appeal in this fashion.
Assessing the Validity of Other Administrative Sources of the Tax Law
Revenue Rulings issued by the IRS carry less weight than Treasury Department Regulations. Rulings are important, however, in that they reflect the position of the IRS on tax
matters. IRS agents will follow the results reached in a Revenue Ruling.
Actions on Decisions document the IRS’s reaction to certain court decisions. The IRS
follows a practice of either acquiescing (agreeing) or nonacquiescing (not agreeing)
with selected court decisions.
Assessing the Validity of Judicial Sources of the Tax Law
The judicial process as it relates to the formulation of tax law has been described.
How much reliance can be placed on a particular decision depends on the following
variables:
• The level of the court. A decision rendered by a trial court carries less weight than
one issued by an appellate court. Unless Congress changes the Code, decisions
by the U.S. Supreme Court represent the last word on any tax issue.
• Residence of the taxpayer. A decision of the appellate court in the taxpayer’s circuit
carries more weight than one rendered by an appellate court in a different circuit.
If, for example, a taxpayer lives in Texas, a decision of the Fifth Circuit Court of
Appeals (which would hear an appeal from a Texas trial court) means more than
one rendered by the Second Circuit Court of Appeals.
61
However, see Mayo Foundation for Medical Education and Research,
2011–1 USTC ¶50,143, where the Supreme Court provided greater
19961_ch01_hr_002-049.indd 35
deference to interpretive regulations (and appeared to blur the line
between legislative and interpretive regulations).
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1-36
Part 1
Introduction to Taxation and Business Entities
• Whether the decision represents the weight of authority on the issue. In other words,
is it supported by the results reached by other courts?
• The outcome or status of the decision on appeal. That is, if the decision was
appealed, what was the result?
In connection with the last two variables, the use of a citator is invaluable to tax
research. A citator provides the history of a case, including the authority relied on
(e.g., other judicial decisions) in reaching the result. Reviewing the references listed
in the citator discloses whether the decision was appealed and, if so, with what result
(e.g., affirmed, reversed, or remanded). The Thomson Reuters Checkpoint citator also
shows other cases with the same or similar issues and explains how they were decided.
As a result, a citator reflects on the validity of a case and may lead to other relevant
judicial material.62 If one intends to rely on a judicial decision, “citating” the case is
imperative.
Assessing the Validity of Other Sources
Primary sources of tax law include the Constitution, legislative history materials, statutes, treaties, Treasury Regulations, IRS pronouncements, and judicial decisions. The IRS
regards only primary sources to constitute substantial authority. However, reference to
secondary sources such as legal periodicals, treatises, legal opinions, IRS publications,
and other sources can be useful. In general, secondary sources are not authority.
Although the statement that the IRS regards only primary sources as substantial
authority generally is true, there is one exception. For purposes of the accuracy-related
penalty in § 6662, the IRS expands the list of substantial authority to include a number
of non-primary sources (e.g., letter rulings, Chief Counsel Advice, and a Bluebook).63
A “Bluebook” is the general explanation of tax legislation prepared by the Joint Committee
on Taxation of the U.S. Congress. “Authority” does not include conclusions reached in
treatises, legal periodicals, or opinions rendered by tax professionals.
1-6d Arriving at the Solution or at Alternative Solutions
Returning to The Big Picture on p. 1-1, assume that everyone agrees that treating the
advance as a loan is justified based on the facts. As a result, will a bad debt deduction
be allowed for the aunt? To answer this question, the loan must be classified as either
a business or nonbusiness debt. Knowing this classification is important because a
nonbusiness bad debt cannot be deducted until it becomes entirely worthless. Unlike
a business debt, no deduction for partial worthlessness is allowed.64
Given the facts, it is likely that the aunt made a nonbusiness loan in 2015. Almost
always, loans made in a related-party setting are treated as nonbusiness.
The aunt has the burden of proving that the remaining unpaid balance of $77,000
is entirely worthless.65 Some additional questions will need to be answered: Has the
aunt tried to collect on the loan? Has the nephew told her he cannot repay the loan
(maybe due to insolvency)? Maybe the aunt has lost touch with her nephew and does
not know where he is.
If the debt is entirely worthless, we need to determine the year it became worthless.
For example, the worthlessness could have taken place in a year before it was claimed.66
Without additional information, a definitive answer may not be possible. The value of
the research in this case was to raise additional questions. With answers to these questions (or some of the questions), a specific answer can be given to the aunt. Sometimes
guarded judgment is the best possible solution to a tax problem.
62
he major citators are published by CCH, RIA, Westlaw, and Shepard’s. The
T
CCH and RIA citators are available electronically through the CCH IntelliConnect service and Thomson Reuters Checkpoint, respectively. Westlaw’s citator
(KeyCite) is part of its online service. Shepard’s citator is part of LexisNexis.
63
Notice 90–20.
19961_ch01_hr_002-049.indd 36
64
See § 166 and the discussion of investor losses in Chapter 4.
Compare John K. Sexton, 48 TCM 512, T.C.Memo. 1984–360, with Stewart
T. Oatman, 45 TCM 214, T.C.Memo. 1982–684.
66
Ruth Wertheim Smith, 34 TCM 1474, T.C.Memo. 1975–339.
65
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Chapter 1 Understanding and Working with the Federal Tax Law
1-37
1-6e Communicating Tax Research
Once the research process has been completed (including checking for any new developments; see Exhibit 1.8), the researcher will need to prepare a memo, letter, or presentation. The form of communication depends on a number of factors. For example,
most firms document the results of a tax research project in a memorandum. Although
the format of this memorandum can vary, certain elements will appear in all memos. In
addition, virtually all memos are reviewed by senior tax professionals to ensure accuracy.
How are results communicated to the client (does the client receive the tax research
memo, a letter, or some other form of communication)? If an oral presentation is
required, who will be the audience?67 Whatever form it takes, the following elements
will be part of the communication:
• A clear statement of the issue.
• In more complex situations, a short review of the facts that raised the issue.
• A review of the relevant tax law sources (e.g., Code, Regulations, Revenue Rulings,
Revenue Procedures, Notices, and judicial authority).
• Any assumptions made in arriving at the solution.
• The solution recommended and the logic or reasoning supporting it.
• The references consulted in the research process.
Exhibits 1.9, 1.10, and 1.11 present a sample client letter and memoranda for the tax
files based on the facts of The Big Picture.
E x h i b i t 1.9
Client Letter
SWFT, LLP
5191 Natorp Boulevard
Mason, OH 45040
August 25, 2022
Dana Andrews
111 Avenue G
Lakeway, OH 45232
Dear Ms. Andrews:
This letter is in response to your question with respect to your $93,000 advance to your nephew
in 2015. In order to advise you correctly, I need the following additional information:
1. Is there a written instrument evidencing this obligation, and is an interest rate
specified?
2. When and how much has your nephew paid on the loan?
3. What factors exist to indicate whether the remaining debt will be repaid (for example,
does he live within his means)?
4. Does he have a job?
5. Does he owe money to other people?
6. What is his credit rating?
7. How much credit card debt does he have?
8. What collection efforts, if any, have you made to collect the remaining $77,000?
Any other information or material you can provide would be greatly appreciated.
Sincerely,
James Hicks, CPA
Partner
67
or more on crafting oral presentations, see W. A. Raabe and G. E. WhitF
tenburg, “Talking Tax: How to Make a Tax Presentation,” Tax Adviser,
March 1997, pp. 179–182.
19961_ch01_hr_002-049.indd 37
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1-38
Part 1
Introduction to Taxation and Business Entities
E x h i b i t 1.10
Tax File Memorandum
August 20, 2022
TAX FILE MEMORANDUM
FROM:
James Hicks
SUBJECT: Dana Andrews
Engagement Issues
Today I talked to Dana Andrews with regard to her letter of August 15, 2022.
Dana Andrews advanced $93,000 to her nephew in 2015 to enable him to attend a private
college. Seven years later she claims a bad debt deduction for $77,000 that the nephew has
not repaid.
ISSUE: Is Dana entitled to a bad debt deduction?
Exhibit 1.11
Tax File Memorandum
August 29, 2022
TAX FILE MEMORANDUM
FROM:
James Hicks
SUBJECT: Dana Andrews
Tentative Conclusions
The initial advance could have been a gift rather than a loan and possibly subject to the gift
tax. In any case, if the advance was a gift, it should have been reported on Form 709. Further,
the statute of limitations does not begin to run when a tax return is not filed.
If the advance is treated as a loan, the probability is high that the aunt would receive
­nonbusiness bad debt status. This classification means that Ms. Andrews has the burden of
proving that the $77,000 unpaid balance is entirely worthless.
LO.9
Describe various tax planning
procedures.
1-7 Working with the Tax Law—Tax Planning
Tax research and tax planning are inseparable. The primary purpose of effective tax
planning is to maximize the taxpayer’s after-tax wealth. The course of action selected
might not produce the lowest possible tax under the circumstances. The minimization
of tax liability must be considered in context with the nontax goals of the taxpayer.
1-7a Nontax Considerations
There is a danger that tax considerations may impair the exercise of sound financial
planning or business judgment by the taxpayer. As a result, the tax planning process
can lead to ends that are economically (or socially) incorrect. Unfortunately, a tendency
exists for planning to move toward the opposing extremes of either not enough or too
much emphasis on tax considerations. The goal should be a balance that recognizes
the significance of taxes, but not beyond the point at which planning detracts from the
exercise of good business judgment. In general, if the only reason for pursuing a specific
course of action is because of the tax benefits, then one should rethink that decision.
1-7b Components of Tax Planning
Popular perception of tax planning often is restricted to the adage “defer income and
accelerate deductions.” Although this timing approach does hold true and is important,
meaningful tax planning involves considerably more.
19961_ch01_hr_002-049.indd 38
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Chapter 1 Understanding and Working with the Federal Tax Law
1-39
Preferable to deferring taxable income is complete avoidance of taxation. Consider,
for example, the employee who chooses nontaxable fringe benefits over a fully taxable
future pay increase.68 Complete avoidance of gain recognition also occurs when the
owner of appreciated property transfers it by death. Here, the “step-up” (appreciation)
in basis to fair market value completely escapes the income tax.69
If the recognition of income cannot be avoided, its deferral will postpone income
tax consequences. A tax paid in the future costs less than a tax paid today because of
the time value of money. Deferral of income can take many forms. Besides like-kind
exchanges and involuntary conversions, most retirement plans postpone income tax
consequences until benefits are paid. Deferral of gain recognition also can occur when
appreciated property is transferred to a newly formed corporation or partnership.70
A corollary to the deferral of income is the acceleration of deductions. For example,
if an accrual basis, calendar year corporation authorizes a charitable contribution in
2022 and pays it on or before the due date of its tax return in 2023, the deduction can
be claimed for 2022.71 Taxes also can be saved by shifting income to lower-bracket
taxpayers. Gifts of appreciated property to lower-bracket family members can reduce
the related capital gain tax rate on a later sale by up to 20 percentage points (from
20 percent to 0 percent).72
If income cannot be avoided, deferred, or shifted, the nature of the gain can be
converted. By changing the classification of property, income taxes can be reduced. As
a result, the taxpayer who transfers appreciated inventory to a controlled corporation
has converted ordinary income property (the inventory) to a capital asset (stock in the
corporation). When the stock is later sold, preferential capital gain rates apply.
The conversion approach also can work in tax planning for losses. Properly structured, a loan to a corporation that becomes worthless can be an ordinary loss rather
than a capital loss. Likewise, via § 1244, an investor in qualified small business stock
can convert what would be a capital loss into an ordinary loss.73
Effective tax planning requires that careful consideration be given to the choice of
entity used for conducting a business. The corporate form results in double taxation but
permits shareholder-employees to be covered by fringe benefit programs. Partnerships
and S corporations allow a pass-through of losses and other tax attributes, but transferring ownership interests as gifts to family members may be difficult.74
Although the substance of a transaction rather than its form generally controls, this
rule is not always the case with tax planning. Preserving formalities, with particularly
clear documentation, often is crucial to the result. Is an advance to a corporation a loan
or a contribution to capital? The answer may depend on the existence of a note.
Along with preserving formalities, the taxpayer should keep records that support how
a transaction is treated. Returning to the issue of loan versus contribution to capital, how
is the advance listed on the books of the borrower? What do the corporate minutes say
about the advance?
Finally, effective tax planning requires consistency on the part of taxpayers. A shareholder who treats a corporate distribution as a return of capital cannot later avoid a
stock basis adjustment by contending that the distribution was really a dividend.
In summary, the key components of tax planning include the following:
• Avoid the recognition of income (usually by resorting to a nontaxable source or
nontaxable event).
• Defer the recognition of income (or accelerate deductions).
• Convert the classification of income (or deductions) to a more advantageous form
(e.g., ordinary income into capital gain).
68
See
See
70
See
71
See
69
Example
Example
Example
Example
19961_ch01_hr_002-049.indd 39
9 (and related discussion) in Chapter 13.
17 in Chapter 19.
1 in Chapter 4 and Example 5 in Chapter 10.
11 in Chapter 3.
72
See Example 26 in Chapter 19. A 3.8% Medicare tax also might be avoided.
See Examples 33 and 34 in Chapter 4.
74
See Example 38 in Chapter 11 and Example 40 in Chapter 12.
73
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1-40
Part 1
Introduction to Taxation and Business Entities
• Choose the business entity with the desired tax attributes.
• Preserve formalities by generating and maintaining supporting documentation.
• Act in a manner consistent with the intended objective.
1-7c Follow-Up Procedures
Because tax planning usually involves a proposed (rather than a completed) transaction, being aware of if or when the law changes is critical to the tax planning process.
A change in the tax law (legislative, administrative, or judicial) could alter the original
conclusion. Additional research may be necessary to test the solution in light of current
developments.
Under what circumstances does a tax professional have an obligation to inform a
client as to changes in the tax law? The legal and ethical aspects of this question are
discussed in Chapter 17.
1-7d Tax Planning—A Practical Application
Returning to the facts in The Big Picture on p. 1-1, what should be done to help protect
the aunt’s bad debt deduction?
• All formalities of a loan should be present (e.g., written instrument and definite
and realistic due date).
• Upon default, the lender (aunt) should make a reasonable effort to collect from
the borrower (nephew). If not, the aunt should be in a position to explain why
any such effort would be to no avail.
• If interest is provided for, it should be paid.
• Any interest paid (or imputed under § 7872) should be recognized as income by
the aunt.
• Because of the annual gift exclusion of $14,000 in 2015 (it is currently $16,000),
it appears doubtful that actual (or imputed) interest would necessitate the filing
of a Federal gift tax return by the aunt. But should a return be due, it should
be filed.
• If § 7872 applies (not enough or no interest is provided for), the nephew should
keep track of his net investment income. This record keeping is important because
the income the aunt must recognize may be limited by this amount.
In terms of the components of tax planning (see text Section 1-7b), what do these
suggestions entail? Note the emphasis on the formalities—written instrument and d
­ efinite
and realistic due date. Also, much is done to provide the needed d
­ ocumentation—
gift tax returns, if necessary, are filed, and the nephew keeps track of his investment
income. Most important, however, is that the aunt will have been consistent in her
actions—recognizing actual (or imputed) interest income and making a reasonable
effort to collect on the loan.
Throughout this text, each chapter concludes with observations on Tax Planning.
Such observations are not all-inclusive, but they are intended to illustrate some of the
ways in which the material covered in the chapter can be effectively used to minimize
taxes.
LO.10
Explain the role of taxation
on the CPA examination.
19961_ch01_hr_002-049.indd 40
1-8 Taxation on the CPA Examination
The CPA exam continues to test in the familiar four sections—Auditing and Attestation
(AUD), Business Environment and Concepts (BEC), Financial Accounting and Reporting (FAR), and Regulation (REG). However, the exam continues to evolve, placing less
emphasis on remembering-and-understanding skills, and greater focus on higher-level
analysis and evaluation skills.
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Chapter 1 Understanding and Working with the Federal Tax Law
1-41
• Task-based simulations, a highly effective way to assess higher-order skills, are
part of each section of the CPA exam. Four task-based simulations appear on the
BEC section, and eight task-based simulations appear on the AUD, FAR, and REG
sections.
• Total testing time is 16 hours (4 hours per section).
• Multiple-choice questions and task-based simulations each contribute about
50 percent toward the candidate’s score in the AUD, FAR, and REG sections. In
the BEC section, multiple-choice questions contribute about 50 percent of the
scoring, with 35 percent coming from task-based simulations and 15 percent from
written communication.
• Using Bloom’s taxonomy, the CPA exam tests remembering and understanding,
application, analysis, and evaluation. In prior years, the CPA exam only tested for
the first two of these items.
1-8a Preparation Blueprints
To prepare for the CPA exam, candidates are able to use AICPA-developed Blueprints
that replaced the Content Specification Outline (CSO) and Skill Specification Outline
(SSO).75
The Blueprints provide candidates with more detail about what to expect on the
exam. They contain about 600 representative tasks, which are aligned with the skills
required of newly licensed CPAs, across the four exam sections. The Blueprints are
designed to provide candidates with clearer information on the material the exam tests
and show educators what knowledge and skills candidates need as newly licensed
CPAs. In addition, the Blueprints provide candidates with sample tasks that align with
both the content and the skill level at which the content will be tested.
1-8b Regulation Section
Taxation continues to be tested within the REG section of the CPA exam. Testing
within REG is administered in five blocks called testlets, which feature multiple-choice
questions (MCQs) and task-based simulations (TBSs). Candidates receive at least one
research question (research-oriented TBS) that requires the candidate to search the
applicable authoritative literature and find an appropriate reference.
Each of the five topics in REG includes one or more representative tasks that are not
necessarily questions on the exam. For example, the exam does not specifically ask
a candidate to “Calculate taxpayer penalties relating to Federal tax returns.” However,
identifying situations where a taxpayer penalty might apply would be appropriate.
In addition, tasks are to be inclusive, not exclusive, of exam content. For example, the
task “Calculate tax depreciation for a tangible business property…” could include the
calculation of additional first-year (bonus) depreciation.
Task-based simulations are case studies that allow candidates to demonstrate their
knowledge and skills by generating responses to questions rather than simply selecting an answer. They typically require candidates to use spreadsheets and/or research
authoritative literature provided in the CPA exam (e.g., Internal Revenue Code, Regulations, IRS publications, and tax forms).
There are five content areas in the REG section of the CPA exam:
• Area 1: E
thics, professional responsibilities, and Federal tax procedures (weight
10–20 percent).
• Area 2: Business law (weight 10–20 percent).
75
he Blueprints can be accessed at future.aicpa.org/resources/article/
T
learn-what-is-tested-on-the-cpa-exam; the Practice Analysis Final Report
19961_ch01_hr_002-049.indd 41
that details the changes reflected in the Blueprints is also available at this
website.
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1-42
Part 1
Introduction to Taxation and Business Entities
• Area 3: Federal taxation of property transactions (weight 12–22 percent).
• Area 4: Federal taxation of individuals (weight 15–25 percent).
• Area 5: Federal taxation of entities (weight 28–38 percent).
Area 1 covers ethics and responsibilities in tax practice, licensing and disciplinary
systems, Federal tax procedures, and legal duties and responsibilities of a CPA.
Area 3 covers Federal taxation of property transactions and Federal estate and gift
taxation.
Area 4 covers the Federal income taxation of individuals from both a tax ­preparation
and tax planning perspective (e.g., income, exclusions, deductions, and retirement
plans).
Area 5 covers the Federal income taxation of entities including sole proprietorships,
partnerships, limited liability companies, C corporations, S corporations, joint ventures,
trusts, estates, and tax-exempt organizations from both a tax preparation and tax planning perspective.
Accounting methods and periods and tax elections are included in Areas 3, 4, and 5.
Only Area 2 does not involve taxation.
Remembering-and-understanding skills are tested mainly in Areas 1 and 2. Application and analysis skills are tested primarily in Areas 3, 4, and 5. These three areas
contain more of the day-to-day tasks that newly licensed CPAs are expected to
perform. As a result, they are tested at the higher end of the skill level continuum.
Overall, the REG section tests skills in the following way: remembering and learning
(25 to 35 percent), application (35 to 45 percent), and analysis (25 to 35 percent).
The REG section does not test any content at the Evaluation skill level since newly
licensed CPAs are not expected to demonstrate that level of skill in regards to the
REG content.
Topical coverage in the REG section of the CPA exam is reviewed and updated
regularly. For example, beginning in July 2021, the alternative minimum tax, estate
taxation, and certain tax-exempt organization topics (obtaining and maintaining taxexempt status) are no longer covered. In addition, net operating loss and capital loss
limitations, unrelated business income of tax-exempt organizations, and bankruptcy
and insolvency are being tested on a more simplified level.
The REG section has 76 multiple-choice questions and eight task-based simulations
(TBSs). The TBSs are used by the AICPA to assess the candidate’s higher-order skills. In
addition, TBSs on the CPA exam provide increased background material and data that
require candidates to determine what information is or is not relevant to the question.
The scoring weight of multiple-choice questions and TBSs is about 50 percent each on
the REG section of the CPA exam.
Depending on the skill level being assessed, well-prepared candidates likely will
spend 15 to 20 minutes for each TBS. Certain analysis and/or evaluation level TBSs
could take a well-prepared candidate up to 30 minutes to complete. Several examples
of task-based simulations follow.
CPA Exam Simulation Examples
Example
20
19961_ch01_hr_002-049.indd 42
The tax citation type simulation requires the candidate to research the Internal Revenue Code and
enter a Code Section and subsection.
For example, Amber Company is considering using the simplified dollar-value method of pricing its inventory for purposes of the LIFO method that is available to certain small businesses.
What Code Section is the relevant authority in the Internal Revenue Code to which you should
refer to determine whether the taxpayer is eligible to use this method? To be successful, the
candidate must find § 474.
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Chapter 1 Understanding and Working with the Federal Tax Law
1-43
CPA Exam Simulation Examples
A tax form completion simulation requires the candidate to fill out a portion of a tax form. For
example, Blue Company is a limited liability company (LLC) for tax purposes. Complete the income
section of Form 1065 for Blue Company using the values found and calculated on previous tabs
along with the following data:
Ordinary income from other partnerships
Net gain (loss) from Form 4797
Management fee income
Example
21
$ 5,200
2,400
12,000
The candidate is provided with page 1 of Form 1065 on which to record the appropriate
amounts. Any field that requires an entry is a shaded rectangular cell. Some white rectangular
cells automatically calculate based on the entries in the shaded cells.
Candidates can learn more about the CPA examination at aicpa.org/becomeacpa/
cpaexam.html. In addition to accessing the Uniform CPA Examination Blueprints,
candidates will find tutorials related to the exam, have the ability to take sample exams,
learn how the exam is graded, and discover the requirements needed to sit for the CPA
exam in each licensing jurisdiction.
In 2020, the AICPA and the National Association of State Boards of Accountancy
(NASBA) announced the start of a modification to the CPA exam expected for 2024
(see evolutionofcpa.org). The change aims to ensure the CPA designation reflects the
knowledge and skills expected of a CPA today. The new approach to the CPA exam
(and licensure) is a core plus disciplines. The core includes accounting, auditing, tax,
and technology; all candidates take this part of the CPA exam. The three disciplines are
business analysis and reporting, information systems and controls, and tax compliance
and planning, with candidates taking an exam in one of these areas. Regardless of the
chosen discipline, this model leads to full CPA licensure, and the CPA is not limited to
practice only in the discipline selected for testing on the CPA exam.
Key Terms
Acquiescence, 1-26
Revenue neutrality, 1-2
Arm’s length, 1-11
Generally Accepted Accounting
Principles (GAAP), 1-13
Business purpose, 1-12
Indexation, 1-8
Revenue Rulings, 1-18
Citator, 1-36
International Financial Reporting
Standards (IFRS), 1-13
Substance over form, 1-11
Letter rulings, 1-19
Technical Advice Memoranda (TAMs), 1-19
Nonacquiescence, 1-26
Temporary Regulations, 1-17
Determination letters, 1-20
Notices, 1-19
Wherewithal to pay, 1-5
Final Regulations, 1-18
Proposed Regulations, 1-17
Writ of Certiorari, 1-24
Continuity of interest, 1-11
Court of original
jurisdiction, 1-20
Revenue Procedures, 1-18
Tax benefit rule, 1-12
Discussion Questions
1.
LO.1 What is meant by revenue neutrality ?
2.
LO.2 Have nonrevenue factors had any impact upon the development of our taxation system? If so, how?
3.
LO.2 How does the tax law encourage technological progress?
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1-44
Part 1
Introduction to Taxation and Business Entities
4.
5.
LO.2 Why is personal saving desirable for the U.S. economy?
LO.2 Explain how the following tax provisions encourage small businesses.
a. The nature of a shareholder’s loss on a stock investment.
b. The S corporation election.
6.
LO.2 The concept of equity is relative. Explain.
7.
LO.2 What purpose is served by allowing a deduction for contributions to qualified
charitable organizations?
8.
LO.2 Savings leads to capital formation and thus makes funds available to finance
home construction and industrial expansion. What is a major tax law incentive
to encourage savings?
9.
LO.2 How does the tax law encourage the development of natural resources?
10. LO.2 What is the justification for the favorable treatment of corporate reorganizations?
11. LO.2 Other than raising revenue, what considerations explain various provisions
in our tax laws?
Critical Thinking
12. LO.2 A provision of the Code allows a taxpayer a deduction for Federal income
tax purposes for some state and local income taxes paid (with an overall limit
of $10,000). Does this provision eliminate the effect of multiple taxation of the same
income? Why or why not? In this connection, consider the following:
a. Taxpayer, an individual, has itemized deductions that are less than the standard
deduction.
b. Taxpayer is in the 10% tax bracket for Federal income tax purposes. The 32%
tax bracket.
13. LO.2 Heather and her partners operate a profitable partnership. Because the business is expanding, the partners would like to transfer it to a newly created
corporation. Heather is concerned, however, over the possible tax consequences
that would result from incorporating. Please comment.
Critical Thinking
14. LO.2 Assume the same facts as in Question 13. Heather also is worried that once the
partnership incorporates, the business will be subject to the Federal corporate
income tax. What suggestions do you have?
15. LO.2 Give some examples of the wherewithal to pay concept.
16. LO.2 Can recognized gain exceed the realized gain? Explain.
17. LO.2 In a like-kind exchange, recognized gain is postponed and not avoided. Explain.
18. LO.2 Under the annual accounting period concept, what time period is normally
selected for final settlement of most tax liabilities?
19. LO.2 How does the installment method overcome the harsh treatment of the annual
accounting treatment concept?
20. LO.2 Why is there a grace period for contributions to a Keogh retirement plan?
21. LO.2 Contrast the tax treatment between a community property state and a common law state.
22. LO.2 List some tax provisions used to deter affluent taxpayers from obtaining preferential tax treatment.
Critical Thinking
23. LO.3 White Corporation lends $425,000 to Blue Corporation with no provision for
interest. White Corporation and Blue Corporation are owned by the same shareholders. How might the IRS restructure this transaction with adverse tax consequences?
24. LO.4 Explain the continuity of interest concept.
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Chapter 1 Understanding and Working with the Federal Tax Law
1-45
25. LO.5 Federal tax legislation generally originates in the Senate Finance Committee.
Comment on the validity of this statement.
26. LO.5 If a tax bill is vetoed by the President, the provisions cannot become law.
Evaluate this statement.
27. LO.5 Determine the subparts of § 1563(a)(1)(A).
28. LO.5 Is § 212(1) a proper Code Section citation? Why or why not?
29. LO.5 Why are certain Code Section numbers missing from the Internal Revenue
Code (e.g., §§ 6, 7, 8, 9, 10)?
30. LO.5 Where can a researcher find newly issued Proposed, Final, and Temporary
Regulations?
31. LO.5 Interpret each of the following citations:
a. Temp.Reg. § 1.707–5T(a)(2).
b. Rev.Rul. 60–11, 1960–1 C.B. 174.
c. TAM 8837003.
32. LO.5 Jennifer Olde calls you requesting an explanation of the fact-finding determination of a Federal Court of Appeals. Prepare a letter to be sent to Jennifer
answering this query. Her address is 3246 Highland Drive, Clifton, VA 20124.
Communications
33. LO.5 Will Thomas calls you with respect to a tax issue. He has found a tax case
in the U.S. District Court of South Carolina that is in favor of his position.
The IRS lost and did not appeal the case. Over the phone, you explain to Will the
significance of the failure to appeal. Prepare a tax file memorandum outlining your
remarks to Will.
Communications
34. LO.5, 8 In assessing the validity of a court decision, discuss the significance of the
following:
a. The decision was rendered by the U.S. District Court of Utah. Taxpayer lives in Utah.
b. The decision was rendered by the U.S. Court of Federal Claims. Taxpayer lives
in Utah.
c. The decision was rendered by the Second Circuit Court of Appeals. Taxpayer
lives in California.
d. The decision was rendered by the U.S. Supreme Court.
e. The decision was rendered by the U.S. Tax Court. The IRS has acquiesced in
the result.
f. Same as part (e), except that the IRS has issued a nonacquiescence as to the result.
35. LO.6, 7 Aleshia needs to learn quickly about § 351 transfers to a controlled corporation. How should Aleshia approach her research?
Decision Making
36. LO.7 Where does most tax research begin when someone is searching for an
answer about a tax dispute?
37. LO.5, 8 Determine whether the following items are primary sources or secondary
sources for the purpose of substantial authority.
a. Revenue Procedure.
b. Article written by a judge in Journal of Taxation.
c. U.S. District Court decision.
d. A “Bluebook.”
e. A general counsel memorandum.
38. LO.9 What are the key components of effective tax planning?
39. LO.10 Describe the task-based simulations that are part of the CPA examination.
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1-46
Part 1
Introduction to Taxation and Business Entities
Problems
Note: Relevant documents for these problems can be found by using the Thomson
Reuters Checkpoint™ online tax research database (which accompanies this textbook),
Tax Notes (taxnotes.com/research/federal), or the IRS website (including irs.gov/irb).
40. LO.2 Juniper, Inc., exchanges some real estate (basis of $800,000 and fair market
value of $1,000,000) for other real estate owned by Birch, Inc., (basis of
$1,200,000 and fair market value of $900,000) and $100,000 in cash. The real estate
involved is unimproved and is held by Juniper and Birch, before and after the
exchange, as non-investment property.
a. What is Juniper’s realized gain on the exchange? Recognized gain?
b. What is Birch’s realized loss? Recognized loss?
c. Support your results in parts (a) and (b) under the wherewithal to pay concept
as applied to like-kind exchanges (§ 1031).
41. LO.2, 3 Using the legend provided, classify the overall objective of the particular
tax provision.
Legend
CE 5 Control of the economy
EA 5 Encouragement of certain activities
EI 5 Encouragement of certain industries
SC 5 Social considerations
a.
b.
c.
d.
e.
f.
g.
W 5 Wherewithal to pay concept
AF 5 Administrative feasibility
ESB 5 Encouragement of small business
Like-kind exchange treatment.
An increase in the individual tax rate.
The S corporation election.
Adoption expense credit.
Percentage depletion.
Annual gift tax exclusion.
Charitable contribution deduction.
42. LO.2 Determine whether the following states are community property or common
law states.
a. Louisiana.
d. Rhode Island.
b. Virginia.
e. Alaska.
c. Arizona.
f. California.
Communications
43. LO.4 Benny sells property (basis of $70,000) to Jet Corporation for $100,000. Based
on the following conditions, how could the IRS challenge this transaction?
a. Benny is the sole shareholder of Jet Corporation.
b. Benny is the son of the sole shareholder of Jet Corporation.
c. Benny is neither a shareholder in Jet Corporation nor related to any of Jet’s
shareholders.
d. Summarize your conclusions in an e-mail to your instructor.
44. LO.5 Locate §263A and determine how oil/gas delay rentals are treated to a lessee.
Also, provide a court decision that provides the tax treatment of how delay
rentals are treated to a lessor.
45. LO.5 Answer the following questions:
a. What are letter rulings?
b. What are technical advice memoranda (TAMs)?
46. LO.5 Explain what is meant by the following citations:
a. Rev.Proc. 2001–10, 2001–1 C.B. 272.
b. Rev.Rul. 2011–14, 2011–27 I.R.B. 31.
c. Ltr.Rul. 201125030.
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Chapter 1 Understanding and Working with the Federal Tax Law
1-47
47. LO.5 A client contacts you and asks if an exchange of different cryptocurrencies
qualifies for like-kind exchange treatment (e.g., an exchange of bitcoin for
ethereum). In addition, they mine cryptocurrency and would like to know if their
activities result in self-employment income. Research these questions in preparation
for a meeting with your client.
48. LO.5 A client contacts you and indicates that she would like to obtain a private
letter ruling from the IRS. You are not familiar with the process. How do you
determine what is required to obtain a private letter ruling?
49. LO.5 U
sing the legend provided, classify each of the following citations as to the
location. A citation may have more than one answer.
Legend
IRC 5 Internal Revenue Code
IRB 5 Internal Revenue Bulletin
CB 5 Cumulative Bulletin
a.
b.
c.
d.
e.
f.
g.
FR 5 Federal Register
NA 5 Not applicable
§ 61(a)(13).
Prop.Reg. § 1.368–2(b)(1).
Rev.Proc. 77–37, 1977–2 C.B. 568.
Temp.Reg. § 1.163–9T(b)(2)(I)(A).
Rev.Rul. 64–56, 1964–1 C.B. 133.
Jack E. Golsen, 54 T.C. 742 (1970).
Ltr.Rul. 9802018.
50. LO.5 A taxpayer living in the following states would appeal a decision of the U.S.
Tax Court to which U.S. Court of Appeals?
a. Texas.
b. Colorado.
c. Georgia.
d. Montana.
e. New York.
51. LO.5 Using the legend provided, classify each of the following citations as to the court.
Legend
T 5 U.S. Tax Court
C 5 U.S. Court of Federal Claims
U 5 U.S. Supreme Court
a.
b.
c.
d.
e.
f.
g.
h.
D 5 U.S. District Court
A 5 U.S. Court of Appeals
N 5 None of the above
491 F.3d 95 (CA–2, 2007).
20 T.C. 734 (1953).
135 S.Ct. 2726 (USSC, 2015).
3 B.T.A. 1042 (1926).
T.C.Memo 1954–141.
129 Fed.Cl. 218 (2016).
Ltr.Rul. 9414051.
369 F.Supp.2d 275 (Eastern District N.Y., 2005).
52. LO.6 Identify the name of the publisher for the following tax services:
a.
b.
c.
19961_ch01_hr_002-049.indd 47
United States Tax Reporter.
Standard Federal Tax Reporter.
Federal Tax Coordinator 2d.
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1-48
Part 1
Introduction to Taxation and Business Entities
d.
e.
f.
Mertens Law of Federal Income Taxation.
Tax Management Portfolios.
Tax Pro Library.
53. LO.5, 8 Using the legend provided, classify each of the following tax sources:
Legend
P 5 Primary tax source
S 5 Secondary tax source
a.
b.
c.
d.
e.
f.
g.
h.
i.
j.
k.
l.
m.
n.
o.
B 5 Both
N 5 Neither
Sixteenth Amendment to the Constitution.
Tax treaty between the United States and China.
Temporary Regulations (issued 2015).
Revenue Procedure.
An IRS publication.
Tax Court Memorandum decision.
Harvard Law Review article.
Legislative Regulations.
Letter ruling (before 1991).
Fifth Circuit Court of Appeals decision.
Small Cases Division of U.S. Tax Court decision.
Senate Finance Committee Report.
Technical advice memorandum (1993).
Proposed Regulations.
Notice
54. LO.5 Interpret each of the following citations:
a. 54 T.C. 1514 (1970).
b. 491 F.3d 53 (CA–1, 2007).
c. 69–1 USTC ¶ 9319 (CA–2, 1969).
d. 23 AFTR 2d 69–1090 (CA–2, 1969).
e. 775 F.Supp.2d 765 (D.Ct. V.I., 2011).
f. 67–1 USTC ¶ 9253 (D.Ct. Miss., 1967).
g. 19 AFTR 2d 647 (D.Ct. Miss., 1967).
h. 56 S.Ct. 289 (USSC, 1935).
i. 36–1 USTC ¶ 9020 (USSC, 1935).
j. 16 AFTR 1274 (USSC, 1935).
k. 319 F.3d 732 (CA–5, 2003).
55. LO.5 Alejandra invites Zach, a business client, to a college football game. Alejandra
purchases both tickets and also buys Zach’s lunch in the alumni tent before
the game. The lunch is purchased separately from the tickets. Substantive business
discussions occur during lunch and at various times during the football game. Consult § 274, Reg. §§ 1.274–12 and 1.274–11(b)(1), and Notice 2018–76 to determine
which of these expenses are deductible (if any).
Research Problems
Note: Solutions to the Research Problems can be prepared by using the ­Thomson
Reuters Checkpoint™ online tax research database, which accompanies this
­textbook. Solutions can also be prepared by using research materials found in a
typical tax library.
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Chapter 1 Understanding and Working with the Federal Tax Law
1-49
Research Problem 1. Locate the following cited items, and give a brief description of
the topic or opinion in the item.
a.
b.
c.
d.
§ 6694(a).
Reg. § 1.6694–1(b).
Rev.Rul. 86–55, 1986–1 C.B. 373.
PLR 8022027.
Research Problem 2. Determine the disposition of the following decisions at the
appellate level.
a.
b.
c.
d.
e.
Gary A. Sargent, 93 T.C. 572 (1989).
Charles Johnson, 78 T.C. 882 (1982).
Smith & Wiggins Gin, Inc., 37 T.C. 861 (1962).
George W. Wiebusch, 59 T.C. 777 (1973).
Zanesville Inv. Co., 38 T.C. 406 (1962).
Research Problem 3. The TV show TMZ spoke with Larry Edema from Michigan, who
was selected to be in the audience for Oprah’s big giveaway: a free trip to Australia. Supposedly, Winfrey had a certified public accountant on hand to address the tax issue right
after the taping. Edema said that the CPA assured the group that all taxes associated with
the trip would be “handled by the Oprah show,” so the trip would truly be 100% free.
The CPA also explained that Oprah would cover all sightseeing costs and travel-related
expenses, including passport costs for people who could not afford them. It was a big
change from Oprah’s 2004 controversy when she famously gave away brand-new cars
but saddled audience members with as much as $7,000 in income taxes.
Discuss any tax aspects or problems with this statement. E-mail a response to
your instructor.
Communications
Use internet tax resources to address the following questions. Look for reliable websites and blogs of the IRS and other government agencies, media outlets, businesses,
tax professionals, academics, think tanks, and political outlets.
Research Problem 4. Locate the following on the internet:
a.Several primary sources of the tax law, including the U.S. Supreme Court, a Court
of Appeals, the Internal Revenue Service, the U.S. Tax Court, and Final Regulations.
b. Sources of proposed Federal tax legislation.
c. A collection of tax rules for your state.
Research Problem 5. Using the internet, find a definition for each of these terms.
a.
b.
c.
d.
e.
f.
g.
h.
Rule 155.
En banc.
Pro se.
Dicta.
Parallel cite.
Sunset provisions.
Work product.
Remanded.
Research Problem 6. Go the the U.S. Tax Court website (ustaxcourt.gov).
a. What different types of cases can be found on the site?
b. What is a Summary Opinion? Find one (and record its citation).
c. What is a Memorandum Opinion? Find one (and record its citation).
d. Find the court’s Rules of Practice and Procedures. Summarize one (and its citation).
e.Communicate your findings in an e-mail to your instructor. Is the website readerfriendly? If not, e-mail the Tax Court (and copy your instructor).
19961_ch01_hr_002-049.indd 49
Communications
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2
C h a p ter
The Deduction for
­Qualified Business
Income for
Noncorporate Taxpayers
L e a r n i n g O b j e c t i v e s : After completing Chapter 2, you should be able to:
LO.1
Summarize the tax treatment of various forms of
­conducting a business.
LO.4
LO.2
Explain the rationale for the deduction for qualified
business income.
LO.5
LO.3
Describe the types of taxpayers and activities that
potentially generate a deduction for qualified
­business income.
Determine a taxpayer’s deduction for qualified
­business income.
List and evaluate tax planning ideas for choice of
entity and the deduction for qualified business
income.
Chapter Outline
2-1 Tax Treatment of Various Business Forms, 2-2
2-1a Sole Proprietorships, 2-2
2-1b Partnerships, 2-3
2-1c Corporations, 2-3
2-1d Limited Liability Companies, 2-7
2-2 The Challenges of Taxing Business Activities:
Entity Tax Rates, 2-8
2-2a Challenges of Lowering Tax Rates, 2-8
2-2b Lowering Tax Rates for Different Business Forms, 2-9
2-3 The Deduction for Qualified Business Income, 2-10
2-3a General Rule, 2-10
2-3b The Overall Limitation: Modified Taxable Income, 2-10
2-3c Definition of Qualified Business Income, 2-11
2-3d Definition of a Qualified Trade or Business, 2-11
2-3e Limitations on the QBI Deduction, 2-14
19961_ch02_hr_002-044.indd 2
2-3f Limitation Based on Wages and Capital Investment, 2-14
2-3g Limitation for “Specified Services” Businesses, 2-18
2-3hReporting the Qualified Business Income
Deduction, 2-26
2-3iAggregation of Qualified Trades and Businesses Under
the § 199A Regulations, 2-27
2-3j Treatment of Losses, 2-32
2-3k Coordination with Other Rules, 2-34
2-3l Considerations for Partnerships and S Corporations, 2-35
2-3m Other Items in the § 199A Regulations, 2-35
2-4 Tax Planning, 2-36
2-4aCorporate versus Noncorporate Forms of Business
­Organization, 2-36
2-4bOptimizing the Deduction for Qualified Business
Income, 2-37
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