Chapters 2-6
Administration of Tax Law




Organization of the Internal Revenue
Service
Selection of Returns for Audit
Statute of Limitations
Interest and Penalties
Tax Law Sources

Legislative



Internal Revenue Code
Congressional Committee Reports
Administrative




Treasury Regulations
Revenue Rulings
Revenue Procedures
Private Letter Rulings
Steps in the Legislative
Process
Figure 2-1, Page 2-5
Tax Law Sources--Continued

Judicial Sources




Tax Court, District Court, Claims Court
U.S. Court of Appeals
U.S. Supreme Court
Primary versus Secondary Sources
Components of Tax Practice




Tax Compliance and Procedure
Tax Research
Tax Planning and Consulting
Financial Planning
The Individual Income Tax Formula
Calculation of Taxable Income:
Total income (income from whatever source derived)
Minus: Exclusions (specifically defined items, such as
tax-exempt bond interest)
Gross income
Minus: Deductions for adjusted gross income
Adjusted gross income
Minus: Greater of itemized or standard deduction
Personal and dependency exemptions
Taxable Income
$ xxx
(xxx)
$ xxx
(xxx)
$ xxx
(xxx)
(xxx)
$ xxx
The Individual Income Tax Formula--Continued
Calculation of Balance Due/Refund
Taxable income (from preceding slide)
Times: Applicable tax rate(s)
X
Income tax before credits
Minus: Tax credits
Prepayments (withholding &
estimated taxes)
Balance due or (refund)
$ xxx
xx%
$ xxx
(xxx)
(xxx)
$ xxx
Definitions

Income



§61(a)—income from any source
Does not include return of capital or
receipts received from borrowed funds
Exclusions


Any item of income specifically excluded by
the Internal Revenue Code
Review Exhibit 3-1 Major Exclusions
Definitions--Continued

Gross Income


Income from taxable sources and is
reported on the income tax return. (Tax
exempt interest is the only exclusion
reported on the Form 1040.)
Review Exhibit 3-2 Gross Income Items
Listed Under §61(a)
Definitions--Continued
Deductions for Adjusted Gross Income



Expenses connected with a trade or business
Other expenses
Adjusted Gross Income




Established floors and ceilings for itemized
deductions
Basis for phase out of itemized deductions and
exemptions
Basis for limiting eligibility for other tax benefits
Definitions--Continued

Itemized Deductions






Medical Expenses (§213)
State, local and foreign income taxes, property
taxes (§164)
Home mortgage and investment interest (§163)
Contributions (§170)
Casualties and Thefts (§165)
Miscellaneous Itemized Deductions (2% and
Other) (§212)
Definitions--Continued

Standard Deduction





Based on filing status
Additional deduction 65+ or Blind ($ 950 S, $ 1,200 MFJ)
Limited for a dependent: >(Earned Income + $ 250)
or $ 800
Indexed
Exemptions




One exemption for each person
Cannot be claimed as a dependent by another person
Dependency exemptions (5 tests), phase out based on filing
status and AGI level
Subject to phaseout at high income levels
Child Tax Credit



In addition to dependency exemption
$1,000 for each dependent child under
age 17
Phased out starting at $75,000 (single)
and $110,000 (joint)
Determining The Amount of
Tax


Tax Tables and Tax Schedules
Filing Status





Married Filing Jointly (Surviving Spouse)
Head of Household (Abandoned Spouse)
Single
Married Filing Separately
Dependents with unearned income

Tax on unearned income of a child < 14 years is
figured by reference to the parents’ tax rate if
higher than the child’s.
Types of Tax Rate Structures

Individual Income Tax Rates


Corporate Income Tax Rates


Review of Rate Schedule in Text
Review of Rate Schedule in Text
Marginal Tax Rate

“Incremental Amount of Taxable Income
That is Added to the Tax Base”
Capital Gains and Loss

Capital Assets


Assets others than those listed in § 1221
(Inventory, Depreciable Property, A/R & N/R,
Copyrights & Compositions, Other Assets)
Holding Periods for Sales or Dispositions:



Short term—1 year or less
Long term—More than one year
Sales on or after 5/06/03, maximum rate is 15%
for most investment type assets. AMT reduces the
benefit of this rate reduction to many taxpayers.
Dependency Exemptions Tests—Must Meet All Five





Support (> 50%)
Gross Income (Exception for dependent child
< 19 years or full time student < 24 years)
Joint return (Married dependent cannot file a
joint return)
Relationship (Dependent must be either
related to the taxpayer or reside with the
taxpayer)
Citizenship (U.S. citizens, residents or reside
in Canada or Mexico)
Average and Effective Tax
Rates

Average Tax Rate


Total Tax Liability
Taxable Income
Effective tax rate


Economic Approach:
Tax Liability_____
Economic Income
Accounting Approach: __Tax Liability_____
Income Before Income
Taxes
Concepts of Income

Economic Concept


Accounting Concept



Income = Consumption + Change in Wealth
Transaction Approach
Realization: (1) A change in the form or substance of a
taxpayer’s property and (2) transaction with a second party
Tax Concept



Economic Benefit—cash, other property, debt relief
Realization—(1) & (2) above
Recognition—Statutory Interpretation
Tax Concept of Income-Continued

Administrative Convenience




Valuation and Objectivity
Role of the Courts
Penalties
Wherewithal to Pay



Tax should be collected when the taxpayer is in
the best position to pay the tax
Installment sales
Prepaid income
Tax Concept of Income-Continued

Gross Income Defined §61(a)



Except as otherwise provided in this subtitle, gross
income means all income from whatever source
derived, including (but not limited to) the
following items:
See page 3-4 for list of 15 items
Reg. 1.61-1(a)

Income must be realized in any form, whether in
money, property or services

Economic Benefit

Direct—taxable; Indirect—often excludable
Items That Are Not Income

Unrealized Income



Self-Help Income



Increases in value
Ordinary Stock Dividends
Example: Painting your apartment
Rental Value of Personal Use Property
Selling Price of Property; gain not the sales
price is taxable. This is the “recovery of
capital doctrine.”
When Is Income Taxable?—The Cash
Method



Income is reported in the year of actual or
constructive receipt.
Prepaid income is usually taxed when
received rather than when earned
Constructive receipt—Income is available so
that the taxpayer may draw upon it any time.
Cannot defer income recognition by refusing
payment until a later taxable year.
Accrual Method


Income reported in the year it is earned.
Prepaid Income


Income usually taxed in the year of receipt
Important Exceptions



Reg. 1.451-5: Taxpayer may defer advance payments
for goods (inventory) if the taxpayer’s method of
accounting for the sale is the same for tax and for
financial accounting purposes
IRS Notice 2002-79 Taxpayer may defer advance
payments for services to be performed after the
current tax year to the tax year following the year of
receipt.
Hybrid Method
Cash Basis Exceptions

Series EE Savings Bonds

Farmers and Ranchers

Inventories (Rev. Proc. 2001-10)
Accrual Basis Exceptions




Prepaid Income
Deferral of Advance Payments for Goods
Deferral of Advance Payments for
Services
Income Received under the Claim of
Right Doctrine
§61(a) Items of Gross Income




Compensation—(earned income)
Business Income—(earned income)
Gains from Dealings in Property—(unearned
income)
Interest—(unearned or portfolio income)



Tax Exempt Interest
Series EE exclusion for college expenses
Rents and Royalties

Leasehold improvements—in lieu of paying rent or
paying reduced rent
§61(a) Items of Gross Income-Continued

Dividends




Taxable to the extent of a C Corporation’s earnings
and profits
Additional dividend distributions are a return of
capital and (when capital is exhausted) capital
gain.
Taxed at maximum rate of 15%
Stock Dividends

Generally non taxable, adjust the stock basis.
Taxable is cash option is available.
§61(a) Items of Gross Income-Continued

Dividends—Continued


Capital gain dividends—distributions from a
regulated investment company [LTCG]
Constructive Dividends—associated with closely
held corporations, distributions that are intended
to (1) result in a deduction to the corporation and
taxable income to the shareholder (e.g.
unreasonable compensation) or (2) produce a
non-reportable benefit to the shareholder (e.g.
bargain sale) or (3) deduction to the corporation
without income to the shareholder (e.g.
purchasing assets for employee’s use)
§61(a) Items of Gross Income-Continued

Income from Life Insurance and Endowment
Contracts



Insurance proceeds excluded, subsequent income
is taxed
Income from Discharge of Indebtedness
Income from Pass Through Entities



Partnerships and S Corporations (Schedule K
-1)
Income with respect to a decedent
Income earned by trusts and estates (K-1)
To Whom is Income Taxable?


Assignment of Income
 Lucas vs. Earl 2 USTC ¶496 (USSC, 1930)
 Helvering vs. Horst 40-2 USTC ¶9787 (USSC,
1940)
Allocating Income Between Married People
 Common Law States (community income limited
to jointly owned property)—includes most states
 Community Property States (community income
vs. separate property (owned before marriage and
gifts and inheritances) ID,LA,TX all income
community income, AZ,CA,NV,NM,WA-separate
income
§61(a) Items of Gross Income-Continued

Alimony and separate maintenance
payments




Alimony
Child Support
Property Settlement
Review Concept Summary 4-1, Page 421
§61(a) Items of Gross Income-Continued

Pensions and Annuities

Current Year Exclusion = Amount Received x Exclusion Ratio



Expected Return Multiple—term certain or life
expectancy
Expected Return = Annual Payment x Expected Return
to Recipient
Multiple
Exclusion Ratio = Investment in Contract ÷ Expected
Return
§61(a) Items of Gross Income-Continued

Pensions and Annuities—Continued






Table 4-1, Page 4-30
Simplified Method for Qualified Retirement Plan
Annuities Table 4-1, Page 4-31
Death of taxpayer results in miscellaneous
itemized deduction of remaining investment
Advance Payments
10% Penalty for Early Withdrawal (< 59 ½ years
of age)
Must begin withdrawal in year following the year
taxpayer becomes 70 ½.
Other Items of Gross Income




Prizes, Gambling Awards, Treasure Trove
Illegal Income
Unemployment Compensation
Social Security Benefits



Insurance Proceeds and Court Awards



Low Income—Excluded from Gross Income
High Income—85% included in Gross Income
Exceptions—Accident and Health Benefits and Face Amount
of Life Insurance
The Tax Benefit Rule--§111
Claim of Right—Recipient of disputed amount must include the
amount received in gross income as long as the use of the funds
is unrestricted.
Major Statutory Exclusions

Gifts & Inheritances § 102



Subject to Unified Transfer Tax
Gifts depend on the intent of the donor
Life Insurance Proceeds § 101


Paid to the beneficiary because of the
insured person’s death.
Exclusion not available in exchange for
valuable consideration from a person other
than the insurance company.
Major Statutory Exclusions-Continued

Life Insurance Proceeds—Continued




If a life policy is sold or surrendered
before
the death of the insured, the
amount
is taxable to the extent it exceeds the net
premiums paid.
“Accelerated Death Benefits” excluded.
Dividends on life insurance and endowment
policies excluded.
Cancellation of ordinary life policy → the increase
in cash surrender value is taxable
Major Statutory Exclusions-Continued

Scholarships and Fellowships § 117



Amount paid or allowed to a student (graduate or
undergraduate) to aid degree seeking individuals
Exclusion limited to qualified tuition and related
expenses.
Distributions from Qualified Tuition Programs § 529
Plans




Amounts put in QTP tax free and grow tax free.
Beneficiary can withdraw tax free if amounts are use for
qualified higher education expenses—(books, tuition, fee,
room and board [must be ½ time student])
Amounts deposited are gifts of a present interest.
Donor can change beneficiaries.
Major Statutory Exclusions-Continued

Payments for Injury and Sickness § 104(a)





“Amount of any damages…received…on account of personal
physical injuries or physical sickness.”
“punitive” damages are taxable.
§ 104(a)(3) excludes amounts collected under an accident
and health policy purchased by the taxpayer. Amounts
received from employer sponsored plans are taxable.
§ 101 excludes benefits under a long term care contract (>
$210 per day or actual cost)
§104(a)(1) excludes worker’s compensation from gross
income
Major Statutory Exclusions-Continued

Employee Fringe Benefits



§106 Healthy insurance premiums paid by
employer on behalf of employees are excluded
from gross income.
Self-employed individuals may deduct medical
premiums on Schedule C.
§ 79(a) Premiums on 1st $ 50,000 of group term
life insurance coverage excluded from gross
income, excess of $ 50,000 included in income
based on uniform monthly premium regulations.
Major Statutory Exclusions-Continued

Employee Fringe Benefits Under § 132

Review Concept Summary 5-2, Page 5-25






§
§
§
§
§
§
132(b) No additional cost
132(c) Qualified employee discounts
132(d) Working condition
132(e) De minimis
132(f) Qualified transportation fringes
132(j)(4) Recreation and athletic facilities
Major Statutory Exclusions-Continued

Employee Awards



§74 Employee achievement awards—tangible
personal property other than cash [for safety or
length or service ($ 400 limit)]
§74 Qualified plan awards ($ 400 average cost, $
1,600 limit)
§119 Meals and Lodging

Meals—(excluded if furnished on the employer’s
premises for the convenience of the employer);
Lodging (same convenience rules and employee
must accept lodging as condition of employment)
Major Statutory Exclusions-Continued




Meals and entertainment—generally excluded to
the employee under Rev. Rul. 63-144
Employee death benefits—payment must be a gift
and not compensation. Gifts are not deductible to
the employer.
Dependent care assistant programs—($ 5,000 of
assistance), care must be similar to rules for child
and dependent care credit)
§127 Educational assistance plans (Employee can
exclude up to $ 5,250 for tuition, fees, books,
supplies and equipment)
Major Statutory Exclusions-Continued

§ 125 Cafeteria Plans



Offer employees option of choosing cash (taxable income) or
statutory nontaxable fringe benefits (group term life
insurance, medical insurance, adoption expenses, child
care.)
Arrangements are binding for one year. Plans may be
supplemental or wage reduction arrangements
§ 911(b)(2) Foreign Earned Income Exclusion




Personal services in a foreign country
Must be a resident or present in a foreign country for at
least 330 days in a 12 month period.
First $ 80,000 excluded from gross income
Housing allowance exclusion also available
Major Statutory Exclusions Continued



Interest on Certain State and Local
Government Obligations
Dividends—Patronage Dividends, Mutual
Insurance Dividends and Conventional Stock
Dividends are all non taxable.
Educational Savings Bonds
Major Statutory Exclusions-Continued

§ 61(a)(12) Income from Discharge of
Indebtedness




Debt is cancelled or forgiven
Must distinguish from gift, bequest, or
renegotiation of purchase price
§ 108 Excludes discharge if taxpayer is bankrupt
or insolvent.
§ 108 (f)(2) excludes certain student loans where
the student must perform certain public services.
Deductions for and from
Adjusted Gross Income

§ 62 Principal Deductions for AGI












Trade or business expenses
Reimbursed employee business expenses
Losses from sale of trade, business or investment property
Expenses attributable to rent or royalty income
Moving expenses
Contributions to pension, profit-sharing or retirement plan
arrangements
Early withdrawal penalties
Alimony
Interest on qualified education loans
½ S. E. tax
Tuition and related expenses ($ 3,000 limit)
Teacher supplies ($ 250)
Deductions from AGI






Medical
State, local & foreign income & property
taxes
Housing and investment interest
Losses from personal casualties & thefts
Contributions
Miscellaneous itemized deduction—2% limit &
100% deductible
Criteria for Deducting Business
& Investment Expenses

Requirements (§§ 162, 212)






Related to trade or business or investment
Ordinary (relation to activity)
Necessary (appropriate & helpful to
activity)
Reasonable in amount
Properly documented
Taxpayer’s expense
When is an Expense Deductible?

Cash Method of Accounting

Deduction when payment is made




Cash or other property is transferred
A check is delivered or mailed
An item is charged on a credit card
Prepaid Expenses



Generally deductible over the period covered
Deductible when paid if the period covered does not
exceed one year.
Prepaid interest is generally deductible over the period
covered by the loan.
When is an Expense Deductible?

Cash Method of Accounting

Prepaid Expenses—Points

Deductible when paid if:






The loan was used to purchase or improve the
taxpayer’s principal residence.
The loan is secured by the residence
Points are an established business practice in the
area
Points do no exceed the amount generally charged.
Points paid to purchase a principal residence the
closing agreement clearly designates the amount as
points and the amount must be computed as a % of
the amount borrowed
If not a personal residence amortize over the life of the
loan.
When is an Expense Deductible?

Cash Method of Accounting

Points—Continued


Points paid to refinance an existing home
mortgage cannot be immediately expensed but
must be capitalized over the life of the loan.
Points paid by the seller on behalf of the
buyer are treated as an adjustment to the
price of the residence.
Accrual Method of Accounting

All events test



All events to create liability have occurred
Amount can be determined with reasonable
accuracy
Economic performance test


Service, property, or use of property giving rise to
the liability is actually performed for, provided to,
or used by the taxpayer
Exception for recurring items
Non-Deductible Expenses


§ 265 Expenses associated with tax-exempt
interest
§ 162 (c) Expenditures that are contrary to
public policy




Payment of fines and penalties
Illegal payments
Bribes and kickbacks
Political Contributions and Lobbying Expenses
Business Investigation and
Pre-opening Expenses

Under § 195


Does not apply if the expenses are incurred by a
taxpayer already established in a similar business.
Deduct currently.
If the taxpayer investigates a new business:



And enters the new business, the expenses, including
start up costs are amortized over a 60 month period
and does not enter the new business, the expenses are
non-deductible
However, legal expenses associated with failed
acquisition plans may be deductible. (They must be
associated with plans to acquire a specific business.)
Special Disallowance Rules—Hobby
Losses



Rules is applied upon IRS audit
Hobby Expenses are deductible only to the extent of
hobby income (§ 183(b)(2))
Factors to be considered in determining whether an
activity is profit seeking or a hobby





Whether the activity is conducted in a business like manner.
The expertise of the taxpayers or their advisers.
The time and effort expended.
The expectation that the assets of the activity will increase
in value.
The taxpayer’s previous success in conducting similar
activities.
Special Disallowance Rules—Hobby
Losses

Factors to consider in determining whether an activity
is profit seeking or a hobby (continued)





The history of income or losses from the activity.
The relationship of profits earned to losses incurred.
The financial status of the taxpayer
Elements of personal pleasure or recreation in the activity.
Presumptive Rule of § 183

The Code provides the presumption that an activity is profit
seeking if the activity shows a profit in at least three of
any five prior consecutive years. (two of seven years for
horses)
Special Disallowance Rules—Hobby
Losses

Determining the amount of the deduction if the
activity is a hobby
 Expenses are deducted in the following order:



Amounts deductible under other Code sections without
regard to the nature of the activity (property taxes and
home mortgage interest)
Amounts deductible under other Code sections if the
activity had been engaged in for profit but only if those
amounts do not affect adjusted basis. (maintenance,
utilities, supplies)
Deductible amounts that affect adjusted basis.
(depreciation and amortization)
Rental of Vacation Homes


§280A allows deductions on residences
used primarily for personal purposes
only to the extent of the income
generated.
Three possible tax treatments for residences
used for both personal and rental purposes:



Primarily Personal Use
Primarily Rental Use
Personal/Rental Uses
Rental of Vacation Homes

Primarily Personal Use

If the residence is rented for fewer than 15
days in a year, it is treated as a personal
residence



Rent income is excluded from gross income
Mortgage interest and real estate taxes are
allowed as itemized deductions
No other deductions are allowed
Rental of Vacation Homes

Primarily Rental Use



Treated as rental property. Residence must be
rented for 15 days or more in a year and not used
for personal purposes for more than the greater of
(1) 14 days or (2) 10 % of the total days rented.
Expenses must be allocated between rental days
and personal days. Deduction of expenses to
rental days can exceed rent income and produce a
loss.
Loss is deductible on Schedule E, but is
subject to the passive activity rules.
Rental of Vacation Home

Personal/Rental Use




Subject to special allocation rules. Personal/Rental use
occurs when the residence is rented for 15 days or more
in a year and is used for personal purposes for more than
the greater of (1) 14 days or (2) 10% of the total days
rented.
Expenses allowed only to the extent of rental income.
Three tier approach to allocation: (1) mortgage and interest
(365 days total), (2) maintenance, utilities, insurance (total
days of use), (3) depreciation (total days of use).
Must have positive balance to take a deduction.
General Restrictions on the
Deductibility of Expenses

Capitalization versus Expense Deduction

General Capitalization Requirements §263
(expenses that add to the value,
substantially prolong the useful life, change
the use of the property)


No current deduction for capital expenditures
Maintenance and repair expenditures that only
keep an asset in a normal operating condition
are currently deductible.
Capitalization Versus Expense
Deduction

Election to Deduct Currently, some examples




Soil and water conservation costs
Qualified research expenditures
Purchase of qualified tangible personal property § 179
Capitalization of Deduction Items § 266, some examples



Annual property taxes, interest on mortgage and other
carrying charges incurred on unimproved and unproductive
real estate.
Annual property taxes, interest, employment taxes and
other necessary expenses incurred in the development,
improvement or construction of real property.
Interest and employment taxes incurred in transporting
and installing personalty
Transactions Between Related Parties



§ 267 (a)(1)—Disallows losses on sales and
exchanges between related parties
Section 267 specifically defers the deduction
of the accruing taxpayer until the recipient
taxpayer must include it in income.
Relationships and constructive ownership will
be reviewed in Chapter 14.