Homework

Chapter 1

Introduction to Federal Taxation and Understanding the Federal Tax Law

OBJECTIVES

After completing  Chapter 1 , you should be able to:

1. Identify types of taxes used by federal and state governments to raise revenues.

2. Understand the methods of tax collection and the trends shown by tax collection statistics.

3. Differentiate between tax avoidance and tax evasion.

4. Recall the underlying rationale of the federal income tax and its historical development.

5. Describe the route a tax bill takes until enacted into law.

6. Define the basic tax concepts and terms of federal income taxation.

INTRODUCTION

Federal taxation is the fuel by which Americans power their “Ship of State.” The tax structure which supports our federal government has gone from quill and ink records of revolutionary assessments to lightning speed computers which calculate and validate millions of income tax returns submitted by individuals and corporations. Federal taxes, in addition to the income tax, include a variety of other taxes covering estates, gifts, and customs, as well as excise taxes, and other minor categories of tax. Our governments can thus select among a variety of tax alternatives to produce the revenues required to operate national programs and carry out national policies.

Taxes are big business. Unfortunately, many business decisions are made in the United States today without regard to federal tax consequences. Individuals are concerned with personal income tax decisions and gift and estate tax decisions, while corporations concern themselves with corporate taxes, personal holding company taxes, and accumulated earnings tax decisions. Further, businesspersons must concern themselves with the choice of business entity: corporation, partnership, or S corporation. Differences in tax costs can be considerable. Advantages and disadvantages are virtually unlimited. This book presents information which is required knowledge if you make business decisions.

While most businesspersons (and many advisors) think about how to make decisions in nontax terms, the tax accountant bears the burden of introducing tax considerations. The topics presented in this book must be viewed in terms of decision-making—therefore, tax planning and tax research are of the utmost importance. Tax decisions are not made in a vacuum. Lawyers, accountants, financial managers, and a host of other experts work as a team in the decision-making process. This book is intended to serve as a guide for accounting students and for MBA students interested in gaining insight into and expertise in the tax complexities of business decision-making.

OVERVIEW

This chapter presents information on the magnitude of federal taxes collected and on taxpayer obligations. Then, a brief historical account is presented of federal tax collections prior to and after the adoption of the Sixteenth Amendment to the Constitution, which enabled Congress to levy “taxes on incomes, from whatever source derived.” Following this is an introductory discussion of the federal legislative process and an analysis of the social, political, and economic rationale underlying the federal tax law. Finally, basic tax concepts are explained.

Fundamental Aspects of Federal Taxation

¶1101

SOURCES OF REVENUE

Types of Taxes

From the very beginning, with the ratification of the Sixteenth Amendment to the Constitution, through various Revenue Acts and many court cases, a set of tax laws has evolved that raised $3.0 trillion, net of refunds, on over 250 million tax returns processed by the IRS in 2018. This was higher than the $2.98 trillion raised in 2017. The federal government uses a number of different types of taxes to generate the cash flow it needs for operating the government. The following is a listing of the various types of federal taxes:

Income taxes	Corporations, individuals, fiduciaries
Employment taxes	Old age, survivors, disability, and hospital insurance (federal insurance contributions, self-employment insurance contributions), unemployment insurance, railroad retirement
Estate and gift taxes	Estate, gift, and generation-skipping transfers
Excise and customs taxes	Alcohol, tobacco, gasoline, other

Over the years individuals have borne the burden in the arena of tax payments. Individual taxes account for approximately 52.45 percent of total tax collections. Corporate income tax collections account for approximately 6.75 percent of total tax receipts. This is a dramatic decrease from the 9.85 percent of total receipts that were collected from corporations in 2017.

Historically, Americans have been staunch supporters of the federal government’s tax efforts. The rate of participation and compliance is one of the highest in the world. Realistically, the impact of estimating withholding provisions and the threat of government audits have aided in the outstanding record of the Internal Revenue Service.

Individual Income Taxes

Presently the United States government taxes income, transfers, and several transaction-type items (excise, customs, etc.). The major source of revenues is the tax on individuals (see  Table 2 ). In 2018, individuals contributed 52.45 percent of the gross internal revenue collected. Since 1943, the U.S. has been on a pay-asyou-go system. Income taxes withheld by employers increased from $1.87 trillion in 2017 to $1.97 trillion in 2018. In 2018, 122 million individual taxpayers received a tax refund which totaled almost $395 billion.

Corporate Income Taxes

Corporate income taxes accounted for 6.75 percent of the total revenue collected by the U.S. government in 2018. The Tax Reform Act of 1986 reduced the top corporate income tax rate from 46 percent to 34 percent. The Revenue Reconciliation Act of 1993 raised the corporate income tax rate to 35 percent. The American Jobs Creation Act of 2004 created many business incentives. The corporate tax rate has changed from 1 percent in 1913 to a high of 52 percent between 1952 and 1962. The Tax Cuts and Jobs Act reduced the corporate rate from 35 percent to a flat 21 percent. Generally, corporations are subject to tax based on net income without regard to dividends distributed to their shareholders.

Estate and Gift Taxes

Estate and gift taxes accounted for only 0.76 percent of the total revenue collected by the government in 2018. The estate tax, as we know it today, was enacted on September 8, 1916, and is levied on the transfer of property. The gift tax was originally enacted in 1924, was repealed in 1926, and then was restored in 1932.

Excise and Customs Taxes

Excise and customs taxes are levied on transactions, not on income or wealth. Examples of excise taxes are the taxes on alcohol, tobacco, and gasoline. The government collects the tax, usually at an early stage of production. In 2018, 2.41 percent of the government’s revenue, or $72.4 billion, came from excise taxes.

Customs taxes are levied on certain goods entering the country. There are several reasons why the government levies this tax but by far the most important reason is the protection of U.S. industry from foreign competition.

State and Local Taxes

Just as the federal government needs an ever-increasing amount of dollars to satisfy its requirements, so do the states and local communities. State and local taxes are also big business. The major source of revenue for state governments is the income tax and the sales tax. For local communities, the property tax is a major source of revenue. Approximately 31.1% of state revenues are generated by the property tax. State governments raised $1,409.6 billion in 2018, up from $1,360.3 billion in 2017. California collected the most in state taxes followed by New York and Texas.

Value-Added Tax

The value-added tax (VAT) is of fairly recent origin and much more popular overseas than in the United States. The concept of a VAT was first proposed by a German industrialist and government consultant, Dr. Wilhelm von Siemens, in 1918. In the next three decades much discussion took place. France was the first major country to adopt the VAT. In 1919, France instituted a general sales tax. This stayed in place until 1948, when it was replaced with a tax on production at each stage of the manufacturing process.

There are many forms of taxation, but basically all taxes can be categorized as direct taxes or indirect taxes. The federal income tax on individuals and corporations is a direct tax. Indirect taxes are those levied on producers or distributors with the expectation that these taxes will be passed on to the ultimate consumer. The VAT is an example of an indirect tax. It is merely a sales tax assessed at any or all levels of production and distribution. It is applied only on the value added to the product in an early stage of production or distribution. Notice that the VAT is a tax on products, not on business entities. The major drawback of the VAT is that it is extremely regressive.

EXAMPLE 1.1

A sweater is produced at a cost of $10. If the VAT is 5 percent, then each taxpayer, regardless of income level or ability to pay, must pay the fifty cents for VAT.

The VAT continues to be discussed as an attractive source of revenue in the United States. Each 1 percent of VAT would be expected to raise $12 billion. Even with the exclusions for food and medicine, $7.6 billion would be raised per percentage point of tax. Despite these attractions, the VAT worries many Americans. First, it is a very regressive tax. Second, there is some concern that ultimately the VAT will partially replace the personal income tax. Proponents of the VAT, however, maintain that its use would help shrink the “tax gap” (discussed at  ¶1121 ). That is, the element of the population not currently paying taxes would have to pay a VAT tax, since it is a layered sales tax.

Flat Tax

The past several years have seen heated discussions about using a flat tax. Proponents of a flat tax point to the lower cost of administration and the ease of preparation by Americans as the major benefits. A flat tax would take an individual’s total income minus an allowance for family size and apply one tax rate. This rate would apply to all individuals. There would be no deductions.

Various senators and representatives have presented proposals for consideration. A flat tax has been proposed composed of two tax forms—one for individuals and one for businesses. Their proposal would tax individuals on total income minus an allowance based on family size and then apply a 17 percent tax rate. For businesses, the tax rate would be the same 17 percent, but it would be applied against the firm’s gross revenue minus costs of purchases, wages, salaries, capital equipment, structures, land, and pensions. To date, none of these proposals has been successful.

Fair Tax

The Fair Tax is a consumption tax. The proponents of the fair tax would replace the Internal Revenue Code with a consumption tax. In many respects it would resemble the sales tax that many states now collect. Proponents suggest that low income individuals would receive a rebate from the government as a way to reduce the regressive nature of the tax.

KEYSTONE PROBLEM

The federal government currently uses many forms of taxation, both direct and indirect, to raise revenue. Would it not be more effective and less burdensome just to employ a single tax? What would you consider to be a more effective and efficient system of raising revenue?

¶1121

TAX COLLECTION AND PENALTIES

Returns

The Internal Revenue Service processed over 250 million federal tax returns and supplementary documents in 2018—a slight increase from 2017. This is in comparison to 143 million tax returns processed in 1980. It collected $3.0 trillion in 2018, slightly more than it collected in 2017. Taxes and tax collections are indeed big business.  Table 1 , derived from the 1980 Annual Report of the Commissioner of the Internal Revenue Service and the 2018 Internal Revenue Service Data Book, details the magnitude of work required to support our government. Approximately 61 percent of all returns are filed by individuals. In 2018, individuals filed 152.9 million returns, for a total of approximately $1.57 trillion. In 2018, corporate collections decreased to $202.7 billion.

Table 1. NUMBER OF RETURNS FILED BY PRINCIPAL TYPE OF RETURN (Figures in Thousands)
				Increase or Decrease Between 1980 and 2018
Type of Return	1980	2017	2018	Amount	Percent
Grand Total	143,446	245,412	250,321	106,875	74.51
Income tax, total	107,827	187,407	190,613	82,786	76.78
Individual	93,143	150,691	152,938	59,795	64.20
Declaration of estimated tax	8,699	22,230	22,387	13,688	157.35
Fiduciary	1,877	4,046	4,239	2,362	125.84
Estate and Trust	1,390	2,995	3,097	1,707	122.81
Corporation	2,718	6,893	7,256	4,538	166.96
Estate tax	148	34	34	-114	(77.03)
Gift tax	216	245	246	30	13.89
Employment tax	26,499	30,680	30,943	4,444	16.77
Exempt organizations	444	1,528	1,603	1,159	261.04
Excise tax	909	1,018	1,049	140	15.40
Supplemental documents	6,064	22,275	25,833	19,769	326.01
Sources: 1980 Annual Report of the Commissioner of the Internal Revenue Service and Internal Revenue Service Data Books 2017 and 2018.

Tax Collections

Tax collections have increased dramatically between 1980 and 2018. This was due in part to the growth in the economy.  Table 2  gives data on tax collections from 1980, 2017, and 2018. Obviously, the increase in tax collections from 1980 to 2018 is staggering—$2,482,206,627,000. Now, notice the detail. Corporate taxes have increased 179.99 percent between 1980 and 2018, while individual income taxes have increased 447.5 percent. Estate and gift taxes have increased 253 percent in the same period. Keep these figures in mind as you read the chapters that follow.

Just as the dollar amounts have increased in tax collections, so has the number of returns filed. From 1980 to 2018, the number of corporate income tax returns increased by 166.96 percent. During the same time period, the number of individual income tax returns increased by 64.2 percent. The number of individuals requesting an individual income tax refund decreased slightly in 2018 to 122.2 million.

Table 2. GROSS INTERNAL REVENUE COLLECTIONS (net of refunds) (Figures in Thousands)
Source	Percent of 2018 Collections	1980	2017	2018	Increase or Decrease Between 1980 and 2018
					Amount	Percent
Grand total	100.00	519,375,273	2,979,742,266	3,001,581,900	2,482,206,627	477.92
Income taxes, total	59.20	359,927,392	1,775,102,989	1,776,891,763	1,416,964,371	393.68
Corporation	6.75	72,379,610	293,634,315	202,652,958	130,273,348	179.99
Individual	52.45	287,547,782	1,481,468,674	1,574,238,805	1,286,691,023	447.47
Employment taxes, total	37.62	128,330,480	1,061,451,074	1,129,344,468	1,001,013,988	780.03
Old-age, survivors, disability, and hospital insurance	37.13	122,486,499	1,047,371,143	1,114,343,147	991,856,648	809.77
Unemployment insurance	0.29	3,309,000	8,124,886	8,681,693	5,372,693	162.37
Railroad retirement	0.21	2,534,981	5,955,045	6,319,628	3,784,647	149.30
Estate and gift taxes, total	0.76	6,498,381	22,732,968	22,943,348	16,444,967	253.06
Excise taxes, total	2.41	24,619,021	61,856,711	72,402,321	47,783,300	194.09
Sources: 1980 Annual Report of the Commissioner of the Internal Revenue Service and Internal Revenue Service Data Books 2017 and 2018.

Tax Audits and Penalties

The U.S. tax system is a voluntary compliance tax system. The total number of federal tax returns filed in 2018 was 250,321,000 of which 152,938,000 were filed by individual taxpayers. The IRS conducted examinations of 991,168 returns, and on the basis of these examinations, it recommended additional tax and penalties of almost $26.5 billion.

Although audits of individual returns made up the bulk of the examinations (892,187 returns), they resulted in only $9.05 billion of the total recommended collections, while audits of corporate returns yielded $14.38 billion. Of course, audits do not always favor the IRS, as evidenced by the fact that, of the individual returns examined, almost 30,000 resulted in additional refunds; this amount was down from 34,000 in 2017.

Until recently, there had been an upsurge in the number of taxpayers who illegally sought, either openly or covertly, to reduce or eliminate their tax obligation. However, the IRS has responded to the challenge by taking advantage of the developing computer technology. Computers already scrutinize tax returns, check errors, and perform a number of routine, repetitive tasks with speed, efficiency, and great accuracy. The IRS continues to match almost all information returns that businesses are required to submit on magnetic media to verify that correct amounts are reported on taxpayers’ returns. Information returns include W-2 Forms listing salary and 1099 Forms listing other income.

In 2018, the IRS audited almost one million individual income tax returns or 0.6 percent of all individual tax returns. The percentage of returns audited was the same as the previous year.  Table 3  presents information on the percentage of returns audited by type of return.

For years, the audit rate for individual returns had been declining. For fiscal year 2018, the audit rate for individual returns was 0.6 percent. In FY 1997 it was 1.28 percent, and in FY 1995 it was 1.67 percent.

Table 3. PERCENTAGE OF RETURNS AUDITED
Type of Return	Percentage Audited
	2017	2018
Individual	0.6	0.6
Partnership	0.4	0.2
Corporation	1.0	0.9
Estate	8.2	8.6
Gift	0.8	0.9
Excise	1.4	1.3
Employment	0.2	0.1
Sources: Internal Revenue Service Data Books 2017 and 2018.

Because of severe budget deficits during the late 1980s and 1990s, the personnel needed to audit the growing number of returns filed have not been added. A major reason for the decline in audit rates has been staff reduction at the IRS and the movement of IRS personnel to focus on customer service. Since the late 1980’s, staff in the examinations division was reduced by over 30 percent.  Table 4  graphically depicts the percentage of returns audited by the Internal Revenue Service. The IRS budget in FY 2018 was $11.7 billion. This is up from FY 2017 when it was $11.5 billion.

Table 4. PERCENTAGE OF RETURNS AUDITED—1980—2018

Sources: 1980 Annual Report of the Commissioner of the Internal Revenue Service and Internal Revenue Service Data Book 2018.

Naturally, for certain types of taxpayers and those with higher incomes, the probability of audit is much greater. Individuals with income of over $100,000 were most likely to be audited.

The Internal Revenue Service has acknowledged that the problem of tax evasion is indeed a serious one. The “tax gap,” that is, the total revenue lost through tax evasion, has increased from $81 billion in 1981 to $345 billion in 2001 and to $450 billion in 2006. IRS officials estimate that enforcement activities along with late payments have recovered $65 billion of the tax gap for 2006 resulting in a net tax gap in 2006 of $385 billion. The IRS updated the study and the average annual tax gap for 2008–2010 was $458 million. Enforcement activities recovered $52 billion for a net annual tax gap of $406 billion. In September 2019 the IRS released a new set of data for tax years 2011, 2012, and 2013. The net result is that the tax gap has remained substantially unchanged. The IRS estimated that 61 percent of the tax gap was caused by individuals and the remainder by corporations. Today, the voluntary compliance rate is estimated by the Commissioner of Internal Revenue to be 83 to 85 percent. Each percentage point of noncompliance costs the government $26 billion in lost revenue.

The Tax Reform Act of 1986 closed many of the loopholes associated with tax shelters. Since 1988 the IRS has been using a revised audit-selection formula that is aimed at high-income returns. Further, the Tax Acts of 1986 and 1987, the Technical and Miscellaneous Revenue Act of 1988, and the Revenue Reconciliation Acts of 1989, 1990, and 1993 changed the penalties imposed on taxpayers for not complying with the tax laws.

The Improved Penalty and Compliance Act, which was incorporated into the Revenue Reconciliation Act of 1989, revamped the civil tax penalty provisions of the Internal Revenue Code. The goal was to create a fairer, less complex, and more effective penalty system. The Act made changes in the following broad areas:

1. Document and information return penalties

2. Accuracy-related penalties

3. Preparer, promoter, and protestor penalties

4. Penalties for failures to file or pay tax

¶1131

TAXPAYER OBLIGATIONS

Tax accountants, lawyers, and businesspersons, since the inception of the first federal income tax law, have concerned themselves with choosing among the various forms a transaction may take. There is an acute awareness among tax accountants that tax consequences of an action may differ depending upon procedural variations and alternative approaches to a business decision. The increasing complexity of the modern tax laws serves only to accentuate the problem.

Because of the extreme difficulty experienced in trying to differentiate between tax avoidance and tax evasion, Congress enacted, in the 1954 Internal Revenue Code, a provision which illustrates circumstances that constitute prima facie evidence of the tainted purpose. The 1986 Code contends with the problem of criminal tax evasion in Section 7201, entitled “Attempt to Evade or Defeat Tax.” It reads:

Any person who willfully attempts in any manner to evade or defeat any tax imposed by this title or the payment thereof shall, in addition to other penalties provided by law, be guilty of a felony and, upon conviction thereof, shall be fined not more than $100,000 ($500,000 in the case of a corporation), or imprisoned not more than five years, or both, together with the costs of prosecution.

The goal of every businessperson should be profit maximization. The government endorses this goal. Tax avoidance is legal and a legitimate pursuit of a business entity.

Tax Avoidance

All citizens have the prerogative to arrange their transactions and affairs in such a manner as to reduce their tax liabilities. A good businessperson is obligated to search out those transactions and to time those events which will lower the tax liability. Judge Learned Hand, in S.R. Newman, declared many years ago:

Over and over again courts have said that there is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced extractions, not voluntary contributions. To demand more in the name of morals is mere cant. CA-2, 47-1 USTC ¶9175, 159 F.2d 848.

There is a clear demarcation between tax avoidance and tax evasion. The saving of tax dollars requires specific actions so as to avoid the tax liability prior to the time it would have occurred according to law. It requires the proper handling of affairs so that items of income are subjected to a lower tax rate than would apply if no action had been taken. In some instances, it requires the postponing of income which is subject to taxation until a time when the individual’s tax bracket would be lower.

Tax Evasion

To be guilty of evading taxes, the individual must already have a tax liability. All actions must be definitely complete, and in spite of this liability, the taxpayer does not report income. The courts have ruled that it is not wrong to find a form of a transaction that does not lead to any tax liability. However, there is a legal obligation to disclose a tax liability based on completed transactions, and the refusal to report the tax liability is illegal.

The Tax Court in Berland’s Inc. of South Bend (16 TC 182, acq., 1951-2 CB 1, Dec. 18,057) said that the purpose of tax evasion must be the “principal” purpose, and the taxpayer is not guilty of tax evasion merely because the tax consequences of the particular transaction are considered. Furthermore, the Tax Court said:

The consideration of the tax aspects of the plan was no more than should be expected of any business bent on survival under the tax rates then current. Such consideration is only part of ordinary business prudence.

What frequently distinguishes tax avoidance from tax evasion is the intent of the taxpayer. The intent to evade tax occurs when a taxpayer knowingly misrepresents the facts. Intent is a mental process, a state of mind. A taxpayer’s intent is judged by his or her actions. The taxpayer who knowingly understates income leaves evidence in the form of identifying earmarks, referred to as “badges” of fraud. Internal revenue agents are on the lookout for these badges of fraud. The more common badges are:

1. Understatement of income. The IRS considers the failure to report entire sources of income, such as tips, or specific items where similar items are included in income, such as dividends received, as an indication that there may have been an understatement of income. Other such indications include the unexplained failure to report substantial amounts of income determined by the IRS to have been received, the concealment of bank accounts or other property, and the failure to deposit receipts to a business account contrary to normal practices.

2. Claiming of fictitious or improper deductions. To the IRS, a substantial overstatement of deductions is a badge of fraud that could warrant a further look at the taxpayer’s books. Other indications of improper deductions are the inclusion of obviously unallowable items in unrelated accounts and the claiming of fictitious deductions or dependency deductions for nonexistent, deceased, or self-supporting persons.

3. Accounting irregularities. Accounting practices that are considered a badge of fraud include the keeping of two sets of books or no books, false entries, backdated or postdated documents, inadequate records, and discrepancies between book and return amounts.

4. Allocation of income. The distribution of profits to fictitious partners and the inclusion of income or deductions in the return of a related taxpayer with a lower tax rate than that of the taxpayer are indications of an intentional misstatement of taxable income.

5. Acts and conduct of the taxpayer. Aside from the improper reporting of income or deductions, a taxpayer’s conduct can give the IRS reason to question the propriety of a return. For example, false statements, attempts to hinder an examination of a return, the destruction of books or records, the transfer of assets for purposes of concealment, or the consistent underreporting of income over a period of years are badges of fraud.

The presence of one or more of these badges of fraud does not in itself mean that the return is fraudulent. However, it should alert an examiner that additional probing and inquiry are necessary. Internal Revenue Manual, Sec. 4.10.

Corporate Tax Avoidance

Normally, the Commissioner and the courts accept a corporation as being distinct from its shareholders. However, if it appears that a sham transaction has taken place, then the Commissioner has grounds for taking action. Judge Learned Hand, in summarizing many cases on the subject of tax avoidance v. tax evasion, stated in National Investors Corp. v. Hoey:

To be a separate jural person for purposes of taxation, a corporation must engage in some industrial, commercial, or other activity besides avoiding taxation: in other words, that the term “corporation” will be interpreted to mean a corporation which does some “business” in the ordinary meaning; and that escaping taxation is not “business” in the ordinary meaning. 44-2 USTC ¶9407, 144 F.2d 466, 467-68 (CA-2 1944).

Section 269 of the Internal Revenue Code provides the Commissioner with a very important tool in judging whether or not a corporate acquisition is tax avoidance or merely a sham. If the Commissioner feels that there is no principal purpose for the tax-free acquisition, “such deduction, credit, or other allowance” may be disallowed. The key defense by the taxpayer is to substantiate that there was indeed a “principal purpose.” If there is a principal purpose, nothing stops the taxpayer from having other purposes, such as the saving of taxes. Kershaw Mfg. Co., Inc., 24 TCM 228, TC Memo. 1965-44, Dec. 27,268(M).

Taxpayer’s Assessment of Tax Liability

In order to decrease potential tax liability, the taxpayer must choose the action that will allow the greatest tax savings. An example of a tax savings device is investment in municipal bonds instead of corporate bonds. The interest derived from corporate bonds is taxable income, whereas the interest received from municipal bonds is tax free. In the above example, the taxpayer does not have to hide the fact that there is a lower tax liability on the profit.

When contemplating a transaction, the taxpayer makes an assessment of the tax liability. Naturally, any doubtful issues are resolved in the taxpayer’s own favor. Certainly, there is nothing fraudulent about using this procedure. On the other hand, if the taxpayer knowingly overstates expenses, thereby reducing the tax liability, then the taxpayer is guilty of tax evasion.

¶1151

BRIEF HISTORY OF THE FEDERAL INCOME TAX

The origin of taxation in the United States dates back to the Constitution and, therefore, the Constitution is the ultimate source of the power to tax. Originally, the Constitution empowered Congress “to lay and collect taxes, duties, imports and excises, to pay the debts and provide for the common defense and general welfare of the United States.” In granting this power, Congress also limited the power of taxation in that “all duties, imports, and excises shall be uniform throughout the United States, that direct taxes should be laid in proportion to the population.” It was within these confinements that many cases tested the constitutionality of the early tax laws—a test many of the taxes did not pass. During the late 1800s, the terms “uniform” and “direct taxes” were very important concepts.

Income Tax Law of 1894

In the late 1880s, support was mounting at the state level for an income tax. In Ohio, the State Democratic Convention approved a graduated income tax in the summer of 1891. Reflecting on the mood of the country at that time, William Jennings Bryan supported an income tax as preferential to a tax on tobacco and beer which he felt would put an unfair hardship on the poor. Although this proposed tax and others like it were never passed, they encouraged others to investigate the possibilities of a federal income tax. Ultimately this led to the actual passage of the Wilson Tariff Bill of 1894. This bill was not an income tax bill; however, an amendment was attached to the bill which allowed for an income tax. The provisions of this income tax law stated that the tax would commence on January 1, 1895, and continue until January 1, 1900. It was a 2 percent tax on all “gains, profits, and income” over $4,000 “derived from any kind of property, rents, interest, dividends, or salaries, or from any profession, trade, employment, or vocation.” Income was defined to include interest on all securities except federal bonds which were exempt by law of their issuance from any federal taxation. The Act also imposed a 2 percent tax on net profits of corporations but not on partnerships.

There was much criticism of this law. Concerns arose that provisions such as the $4,000 exemption made the law discriminatory against certain groups. Consequently, many cases were brought before the courts. The major point raised by opponents of the Act was whether or not such a tax on income derived from property was a “direct tax” in the sense commonly understood in the Constitution. A direct tax was held to be a tax on the land and, therefore, had to be apportioned among the states.

The Supreme Court declared the law unconstitutional in the famous Pollock v. Farmers’ Loan & Trust Co. case, 157 U.S. 429, 15 S.Ct. 673 (1895). It characterized the income tax as a “direct tax” and stated that the Constitution provides that “no direct tax shall be laid, unless in proportion to the census or enumeration hereinbefore directed to be taken.” Therefore, the Court invalidated a significant portion of the law and rendered income tax apportionment impossible. Further, the Court considered the property tax a direct tax and excise and duties taxes as indirect taxes. The Court stated, in a five-to-four decision, that a tax on real estate and on personal property is a direct tax and, therefore:

unconstitutional and void, because not apportioned according to representation, all these sections constituting one entire scheme of taxation, are necessarily invalid.

The Court expressed, in one of its longest opinions, no opinion on whether or not the income tax provisions were unconstitutional. Thus, with this decision, the first federal income tax law since the Civil War in the United States was declared to be unconstitutional.

Corporation Excise Tax of 1909

Support for an income tax was growing even though the courts had voided all attempts made by Congress. Government was becoming more costly and new sources of revenue were essential. The Spanish American War produced a great need for funds, and many believed that an income tax was the only solution. In the Pollock decision, the Supreme Court voted five to four that the tax was unconstitutional. By late 1908, it was abundantly clear that only by passage of a constitutional amendment would the government receive the power needed to impose a federal income tax. Therefore, an amendment was passed by Congress in 1909. However, because of the length of time required to ratify a constitutional amendment, Congress simultaneously passed the Corporation Excise Tax of 1909. The Supreme Court had ruled in the Pollock case that an “excise tax” was not required to be apportioned. Further, the Court indicated in several cases that an income tax on corporations would be upheld if it were deemed an excise tax levied on corporations for the privilege of carrying on or doing business as a corporation, granted the amount of tax due was based upon the net income of the corporation.

The Tax Act of 1909 was the first Act to be upheld by the courts that taxed corporate profits. Prior to this time, corporate profits were tax free except for a short period of time during the Civil War. The 1909 Act provided that corporations would pay an annual special excise tax. This tax amounted to 1 percent on net income over $5,000 exclusive of dividends from other corporations.

As can be imagined, many influential people objected to the 1909 Act. By 1910, fifteen cases challenging the Act had reached the Supreme Court. In a unanimous decision, the Supreme Court upheld that the Tax Act of 1909 was not a direct tax, but an indirect tax and “an excise upon the particular privilege of doing business as a corporate entity.”

The Revenue Act of 1909 was a tax for the privilege of doing business as a corporation, even though the assessment was on the net income of the corporation. A unanimous Supreme Court upheld the law in Flint v. Stone Tracy Co., 220 U.S. 107, 31 S.Ct. 342 (1911).

When examining the differences between the 1895 law which was held to be unconstitutional and the 1909 law which was upheld as constitutional, the difference is indeed in only a few words, changing a tax upon income to a tax measured by income. Justice Day wrote the opinion for the Supreme Court and stated that the difference was “not merely nominal, but rests upon substantial difference between the mere ownership of property and the actual doing of business in a certain way.”

Sixteenth Amendment and the Revenue Act of 1913

Taxation laws as we know them today derive their authority from the Sixteenth Amendment as passed by Congress on July 12, 1909. The amendment stated:

The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.

Alabama became the first state to ratify the amendment in the same year that it was passed—1909. On February 25, 1913, the final vote for ratification was received.

Congress now was given the clear authority to enact a tax on income from whatever source derived. Taxes could be either direct or indirect and could be imposed without regard to any census or enumeration.

On October 3, 1913, pursuant to the power granted by the Sixteenth Amendment, Congress enacted the Revenue Act of 1913 which imposed a tax on the net income of individuals and corporations. The Revenue Act of 1913 was retroactive to March 1, 1913. This date is important for tax purposes because this is the date which is sometimes used as a basis for computing gains and losses. Simultaneous to the enactment of the Revenue Act, the Corporation Excise Tax was repealed.

The Revenue Act of 1913 serves as the basis for the income tax laws of the United States. However, it would never have been passed without its two precedents, the Income Tax Law of 1894 and the Corporation Excise Tax of 1909. These two laws laid the foundation and framework for an income tax. The Supreme Court ruling in the Pollock case made it mandatory that an amendment to the Constitution be passed to allow for a direct tax on income.

1913 to Date

Following the passage of the Sixteenth Amendment, there have been many changes in the tax law. Many of the more important changes in our federal taxing system are outlined below. Some of the data for 1916–1962 came from World Tax Series: Taxation in the United States, CCH (Commerce Clearing House), 1963, pp. 117–118.

1913	The Revenue Act of 1913—Normal tax and surtax approved. Personal exemptions established.
1916	The Revenue Act of 1916—Established the estate tax.
1917	Charitable contributions granted tax deductible status. Federal income taxes were disallowed as a tax deduction. Credit for dependents allowed for first time.
1918	Tax preferences and exemptions established. Tax credit was granted for foreign income taxes paid. Carryforward provisions adopted for net operating losses. Depletion deductions for mines and oil and gas wells were instituted. Tax-free corporate mergers and other reorganizations permitted.
1921	Capital gains rates established. Profit-sharing and pension trusts exempted from tax.
1924	Gift tax enacted to prevent avoidance of the estate tax.
1926	January 1, 1926—Gift tax repealed.
1932	Gift tax restored in more effective form.
1934	The personal exemption and exemption for dependents were made deductible in determining net income for the purpose of surtax as well as normal tax.
1935	Federal Social Security Act enacted.
1936	Mutual investment companies allowed deduction for dividends distributed by them.
1938	LIFO adopted as an acceptable inventory method.
1939	Internal Revenue Code of 1939—Set out to codify separately the Internal Revenue laws.
1942	Net operating losses were allowed to be carried back. Provisions were made or changed for medical expenses, alimony, capital gains, and a standard deduction in lieu of itemized deductions.
1943	Current Tax Payment Act—Pay-as-you-go system adopted.
1948	Marital deduction originated for estate and gift tax. Split-income treatment approved for married couples.
1950	Self-employment tax enacted.
1954	Internal Revenue Code of 1954—Successor to the 1939 Code. Completely overhauled federal tax laws. Largest piece of federal legislation enacted to date. Broad changes were made in an attempt to codify income, estate, gift, and excise tax laws along with administration and procedure rules into one document.
1962	The Revenue Act of 1962—Granted a tax credit of 7 percent for investment in Section 38 Property. Further, the concept of “depreciation recapture” was introduced.
1964	The Revenue Act of 1964—Intended to stimulate sagging economy. Largest corporate and individual tax rate reduction since the Act of 1913. The Act extended depreciation recapture to business realty. Foreign investment income subjected to increased taxation.
1966	The Tax Adjustment Act of 1966—Suspended the 7 percent investment credit. It was reinstituted six months later. Graduated withholding replaced flat-rate. Corporations required to pay estimated tax more quickly.
1969	The Tax Reform Act of 1969—Investments in commercial and industrial buildings were significantly affected when depreciation allowances were reduced and the recapture rules changed. Investment tax credit repealed.
1971	The Revenue Act of 1971—Restored investment credit at 7 percent.
1974	Employee Retirement Income Security Act of 1974 (ERISA)—Major changes to the entire private pension system.
1975	The Tax Reduction Act of 1975—Reduced taxes for both individuals and corporations. Changed the investment tax credit from seven to 10 percent for a two-year period.
1976	The Tax Reform Act of 1976—Established at-risk rules for tax shelters and eliminated many tax shelters. Also, the Act made extensive changes in the treatment of foreign income.
1977	The Tax Reduction and Simplification Act of 1977—Attempted to simplify the system. Established zero-bracket amount exemption deductions.
1978	The Revenue Act of 1978—Revised corporate rate structures. New structure taxes the first $100,000 of income on a graduated scale, ranging from 17 to 40 percent, and at a 46 percent rate on all taxable income over $100,000. The Act made the 10 percent investment credit permanent. The Act also made changes to capital gains, tax shelter rules, employee benefits, and estate and gift taxes.
1978	The Energy Tax Act of 1978—Instituted a tax credit for residential energy savings.
1980	The Bankruptcy Act of 1980—Added a seventh type of tax-free reorganization, the “G” type. Clarified rules for tax treatment of bad debts.
1980	The Windfall Profit Tax Act—Excise tax levied on domestic oil.
1980	The Installment Sales Revision Act of 1980—Revised installment sales rules.
1981	Economic Recovery Tax Act (ERTA)—Largest tax cut bill ever passed. Top individual tax rates decreased from 70 to 50 percent. All property placed in service after December 31, 1980, eligible for the Accelerated Cost Recovery System (ACRS). Increased allowable contributions to Keoghs, SEPs, and other retirement systems. Permitted two-earner married couples a deduction to reduce the inequity of the “marriage penalty.” Extended the investment credit to include a wider array of investments.
1982	Tax Equity and Fiscal Responsibility Act (TEFRA)—Largest revenue-raising bill ever passed. Tightened up on itemized deductions. New rules on partial liquidations and for the taxation of distributed appreciated property. Tightened up pension rules. Corporate deductions for certain tax preferences cut by 15 percent. Required that basis of depreciated property must be reduced by 50 percent of investment credit. ACRS modified for 1985 and 1986 and Federal Unemployment Tax Act (FUTA) notes increased.
1982	Technical Corrections Act of 1982—Made changes to: ACRS, the investment credit, targeted jobs credit, the credit for research costs, and incentive stock options. Made changes to the Windfall Profit Tax Act.
1982	Subchapter S Revision Act of 1982—Enacted many new provisions for S corporations.
1983	Social Security Act Amendments of 1983—Bailed out the Social Security System.
1984	Deficit Reduction Act of 1984—Composed of two parts: first, the Tax Reform Act of 1984 and second, the Spending Reduction Act of 1984. The Tax Reform Act of 1984 provided for reducing the holding period on capital gains from more than one year to more than six months, extending the ACRS recovery period for 15-year real property to 18 years, taxing interest-free loans between family members, and drastically slashing the income-averaging provisions.
1986	The Tax Reform Act of 1986—The most significant and complex tax revision in the history of this country. The scope of the changes was so comprehensive that the tax law was redesignated the Internal Revenue Code of 1986.
1987	Revenue Act of 1987—Focused primarily on business tax rules. Areas affected included accounting for long-term contracts, limitations on the use of the installment method, application of corporate tax rates to master limited partnerships, and changes in the estimated tax rules for corporations. The Act postponed for five years the reduction to 50 percent of the top estate and gift tax rate.
1988	Family Support Act of 1988—Provided for major reform in the area of modifying the principal welfare program, Aid to Families with Dependent Children (AFDC). Also included in the Act was the modification of employee business expense reimbursement rules. Beginning in 1989 additional amounts will have to be deducted as miscellaneous itemized deductions.
1988	Technical and Miscellaneous Revenue Act of 1988—TAMRA contained a number of substantive provisions. Included in the Act were the taxpayer’s bill of rights, limitations on the completed-contract accounting method, and extension of the exclusions for employee-provided educational assistance and the business energy credits.
1989	P.L. 101-140. Repealed Code Sec. 89. The nondiscrimination and qualification rules for employee benefit plans were repealed. Prior law nondiscrimination rules were reinstated.
1989	Medicare Catastrophic Coverage Repeal Act of 1989—Repealed the medicare surtax retroactively.
1989	Revenue Reconciliation Act of 1989—The Act achieved a deficit reduction of about $17.8 billion and accelerated the rate of collection of withholding and payroll tax. The Act also changed the partial interest exclusion on ESOPs. Modifications were also made to the like-kind exchange rules.
1990	Revenue Reconciliation Act of 1990—The Act contained a number of significant changes, including a deficit reduction of about $40 billion in 1991. The Act also increased from two to three the number of statutory rates, 15 percent, 28 percent, and 31 percent. Also, a maximum capital gain rate of 28 percent was established.
1991	Tax Extension Act of 1991—The Act extended, for six months only, 11 tax provisions that were to expire on December 31, 1991.
1992	Energy Policy Act of 1992—The Act greatly increased the amount of employer-provided transportation benefits excludable by employees.
1993	Revenue Reconciliation Act of 1993—The Act raised the tax rates for high-income earners. Changes also were made to the AMT, passive losses, and Section 179. Corporate tax rates increased by 1 percent.
1994	Social Security Domestic Employment Reform Act of 1994—The Act raised the threshold for paying Social Security and federal unemployment taxes on domestic workers from $50 per quarter to $1,000 annually, retroactive to the beginning of 1994.
1994	General Agreement on Tariffs and Trade (GATT)—To offset the loss of revenue from the reduction in tariffs, Congress passed several tax and revenue provisions. The major revenue items were: estimated tax treatment for Code Sec. 936 and subpart F income; increased premiums for employers with underfunded pension plans; and reduced interest rates on large corporate tax refunds.
1996	Taxpayer Bill of Rights 2—The Act included more than 40 separate provisions, many of which provided useful tools for tax practitioners representing clients before the IRS.
1996	Small Business Job Protection Act—The major portion of tax law changes passed in 1996 was contained in this Act. It also contained many technical corrections. The balance of the Act was divided into four major categories: small business provisions, S corporation reform, pension simplification, and revenue-raising offsets.
1996	Health Insurance Portability and Accountability Act—The focus of this Act was on portability of health insurance. However, this Act contained tax provisions that focus on a variety of health-related issues, as well as several revenue-raising provisions unrelated to health care.
1996	Personal Responsibility and Work Opportunity Reconciliation Act—The tax impact of this Act was primarily limited to the earned income tax credit.
1997	Taxpayer Relief Act of 1997—The Act provided significant tax cuts for many taxpayers. Major features included a reduction in capital gains tax rates, expanded IRAs, educational tax incentives, estate tax relief, and a child tax credit.
1998	IRS Restructuring and Reform Act of 1998—The major intent of the Act was to rein in the Internal Revenue Service. Two of the most important provisions of the Act dealt with changing the holding period for a capital asset to be classified as long-term so as to receive the most favored capital gain rate from more than 18 months down to more than 12 months. The second important area of the Act was the “technical corrections” section, which clarified many of the key provisions in the Taxpayer Relief Act of 1997. There were over seventy technical corrections contained in the Act.
1998	Tax and Trade Relief Extension Act of 1998—This Act included extensions of several expiring tax credits through June 30, 2000. The major extensions provided for in this legislation include the research tax credit, the work opportunity credit, and the welfare-to-work credit.
1999	Tax Relief Extension Act of 1999—This Act extended the time period for which tax credits and exclusions continued to be available.
2000	FSC Repeal and Extraterritorial Income Exclusion Act of 2000; the Consolidated Appropriations Act, 2001; the Installment Tax Correction Act of 2000—The year 2000 saw the passage of three important tax bills that contain many provisions impacting taxpayers. The Community Renewal Tax Relief Act of 2000 was contained in the Consolidated Appropriations Act, 2000. This Act renewed provisions designed to enhance investment in low and moderate-income, rural and urban communities. The Act also extended for two years medical savings accounts (MSAs). Also included was a provision expanding innocent spouse relief. The Installment Tax Correction Act of 2000 reinstated the availability of the installment method of accounting for accrual basis taxpayers.
2001	Economic Growth and Tax Relief Reconciliation Act of 2001—The largest tax cut since 1981. The Economic Growth and Tax Relief Reconciliation Act of 2001 (P.L. 107-16) was estimated to provide tax savings of $1.35 trillion over the next 10 years. The Act contained over 440 Code changes and numerous phase-in and transitional rules. The wide range of changes primarily affected individuals, from cuts in marginal income tax rates to changes in contribution limits for retirement plans.
2002	The Job Creation and Worker Assistance Act of 2002 was passed in March 2002. This Act contained a number of general business incentives, special relief for New York City, individual incentives, extenders, and some technical corrections.
2003	Jobs and Growth Tax Relief Reconciliation Act of 2003—The third largest tax cut in U.S. history. The purpose of the tax bill was to jump-start the U.S. economy. The bill contained ten major provisions. Half of the provisions accelerated tax cuts originally scheduled not to take effect until 2006.
2004	Working Families Tax Relief Act of 2004—The primary focus of this $146 billion package was on offering the middle class tax relief.
2004	American Jobs Creation Act of 2004—The primary focus of this $145 billion package was on business incentives.
2005	Energy Policy Act of 2005—The $14.5 billion energy package contained incentives for oil, gas, electric, nuclear and alternative fuel industries.
2005	The Safe, Accountable, Flexible, Efficient Transportation Equity Act: A Legacy for Users—This $286.5 billion, six-year, highway and mass transit bill authorized funds for federal-aid highways, highway safety programs and transit programs.
2005	The Katrina Emergency Tax Relief Act of 2005 (KETRA)—Signed into law by President Bush on September 23, 2005. KETRA provided $6.1 billion in emergency tax relief for victims of Hurricane Katrina. Another major provision of the bill was that it provided tax incentives for charitable giving.
2005	Gulf Opportunity Zone Act of 2005—The hurricane relief act is an $8.6 billion package of tax incentives primarily aimed at the gulf region. Major provisions included creation of Gulf Opportunity (GO) Zones, fifty percent bonus depreciation related to rebuilding in the zones, expansion of Code Sec. 179 expensing for investments in the GO Zone, enhancements of low-income housing and rehabilitation credits within the zones, and expanded tax-exempt bond limits within the zones.
2006	Pension Protection Act of 2006—Provided for significant strengthening of traditional pension plans. Specific focus was on the funding rules for defined benefit plans and strengthening the reporting rules for plan administrators. Further, the Act made permanent the retirement savings enacted under the Economic Growth and Tax Relief Act of 2001.
2006	Tax Relief and Health Care Act of 2006—The Act extended a number of provisions including the higher education tuition deduction, state and local sales tax deduction, welfare to work tax credit, teacher classroom expenses and tax credits for research and development.
2007	Small Business and Work Opportunity Tax Act of 2007—Provided for incentives for small businesses together with an increase in the federal minimum wage. The Act extended the work opportunity tax credit through August 31, 2011. Further, the Act enhanced the Section 179 deduction, extending it through 2010 and indexing it for inflation.
2007	Mortgage Forgiveness Debt Relief Act of 2007—The Mortgage Forgiveness Debt Relief Act was a way of giving tax relief for debt forgiveness on mortgages and continuing the deduction for mortgage insurance payments.
2008	Economic Stimulus Act of 2008—The Act was designed to jump start the U.S. economy. The centerpiece of the Act provided for rebates to individuals reaching as high as $600 and $1,200 for married couples. Beyond the rebates to individuals, the Act also provided for $44.8 billion in business incentives. The major business incentive was the enhanced Code Section 179 expensing. It raised Code Section 179 expensing from $128,000 in 2008 to $250,000 and increased the threshold for reducing the deduction from $510,000 to $800,000.
2008	Farm and Military Acts of 2008—The Food, Conservation and Energy Act of 2008 provided benefits to farmers, ranchers and timber producers. The Military Tax Relief Bill provided benefits to members of the armed forces who are receiving combat pay, saving for retirement, or purchasing a new home.
2008	Housing Assistance Act of 2008—This Act provided first-time homebuyers with a refundable credit of 10% of the purchase of a new home up to $7,500, subject to certain phase-out rules. Furthermore, it provided taxpayers who claim the standard deduction an additional deduction up to $500 or $1,000 on a joint return for state and local property taxes. It also provided an increase for low-income housing tax credits.
2008	Emergency Economic Stabilization Act of 2008—The centerpiece of the legislation was the $700 billion which was made available to stabilize the economy. The Act also included AMT (alternative minimum tax) relief along with the extension of numerous tax provisions that were set to expire.
2009	The American Recovery and Reinvestment Act of 2009—The $789 billion new law contained nearly $300 billion in tax relief. Major provisions included: Making Work Pay Credit, enhancements to the child tax credit, a 2009 Alternative Minimum Tax (AMT) patch, many energy incentives, and extension of bonus depreciation and Section 179 expensing.
2009	Worker, Homeownership, and Business Assistance Act of 2009—The major provisions of the Act were that it extended and expanded the first-time homebuyer credit, it allowed for up to $2,400 in unemployment benefits to be tax-free in 2009, and it allowed for enhanced credits for the years 2009 and 2010 for the earned income credit and the child tax credit.
2010	The Patient Protection and Affordable Care Act—This Act usually referred to as the Affordable Care Act or "Obamacare" was signed into law on March 23, 2010. The Act has two parts, the Patient Protection and Affordable Care Act and the Health Care and Reconciliation Act. PPACA is a law intended to ensure that all Americans have access to affordable health care.
2010	The Hiring Incentives to Restore Employment Act—This bill is referred to as the HIRE Act. The HIRE Act greatly expanded Code Section 179 expensing, COBRA premium assistance extended through March 31, 2010, and an employer’s payroll tax holiday and retention credit for employers hiring workers who were unemployed.
2010	Small Business Jobs Act of 2010—The bill contained several important tax provisions. The Act significantly increased the maximum expensing under Section 179 to $500,000 and increased the beginning of the phase-out range to $2 million for tax years beginning in 2010 and 2011. Also, the Act extended the 50 percent bonus first year depreciation for one year.
2010	Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010—The 2010 Tax Relief Act extended for two years the Bush-era tax cuts including the capital gains and dividend tax cuts. Further it cut payroll taxes two percentage points in 2011, placed a two-year patch on the alternative minimum tax and revived the estate tax.
2012	American Taxpayer Relief Act of 2012—The Act allows all Bush-era tax cuts to sunset after 2012 for individuals with income over $400,000 and $450,000 for couples. Also, the Act permanently patches the alternative minimum tax, increased capital gains rates to 20 percent for those individuals making over $400,000 and extended for five years the American Opportunity Tax Credit.
2014	The Tax Increase Prevention Act of 2014 was signed into law by President Obama on December 19, 2014. H.R. 5771 extends temporarily over 50 expired provisions. The law also creates Achieving a Better Life Experience (ABLE) which affords benefits for persons with disabilities.
2015	Bipartisan Budget Act of 2015—President Obama signed into law the Act on November 2, 2015. It contains several important tax provisions especially with respect to partnership audit rules. It eliminates TEFRA, after December 31, 2017, unified partnership audit rules together with protocols for electing large partnership rules. In its place will be a more streamlined audit regime. The Act also makes changes to the Patient Protection and Affordability Care Act (ACA) with respect to employers with over 200 employees automatically enrolling full-time employees into an employer health plan.
2015	Protecting Americans from Tax Hikes (PATH) Act of 2015—The PATH Act of 2015 did much more than just extend the 50-plus provisions that expired at the end of 2014. Some provisions were made permanent, others extended for five years (through 2019) and others extended for two years (through 2016). Among the more notable extensions for individuals are: the American Opportunity Tax Credit, deduction for certain expenses for elementary and secondary school teachers, increases in the earned income credit and transit benefits parity. For businesses the more notable extensions are: enhanced expensing under Section 179, and the research tax credit.
2017	An Act to Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal 2018. The tax act is more commonly referred to as The Tax Cuts and Jobs Act. It is a massive tax act with as its centerpiece a drop in the corporate tax rate from 35 percent to 21 percent. Its impact on both business and individual taxpayers is huge. From changes in the tax rates and thresholds to the elimination of personal exemptions, The Tax Cuts and Jobs Act changed many items on individuals’ tax returns. The Tax Cuts and Jobs Act is a reconciliation bill. Therefore, the longer title and the Act had to comply with stricter rules with respect to deficits. Many of the changes to corporations are permanent but changes to individual tax provisions are for 8 years only. They will sunset after 2025. The goal of The Tax Cuts and Jobs Act was to reduce taxes on both corporations and individuals and to stimulate economic growth.
2018	Bipartisan Budget Act of 2018 contained several tax provisions. The Act retroactively extended approximately thirty-three tax provisions. Among the more notable is it excludes from gross income discharge of qualified principal residence indebtedness.
2020	The Further Consolidated Appropriations Act, 2020 (HR 1865) was signed into law by President Trump on December 20, 2019. It raised the deficit ceiling by $428 billion. Tax-related provisions in the Act include retroactive and current renewal of the tax breaks known as “extenders” and the Setting Every Community Up for Retirement Enhancement Act of 2019 (the SECURE Act) which makes major changes to 401(k) plans, IRAs, and creates a new multiple employer plan.

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FEDERAL TAX LEGISLATIVE PROCESS

When reviewing the tax acts since the mid to late 1970s, it becomes obvious that tax reform is a yearly event. Tax bills are passed for numerous reasons (i.e., revenue needs, incentive for economic development, or to affect the economy). Tax bills in this country have not followed a uniform path. Normally, major tax legislation originates with the President sending a message to Congress. An alternative approach is for congressional initiative on a tax bill.

The Constitution requires that revenue legislation originate in the House of Representatives. Therefore, the first step is for hearings before the House of Representatives Ways and Means Committee. Many influential bodies present recommendations to this Committee—the Secretary of the Treasury, the Office of Management and Budget, etc. After meeting with various bodies, the Committee meets in executive session, and a tax bill is transmitted by means of a Committee report to the House.

The House of Representatives debates the bill usually under a “closed rule” procedure, which permits amendments to come only if approved by the Ways and Means Committee. If the bill is defeated it may be referred back to committee; if it passes, it is sent to the Senate where it is first discussed in the Senate Finance Committee.

Hearings are held by the Finance Committee which might result in amendments to the House bill. The amendments may range from insignificant to totally changing the bill. The bill is then transmitted to the whole Senate. One significant difference between the House and the Senate is that, in the Senate, any Senator may offer amendments from the floor of the Senate. After passage, if there are any differences between the House and Senate versions of the bill, it goes to the Joint Conference Committee, which is composed of ranking members of the House Ways and Means Committee (seven members) and the Senate Finance Committee (five members) for resolution. The Conference Committee version of the bill must be accepted or rejected—it cannot be changed by either the House or the Senate. Assuming passage by the House and the Senate, the bill becomes law when approved by the President. If it is vetoed, both the Senate and the House must vote affirmatively by a two-thirds majority to override the President’s veto.

Exhibit 1  illustrates the sequence of events whereby a tax bill is introduced before the House Ways and Means Committee, passes through the House of Representatives, the Senate Finance Committee, and the Senate. As indicated in the final portion of  Exhibit 1 , if approved by the President, the tax bill will be incorporated into the Internal Revenue Code.

Exhibit 1. THE LEGISLATIVE PROCESS

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TAX REFORM

Tax reform acts are passed by Congress and signed into law by the President quite regularly. Several tax reform acts stand out because of the magnitude of the act. The year 1986 was a most interesting year for tax legislation. Both political parties, Democrats and Republicans, were “demanding” tax reform. The Treasury Department presented to President Reagan a massive tax reform plan that would impact the tax liability of most individuals and corporations. President Reagan, in his 1986 budget, called for a tax system that would be “simpler, more neutral, and more conducive to economic growth.”

Tax Reform Act of 1986

The Senate passed a bill with only two rate brackets, 15 and 27 percent (28 percent was the final figure approved). Like that of the House of Representatives, their bill called for the removal of many tax deductions. One new feature added in the Senate bill was the drastic reduction in the number of people eligible for Individual Retirement Accounts (IRAs). After much debate, compromising, and political maneuvering, the Tax Reform Act of 1986 was passed and signed into law by President Reagan on October 22, 1986. The Tax Reform Act of 1986 carries the label of the most extensive overhaul of the U.S. tax code in almost 40 years, as well as the most fundamental reform of the U.S. tax structure. The scope of the changes was so comprehensive that the tax code was renamed the Internal Revenue Code of 1986.

Table 5  presents comparative data for the inflation-indexed items for 2019 and 2020.

Table 5. 2019-2020 PARTIAL COMPARISON OF TAX CHANGES FOR INDIVIDUALS
Item		2019	2020
Filing requirements
If filing status is:		A return is required if gross income was at least:	A return is required if gross income was at least:
Single	Under 65	$12,200	$12,400
	65 or older	13,850	14,050
Head of Household	Under 65	$18,350	$18,650
	65 or older	20,000	20,300
Married Filing Jointly	Both under 65	$24,400	$24,800
	One spouse 65 or older	25,700	26,100
	Both 65 or older	26,700	27,400
	Not living with spouse at end of year (or on date spouse died)	$0	0
Married Filing Separately	All	0	0
Qualifying Widow(er)	Under 65	$24,400	$24,800
	65 or older	25,700	26,100
Note: Children and other dependents should see  Chapter 3  for special rules.
Table 5. 2019-2020 PARTIAL COMPARISON OF TAX CHANGES FOR INDIVIDUALS—Continued
Item		2019			2020
Tax rates
Married filing jointly or surviving spouse	10%	0	$19,400	10%	0	$19,750
	12%	$18,650	to $78,950	12%	$19,750	to $80,250
	22%	$75,900	to $168,400	22%	$80,250	to $171,050
	24%	$153,100	to $321,450	24%	$171,050	to $326,600
	32%	$233,350	to $408,200	32%	$326,600	to $414,700
	35%	$416,700	to $612,350	35%	$414,700	to $622,050
	37%	Over	$612,350	37%	Over	$622,050
Single	10%	0	to $9,700	10%	0	to $9,875
	12%	$9,325	to $39,475	12%	$9,875	to $40,125
	22%	$37,950	to $84,200	22%	$40,125	to $85,525
	24%	$91,900	to $160,725	24%	$85,525	to $163,300
	32%	$191,650	to $204,100	32%	$163,300	to $207,350
	35%	$416,700	to $510,300	35%	$207,350	to $518,400
	37%	Over	$510,300	37%	Over	$518,400
Married filing separately	10%	0	to $9,700	10%	0	to $9,875
	12%	$9,325	to $39,475	12%	$9,875	to $40,125
	22%	$37,950	to $84,200	22%	$40,125	to $85,525
	24%	$76,550	to $160,725	24%	$85,525	to $163,300
	32%	$116,675	to $204,100	32%	$163,300	to $207,350
	35%	$208,350	to $306,175	35%	$207,350	to $311,025
	37%	Over	$306,175	37%	Over	$311,025
Head of household	10%	0	to $13,850	10%	0	to $14,100
	12%	$13,350	to $52,500	12%	$14,100	to $53,700
	22%	$50,800	to $84,200	22%	$53,700	to $85,500
	24%	$131,200	to $160,700	24%	$85,500	to $163,300
	32%	$212,500	to $204,100	32%	$163,300	to $207,350
	35%	$416,700	to $510,300	35%	$203,500	to $518,400
	37%	Over	$510,300	37%	Over	$518,400
Social Security wage base	The maximum amount of taxable and creditable annual earnings subject to the Social Security and self-employment income tax is $132,900.	The maximum amount for 2020 is $137,700.

Table 5. 2019-2020 PARTIAL COMPARISON OF TAX CHANGES FOR INDIVIDUALS—Continued
Item		2019	2020
Standard deduction
Basic standard deduction
Single	$12,200	$12,400
Head of household	18,350	18,650
Married filing jointly or qualifying widow(er)	24,400	24,800
Married filing separately	12,200	12,400
Additional standard deduction for blindness or 65
Married (filing jointly or separately) or qualifying widow(er)	$1,300	$1300
Single or head of household	$1,650	$1650
Dependent’s standard deduction	Cannot exceed the greater of (A) $1,100 or (B) earned income plus $350 (limited to $12,200).	Cannot exceed the greater of (A) $1,100 or (B) earned income plus $350 (limited to $12,400).
Nanny Tax	Wage threshold for paying Social Security and federal unemployment taxes on domestic workers is $2,100 annually.	Wage threshold for paying Social Security and federal unemployment taxes on domestic workers is $2,200 annually.

 

American Taxpayer Relief Act of 2012

The “fiscal cliff” was averted. The Act allowed the Bush-era tax cuts to sunset for taxpayers with incomes over $400,000 and for couples with income over $450,000. Many tax breaks that were to expire were extended. It permanently patches the alternative minimum tax and provides for a maximum estate tax of 40 percent with a $5 million exclusion.

Other highlights of the Act include: raising the tax on incomes over $400,000 (individuals) and $450,000 (filing jointly) to 39.6 percent; raising the maximum capital gains tax to 20 percent; five year extension on the American Opportunity Tax Credit; and a two year extension on certain business tax items.

The Tax Cuts and Jobs Act

One of the measures adopted in the Tax Reform Act of 1986 was that inflation adjustments would be provided annually for several specific items such as the standard deduction, tax brackets, personal exemption amounts, and the earned income credit. Indexing was designed to protect individuals from “bracket creep”—that is, where an individual’s income increases only by the inflationary rate but the taxpayer moves into a higher tax bracket.

After many months of discussion both the House of Representatives and the Senate passed tax bills. A joint House-Senate conference committee reconciled the differences and on December 15, 2017, the conference committee approved the tax reform bill and it was then sent back to both the House and the Senate for approval. On December 20, 2017, both branches of Congress passed the tax act. The House approved the bill 227-203. No Democrats voted for the bill. The Senate’s parliamentarian ruled that three provisions violated the reconciliation rules and had to be eliminated. The Senate then passed the bill 51-48 with no Democrats voting in favor. The President then signed the bill into law on December 22, 2017. It is the most significant tax legislation in the past 30 years. Opponents maintain the deficit will grow uncontrolled. Proponents maintain economic growth will be substantial and will pay for the tax cuts.

Tax Extenders

President Trump signed into law on December 20, 2019 a massive appropriations bill that will fund the government through September 30, 2020. The 1773-page document covers a vast array of provisions. Some of the major provisions are: retroactive and current renewal of tax extenders, repeal of ACA taxes and retirement security. Over two dozen provisions were extended through 2020 and two provisions were extended through 2022. Below is a listing of the most important extenders that we cover in this book.

Extenders retroactively renewed through 2020

· Exclusion from gross income of discharge of principle residence acquisition indebtedness

· Mortgage insurance premiums treated as qualified residence interest

· Deduction for qualified tuition and related expenses

· Indian employment tax credit

· Extension of empowerment zone and tax incentives

· Seven-year recovery period for motorsports entertainment complexes

· Special expensing rules for certain film and television productions

· Energy efficient commercial buildings deduction

· Excise tax credits and payment provisions relating to alternative fuel

· The 7.5 percent floor on medical expense deductions

· The New Markets Tax Credits

· Work Opportunity Tax Credit

· Look-through treatment of payments between related controlled foreign corporations

· Employer credit for paid family and medical leave

Extenders renewed through 2022

· Incentives for Biodiesel and Renewable Diesel

· The 45G railroad track maintenance credit

Underlying Rationale of the Federal Income Tax

¶1171

OBJECTIVES OF THE TAX LAW

The federal income tax is comprised of a complicated and continually evolving blend of legislative provisions, administrative pronouncements, and judicial decisions. The primary purpose of the tax law is obviously to raise revenue, but social, political, and economic objectives are also extremely important. These various objectives, which frequently work at cross-purposes with the revenue raising objective of the law, must be examined and understood to gain an appreciation of the rationale underlying the immense multipurpose body of law known as the federal income tax.

It is easy to criticize the entire tax law for being too complex. However, any time one law attempts to raise revenue and achieve a variety of social, political, and economic objectives, while simultaneously attempting to be equitable to all income levels and administratively feasible for the government to enforce, it cannot avoid being complex.

Tax loopholes are frequently attacked as being counterproductive to the revenue raising objective of the Treasury because they cost the U.S. government billions of dollars in lost revenue. However, some of these so-called loopholes can be thought of as tax incentives, enacted by Congress to encourage certain types of investment, or to achieve specified social, economic, or political objectives.

For example, the tax law provides that interest from municipal bonds is generally excluded from gross income, while interest received from all other sources, including savings accounts and corporate obligations, is subject to taxation. The municipal bond provision thus offers excellent tax benefits for individuals with available resources to invest, but these bonds typically provide a lower yield than corporate obligations.

Primarily because of this tax benefit, municipal bonds are a popular type of investment for wealthy taxpayers. To better evaluate the criticism that municipal bonds are a tax loophole, the probable tax consequences of this type of investment can be examined in the case of a taxpayer in the 37 percent marginal tax bracket.

EXAMPLE 1.2

Cliff, a 37% bracket taxpayer, has $50,000 available to invest. After evaluating the pros and cons of stocks, bonds, money market certificates, and other types of investments, his decision is limited to the following two choices:

Freemont Highway municipal bonds, rate of interest		9%
Data-Search Inc., corporate bonds, rate of interest		12%
	Freemont	Data-Search
Interest income (before taxes)	$4,500	$6,000
Income taxes	0	2,220
Yield (after taxes)	$4,500	$3,780

Result. Cliff will select the Freemont municipal bonds. Even with a lower rate of interest than the corporate obligations, Freemont provides a larger after-tax yield.

A common but simplistic criticism of this tax provision is that the wealthy individual has used a loophole to avoid $1,665 of taxes ($4,500 interest × 37 percent tax rate), thereby depriving the U.S. government of a corresponding amount of revenue. However, this criticism must be weighed against the underlying purpose of the municipal bond provision which is encouraging taxpayers to invest in state and local obligations and allowing the various municipalities to compete for resources in the bond market at a lower rate of interest than corporate bonds.

¶1175

ECONOMIC FACTORS

Over the years, numerous provisions of the tax law have been employed to help stimulate the economy, to encourage capital investment, or to direct resources to selected business activities. Perhaps the most well-known provision of the tax law, designed to serve as a stimulus to the economy, was the investment tax credit. This credit, which served to encourage investment in qualified property, primarily tangible personal property used in a trade or business, had been suspended for a period of time, repealed, reinstated, and again repealed.

Similar to its use of the investment credit, Congress has used depreciation write-offs as a means of controlling the economy. Viewed as a popular stimulus for business investment is the tax benefit resulting from the accelerated cost recovery methods of depreciation. The Tax Cuts and Jobs Act liberalized the expensing rules. Additionally, the related election to expense allows the taxpayer to deduct as much as $1,040,000 (in 2020) of the cost of qualifying property in the year of purchase. However, where the cost of qualified property placed in service during the year exceeds $2.59 million, the $1,040,000 ceiling is reduced by the amount of such excess.

Various other tax provisions have been employed to help stimulate selected industries. Thus, unique tax benefits, such as the provisions for percentage depletion, apply to the mining of natural resources. Correspondingly, farming activities benefit from special elections to expense rather than capitalize soil and water conservation expenditures under an approved conservation plan.

Small business investment has been encouraged by various provisions. For example, certain types of small businesses may elect to file as an S corporation, which essentially provides the limited liability protection of corporate status, while treating most items of income as if the entity were a partnership. Correspondingly, a special rule allows ordinary loss treatment for small business stock.

For year beginning after December 31, 2017 the corporate tax is a flat 21 percent.

¶1181

SOCIAL FACTORS

Numerous tax provisions can best be explained in light of their underlying social objectives. For example, premiums paid by an employer on group-term insurance plans are not treated as additional compensation to the employees. This provision encourages business investment in group-term insurance and provides benefits to the family of a deceased employee. Also, social considerations provide the rationale for excluding employer-paid premiums on accident and health plans or the premiums on medical benefit plans from an employee’s gross income.

Deferred compensation plans allow an individual to defer taxation on current income until retirement. The preferential tax treatment is an attempt to encourage private retirement plans to supplement the Social Security benefits. Other socially motivated tax provisions include the deduction for charitable contributions, the child care credit for working parents, and the credit for the elderly.

Frequently, social considerations help to explain a tax provision that discourages certain types of activities. For example, even though an individual may have incurred a fine or a penalty while engaged in a regular business activity, no deduction is allowed for this type of expenditure. The basis underlying this Congressional policy is that by allowing such a deduction, the law would be implicitly condoning and encouraging such activities. Correspondingly, bribes to government officials and illegal kickbacks or rebates are not deductible, even if related to the active conduct of one’s trade or business.

¶1185

POLITICAL FACTORS

Since the tax law is created by Congress, and Congress consists of several hundred elected officials, political factors play a major role in the development of tax legislation. Special interest groups frequently seek to influence tax legislation, while Congressmen themselves are often likely to introduce legislation which would be of particular benefit to their own district or, perhaps, to selected constituents. Of course, special interest legislation does invite widespread criticism if it does not also serve a useful economic or social objective.

As with the economic and social objectives, many politically inspired provisions have been designed in a negative context to discourage certain types of activities. Thus, provisions such as the alternative minimum tax, which imposes an alternative tax rate on taxable income increased by tax preference items, the limitation on investment interest expense, or the accumulated earnings restrictions on corporations can be explained on this basis.

¶1187

TAX POLICY AND REFORM MEASURES

If there has been a trend through the years in tax statutes, it has been toward reform. The word “reform” itself first appeared in the popular name of the tax act entitled Tax Reform Act of 1969, but the concept of reform had begun to take shape long before and the enactment of reform measures has continued unabated through the years.

During the later part of the 1980s, various changes in the tax law, especially the passage of the Tax Reform Act of 1986, have resulted in the most dramatic tax modifications in tax policy since the enactment of the Internal Revenue Code of 1913. For the first time in 73 years, Congress attempted to address the broad public-policy implications of the entire tax law. In undertaking the revision of 1986, Congress sorted through a massive panorama of loopholes, inequities, and antiquated provisions and eliminated provisions that had lost much of their original social, political, or economic purpose.

Clearly, the tax policy implications of the 1986 revision will be under examination for some time to come. A major impact can be expected on the manner in which individuals and businesses save, invest, earn, and spend their money. For example, with the curtailment of the deduction for contributions to individual retirement accounts (IRAs), high-yield securities such as dividend-paying blue chip stocks, corporate bonds, and “municipals” might become more attractive investments than growth stocks. In fact, many wage earners may find it advantageous to pay taxes on their entire salary, rather than investing in a deferred compensation plan if they anticipate future increases in their marginal tax rates. Correspondingly, with the elimination of the consumer interest deduction, many individuals may shift to making cash purchases instead of incurring nondeductible obligations. Of course, some homeowners may be tempted to circumvent these restrictive provisions by using home equity loans to finance consumer purchases.

The Taxpayer Relief Act of 1997 cut taxes in a fashion that had not been seen since 1981. The reduction of capital gains tax rates will have a significant impact on investment strategies.

The student of tax law can anticipate frequent if not annual changes to the way individuals and businesses are taxed. The source of tax revenue to finance the operation of the federal government during the next decade will be a hotly debated issue. Some tax policymakers will promote new taxation schemes, such as a consumption tax, while others will advocate a tax policy that is revenue-neutral and neutral as to its impact on various income groups.

Basic Tax Concepts

¶1195

ESSENTIAL TAX TERMS DEFINED

When studying federal income taxation, it is important to keep in mind several basic tax concepts. By understanding these basic concepts unique to federal taxation, the course will be more interesting and meaningful. Because some of the terms set out below have definitions peculiar to income taxation, it is advisable that they be carefully examined before proceeding to the discussion of specific topics. Refer to the Glossary of Tax Terms in the back of the book for a comprehensive listing of tax terms discussed throughout the text.

Accrual basis of accounting

The accrual basis is distinguished from the cash basis. On the accrual basis, income is accounted for as and when it is earned, whether or not it has been collected. Expenses are deducted when they are incurred, whether or not paid in the same period. In determining when the expenses of an accrual-basis taxpayer are incurred, the all-events test is applied. Such test provides that the expenses are deductible in the year in which all of the events have occurred that determine the fact of liability and the amount of the liability can be determined with reasonable accuracy. Generally, all of the events that establish liability for an amount, for the purpose of determining whether such amount has been incurred, are treated as not occurring any earlier than the time that economic performance occurs.

Assignment of income doctrine

The assignment of income by an individual who retains the right of ownership to the property has generally proved ineffective as a tax-shifting procedure. For the assignment to be effective, a gift of the property would be necessary. For example, Ben is preparing to attend Major State College. As a means of paying for room and board, his father assigns to Ben his salary. This is an invalid assignment of income and Ben’s father would be liable for the tax. In Lucas v. Earl, 2 USTC ¶496, 281 U.S. 111-115, 50 S.Ct. 241 (1930), the Supreme Court ruled that the government could “tax salaries to those who earned them and provide that the tax could not be escaped by anticipatory arrangements and contracts however skillfully devised to prevent the salary when paid from vesting even for a second in the man who earned it.” Also, in this case the Court stated that “no distinction can be taken according to the motives leading to the arrangement by which the fruits are attributed to a different tree from that on which they grew.”

Basis

The basis of property is the cost of such property. It usually means the amount of cash paid for the property and the fair market value of other property provided in the transaction.

EXAMPLE 1.3

An individual paid cash of $20,000 for an automobile and assumed a $7,500 loan on the car; thus, the basis in the automobile is $27,500.

EXAMPLE 1.4

An individual paid $500,000 for a tract of land and a building. Purchase commissions, legal and recording fees, surveys, transfer taxes, title insurance, and charges for installation of utilities amounted to $70,000. The basis of the property would be $570,000. Any amounts owed by the seller and assumed by the buyer are included in the basis of the property.

The definition and the determination of “basis” are of utmost importance because it is that figure which is usually used for depreciation and the determination of gain or loss. If property was acquired by gift, inheritance, or in exchange for other property, special rules for finding its basis apply.

Business purpose

When a transaction occurs it must be grounded in a business purpose other than tax avoidance. Tax avoidance is not a proper motive for being in business. The concept of business purpose was originally set forth in Gregory v. Helvering, 35-1 USTC ¶9043, 293 U.S. 465, 55 S.Ct. 266 (1935). In this case, the Supreme Court ruled that a transaction aiming at tax-free status had no business purpose. Further, the Court stated that merely transferring assets from one corporation to another under a plan which can be associated with neither firm was invalid. This was merely a series of legal transactions that when viewed by the Court in its entirety had no business purpose.

Capital asset

Everything owned and used for personal purposes, pleasure, or investment is a capital asset. Examples of capital assets are stocks, bonds, a residence, household furnishings, a pleasure automobile, gems and jewelry, gold, silver, etc. Capital assets do not include inventory, accounts or notes receivable, depreciable property, real property, works created by personal efforts (copyrights), and U.S. publications.

Cash basis

The cash basis is one of the two principal recognized methods of accounting. It must be used by all taxpayers who do not keep books. As to all other taxpayers (except corporations, certain partnerships, and tax-exempt trusts) it is elective, except that it may not be used if inventories are necessary in order to reflect income. On the cash basis, income is reported only as it is received, in money or other property having a fair market value, and expenses are deductible only in the year that they are paid.

Claim of right

The term claim of right asks whether cash or property received by an individual to which the individual does not have full claim and which the individual might have to return in the future must be included in income. The question here is whether the taxpayer must report the income when received or wait until the taxpayer has full right to it. In North American Oil Consolidated v. Burnet, 3 USTC ¶943, 286 U.S. 417 (1932), the Supreme Court resolved the question by stating that amounts received by an individual under a claim of right must be included in gross income even though the individual might have to refund the amount at a later time.

Conduits

Some entities are not tax paying. They pass through their income (loss) to owners (beneficiaries). A partnership is an example of a conduit. Partnerships do not pay taxes; they merely report the partnership’s taxable income or losses. The income (loss) flows directly to the partners. However, partnerships do compute partnership taxable income. Other types of conduits are grantor trusts and S corporations.

Constructive-receipt doctrine

When a cash-basis individual receives income, or it is credited to an account the individual may draw upon, or it is set aside for the individual, the courts have ruled that the individual has constructively received the income. This concept was developed to stop taxpayers from choosing the year in which to recognize income. Once an individual has an absolute right to the income, it must be recognized. A good example of the constructive receipt doctrine is interest earned on a bank account. If interest is credited to the taxpayer’s account, it is of no consequence that the taxpayer does not withdraw the money. The day the interest is credited to the account is the day the taxpayer must include the amount in income.

Entity

Generally, for tax purposes there are four types of entities: individuals, corporations, trusts, and estates. Each entity determines its own tax and files its own tax return. Each tax entity has its specific rules to follow for the determination of taxable income. Basically the concept of “entity” answers the question “Who is the taxpayer?” Note that partnerships were not in the list of entities. For tax purposes, partnerships are not tax-paying entities. The income (loss) flows directly to the partners.

Gross income

Gross income, for income tax purposes, refers to all income that is taxable. The law enumerates specific items of income that are not to be included in gross income and, therefore, are nontaxable. With these exceptions, all income is includible in gross income.

Holding period

The holding period of property is the length of time that the property has been held by the taxpayer, or the length of time that the taxpayer is treated for income tax purposes as having held it. The term is most important for income tax purposes as it relates to capital gains transactions. Whether capital gain or loss is short or long term depends on whether the asset sold or exchanged has been held by the taxpayer for more than 12 months.

Income

The fundamental concept of income is set forth in the Sixteenth Amendment—”incomes, from whatever source derived.” It is the gain derived from capital, labor, or both. For tax purposes the term “income” is not used alone. The most common usages are gross income, adjusted gross income, and taxable income.

Income-shifting

Income-shifting is the transfer of income from one family member to another who is subject to a lower tax rate or the selection of a form of business that decreases the tax liability for its owners.

Pay-as-you-go tax system

The American tax system is often referred to as a pay-as-you-go tax system. Much of the federal government’s tax collections come from withholdings and estimated taxes. The various types of taxpayers pay tax throughout the year, not just at year-end. The United States has been on a pay-as-you-go system since 1943.

Realized v. recognized gain or loss

A gain or loss is realized when a transaction is completed. However, not all realized gains and losses are taxed (recognized). A recognized gain or loss occurs when a taxpayer is obligated to pay tax on a completed transaction.

Substance v. form

Individuals should arrange their financial transactions in a manner that will minimize their tax liability. If a transaction is all it purports to be and not merely a transaction to avoid taxes, then it is valid. If the transaction is solely to avoid taxes and there is no business purpose to the transaction, then it is invalid. The fact that a taxpayer uses one form of transaction rather than another to minimize taxes does not invalidate the transaction. A good example of when substance v. form is a significant issue is in the area of leases. Payments under a lease are tax deductible. Payments under a purchase agreement are not tax deductible. Therefore, it is of utmost importance to determine the true “substance” of this type of transaction. Questions to be asked might include: Do any equity rights transfer to the lessee at the end of the lease period? May the lessee buy the property at a nominal purchase price? With a lease transaction it is immaterial that the parties refer to the transaction as a lease. The true substance of the transaction controls over the form.

Tax benefit rule

A recovery is includible in income only to the extent that the deduction reduced tax in any prior year by any amount. Therefore, where a deduction reduced taxable income but did not reduce tax, the recovery amount is excludable from income. This rule applies to both corporate and noncorporate taxpayers.

Taxable income

Taxable income for a corporation is gross income minus all deductions allowable, including special deductions such as the one for dividends received. Taxable income for individuals who itemize deductions is equal to adjusted gross income minus the greater of itemized deductions or the standard deduction amount and the qualified business deduction. For taxpayers who do not itemize, taxable income is adjusted gross income minus the standard deduction and the qualified business deduction.

Wherewithal to pay

The concept that the taxpayer should be taxed on a transaction when he or she has the means to pay the tax. For example, a taxpayer owns property that is increasing in value. The IRS does not tax the increased value until the taxpayer sells the property. At the time of sale, the taxpayer has the wherewithal to pay.

SUMMARY

· Taxes are indeed big business. The Internal Revenue Service collected $3,001,581,900,000 in 2018.

· Individuals contributed 52.45 percent of all taxes raised by the IRS.

· Corporations contributed approximately 6.75 percent of all taxes raised by the IRS.

· A basic understanding of tax terminology will help business leaders run their corporations.

Chapter 2

Tax Research, Practice, and Procedure

OBJECTIVES

After completing  Chapter 2 , you should be able to:

1. Identify the primary authoritative sources of the tax law and understand the relative weight of these authorities.

2. Explain the role of the court system as a forum for both the taxpayer and the government.

3. Develop a familiarity with the various forms of judicial citations.

4. Understand the general organization of a loose-leaf tax service and the importance of a citator service and other types of secondary reference materials.

5. Describe the organization of the Internal Revenue Service and selected rules relating to practice before the IRS.

6. Discuss the examination of returns, including correspondence examinations, office examinations, and field examinations.

7. Explain the appeals process, both within the IRS and through the court system.

8. Understand the possible communications between the IRS and taxpayers, including private rulings, determination letters, and technical advice.

9. Describe some of the more common penalties to which taxpayers and tax preparers might be subject.

10. Understand ethics as related to the tax practitioner.

OVERVIEW

To the general public, the tax practitioner is often viewed simply as a preparer of tax returns. However, from a broader, more professional perspective, tax practice also involves extensive research, creative tax planning, and effective representation of clients before the audit or appellate divisions of the Internal Revenue Service.

Tax research is the process whereby one systematically searches for the answer to a tax question, using the various primary and secondary sources of tax-related information. This involves reviewing and evaluating appropriate Internal Revenue Code sections, Treasury Regulations, Internal Revenue Service Rulings, and court decisions. Research into this voluminous material is typically facilitated by the use of one of the loose-leaf tax services, which are organized and cross-referenced in such a manner as to assist the researcher in the confusing trek through the overwhelming mass of authoritative data. Also, due to rapid technological advances made in computer-assisted tax research, the researcher may access the most complete and up-to-date authoritative data with online tax research services.

The tax specialist needs to understand the organizational structure of the IRS and its administrative procedures to provide fully informed tax consulting services to taxpayers involved in disputes with the IRS. Thus, this chapter includes a discussion of the internal organization of the IRS and how its various administrative groups function, the rules relating to practice before the IRS, and the procedures for examination of returns, including service center examinations, office examinations, and field examinations.

What actions can a taxpayer take if there is an adverse decision by the tax auditor or revenue agent? To provide an answer to this question, this chapter details and explains the appeals process, both within the IRS and through the court system. Another approach available to the taxpayer is the right to request advice from the IRS on the tax consequences of a particular transaction. This chapter discusses the various communications between the IRS and taxpayers, including private letter rulings, determination letters, and technical advice.

Some of the more common penalties to which taxpayers and tax preparers might be subject are also discussed. Tax practitioners should be familiar with the code of professional ethics of their profession since a violation of these standards might mean that “due care” has not been exercised and the practitioner might be subject to charges of negligence.

Tax Reference Materials

¶2001

CLASSIFICATION OF MATERIALS

Tax reference materials are usually classified as primary “authoritative” sources or secondary “reference” sources. Primary source materials include the Internal Revenue Code (Statutory Authority), Treasury Regulations and Internal Revenue Service Rulings (Administrative Authority), and the various decisions of the trial courts and the appellate courts (Judicial Authority).

Secondary reference materials consist primarily of the various tax reference services. Additional secondary materials include periodicals, textbooks and treatises, published papers from tax institutes and symposia, and newsletters.

Reminder. While the editorial opinions included in the secondary reference materials are extremely knowledgeable and comprehensive, neither the IRS nor the courts will afford any authoritative weight to these opinions. One exception is Mertens, Law of Federal Income Taxation. This tax service is often quoted in judicial decisions.

Both primary and secondary sources can be accessed through one of the computer-assisted research services. These electronic data bases are updated daily and contain many source documents not normally found in the traditional tax library.

Primary Source Materials

¶2021

STATUTORY AUTHORITY

Statutory authority is primarily the Internal Revenue Code, but it also includes the U.S. Constitution and tax treaties. The authority of the U.S. government to raise revenue through a federal income tax is derived from the Sixteenth Amendment to the Constitution. Following ratification of this Amendment, the federal income tax law was enacted on October 3, 1913, and was made retroactive to March 1, 1913. Various other revenue acts were soon enacted. From these provisions, a loose and disconnected body of tax law emerged, making it virtually impossible to systematically engage in tax research. Accordingly, to facilitate a convenient form of organization, the various revenue acts that were enacted between 1913 and 1939 were codified into Title 26 of the United States Code, known as the Internal Revenue Code of 1939.

In subsequent years, with the growing complexity of the tax law, the Code was revised and rewritten as the Internal Revenue Code of 1954. During the next thirty-two years numerous tax laws were incorporated as amendments into the 1954 Code. Accordingly, the Economic Recovery Tax Act of 1981 (ERTA), the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), and the Tax Reform Act of 1984 were included as part of the Internal Revenue Code of 1954, as amended. However, in 1986, as a result of the sweeping changes made by the Tax Reform Act of 1986, Congress changed the name of the tax law to the Internal Revenue Code of 1986.

Organization of the Code

The Internal Revenue Code of 1986 is comprised of nine subtitles (A-I), each consisting of individual, consecutively numbered chapters (1-98). The subtitles most commonly encountered by the tax practitioner that form the basis of this book are Subtitle A, “Income Taxes,” including  Chapters 1 – 6 , and Subtitle B, “Estate and Gift Taxes,” including  Chapters 11 – 15 . The remaining subtitles relate to topics such as employment taxes, excise taxes, alcohol and tobacco taxes, etc. Portions of Subtitle F, “Procedure and Administration,” including Chapters 61–80, are also examined in this text.

The major portion of the Code dealing with federal income tax is located in  Chapter 1  of Subtitle A. This extremely important Chapter, entitled “Normal Taxes and Surtaxes,” is further divided into Subchapters (A–Z), and each Subchapter is then generally divided into parts and subparts, which are then divided into sections. These sections are typically referred to as “Code Sections.”

The following exhibit ( Exhibit 1 ) provides a Table of Contents for  Chapter 1  of Subtitle A of the Internal Revenue Code of 1986.

Exhibit 1. INTERNAL REVENUE CODE OF 1986—SELECTED TABLE OF CONTENTS Subtitle A—Income Taxes Chapter 1—Normal Taxes and Surtaxes
Subchapter		Beginning Section Number
A	Determination of Tax Liability	1
B	Computation of Taxable Income	61
C	Corporate Distributions and Adjustments	301
D	Deferred Compensation, Etc.	401
E	Accounting Periods and Methods of Accounting	441
F	Exempt Organizations	501
G	Corporations Used to Avoid Income Tax on Shareholders	531
H	Banking Institutions	581
I	Natural Resources	611
J	Estates, Trusts, Beneficiaries, and Decedents	641
K	Partners and Partnerships	701
L	Insurance Companies	801
M	Regulated Investment Companies and Real Estate Investment Trusts	851
N	Tax Based on Income from Sources Within or Without the United States	861
O	Gain or Loss on Disposition of Property	1001
P	Capital Gains and Losses	1202
Q	Readjustment of Tax Between Years and Special Limitations	1301
R	Election to Determine Corporate Tax on Certain International Shipping Activities Using Per Ton Rates	1352
S	Subchapter S: Tax Treatment of S Corporations and Their Shareholders	1361
T	Cooperatives and Their Patrons	1381
U	Designation and Treatment of Empowerment Zones, Enterprise Communities, and Rural Development Investment Areas	1391
V	Title 11 Cases	1398
W	District of Columbia Enterprise Zone [Stricken]	1400
X	Renewal Communities [Stricken]	1400E
Y	Short-Term Regional Benefits [Stricken]	1400L
Z	Opportunity Zones	1400Z-1

 

Citing the Code

Code Sections, particularly those found within  Chapter 1  of Subtitle A, are cited by detailed reference to section, subsection, paragraph, and subparagraph. On occasion, the reference is even broken down to inferior subdivisions, such as a clause.

For example, Section 453(e)(3)(A)(i) might serve as an illustration.

Throughout this text, references to Code Sections are in the form explained above. Unless otherwise noted, references to Code Sections relate to the Internal Revenue Code of 1986. References to the 1939 or 1954 Code are specifically noted.

Congressional Committee Reports

Congressional Committee Reports are the minutes or official statements made by members of the House Ways and Means Committee, Senate Finance Committee, and Conference Committee on their intention in passing a specific piece of legislation. Unlike Treasury Regulations, Revenue Rulings, and Revenue Procedures issued by the IRS that are not binding on the courts, congressional intent expressed in Committee Reports very often is binding as these Committee Reports are regarded as very high authority. Committee Reports are published in the Cumulative Bulletin and by private publishers, including Wolters Kluwer and Thomson Reuters. Additionally, the Congressional Record reports floor debates in the House of Representatives and in the Senate.

Blue Books

As stated in the House Committee Report to the Revenue Reconciliation Act of 1989 (P.L. 101-239), “Blue Books” have been added to the list of authorities on which taxpayers may rely for interpretation of the tax law (see discussion at  ¶2035 ). Blue Books are prepared by the Staff of the Joint Committee on Taxation for major tax acts. Although Blue Books are generally based on Committee Reports for an act, they often contain additional interpretative information. The IRS has used this interpretative information in numerous rulings as the basis for a particular position. Blue Books are published electronically by Wolters Kluwer, CCH.

¶2035

ADMINISTRATIVE AUTHORITY

As a result of congressional authority, the Secretary of the Treasury or a delegate, the Commissioner of Internal Revenue, is authorized to provide administrative interpretation of the tax law. As noted in Section 7805(a):

Except where such authority is expressly given by this title to any person other than an officer or employee of the Treasury Department, the Secretary or his delegate shall prescribe all needful rules and regulations for the enforcement of this title, including all rules and regulations as may be necessary by reason of any alteration of law in relation to internal revenue.

Treasury Regulations

Treasury Regulations have generally been classified into three broad categories: legislative, interpretative, and procedural. Legislative regulations are those that are issued by the Treasury under a specific grant of authority by Congress to prescribe the operating rules for a statute. Generally, legislative regulations have the force and effect of law. Interpretative regulations are issued pursuant to the general rule-making power granted to the Commissioner under Code Sec. 7805(a) and provide taxpayers with guidance in order to comply with a statute. Although interpretative regulations do not have the force and effect of law, the courts customarily accord them substantial weight. Procedural regulations are considered to be directive rather than mandatory and, thus, do not have the force and effect of law. They explain the IRS’s position and provide the mechanics for compliance with the various federal income tax laws, as for example the making and filing of tax elections.

The Regulations are organized in a sequential system consistent with the Code. Additionally, the Regulations are prefixed by a number that designates the applicable area of taxation to which they refer. For example, following are the more important Regulation prefixes:

Part	1.	Final income tax regulations
Part	20.	Estate Tax
Part	25.	Gift Tax
Part	31.	Withholding taxes
Part	301.	Procedure and Administration
Part	601.	Statement of Procedural Rules

Accordingly, an “Income Tax” Regulation relating to Section 453 of the Code would be cited as Reg. §1.453, followed by a dash, then the sequential number of issue, with subparts added for more detailed reference.

Proposed Regulations

New Regulations and changes to existing Regulations usually are issued in proposed form before they are finalized. During the interval between the publication of the Notice of Proposed Rulemaking and finalization of the Regulation, taxpayers and other interested parties are permitted to file objections or suggestions. Proposed Regulations generally do not have the same weight as Temporary Regulations. Tax law publishers, such as Wolters Kluwer and Thomson Reuters, provide a comprehensive listing of these Proposed Regulations, showing the date of their proposal and date of adoption and also publish the text of the Proposed Regulations.

Temporary Regulations

Sometimes Temporary Regulations are issued by the Treasury Department. Their purpose is to provide interim guidance regarding recent tax legislation until final Regulations are adopted. Temporary Regulations (issued after November 20, 1988) must also be issued as Proposed Regulations and must undergo public and administrative scrutiny during a comment period as do Proposed Regulations. Every Temporary Regulation issued after November 20, 1988, will expire three years from the date of issuance. Prior to its expiration, a Temporary Regulation has the same weight as a Final Regulation.

Final Regulations

Finalized Regulations are published in the Federal Register as are the Proposed Regulations and Temporary Regulations. All tax Regulations are also published in the Internal Revenue Bulletin. Final Regulations and Temporary Regulations are designated as Treasury Decisions (T.D.s) and are assigned a sequential number in order of issuance for the year. The effective date and date of adoption are significant.

Final Regulations as well as Proposed and Temporary Regulations are reproduced in major tax services.

Revenue Rulings and Revenue Procedures

Revenue Rulings, the official pronouncements of the IRS, are similar to Treasury Regulations in that they represent administrative interpretations of the internal revenue laws. Revenue Rulings are issued with respect to a particular issue and insure that this issue will be handled uniformly throughout the United States, both in planning and in auditing. Revenue Rulings, however, do not have the same authoritative weight as regulations. Every issue of the Internal Revenue Bulletin includes the following statement:

Rulings and procedures reported in the Bulletin do not have the force and effect of Treasury Department Regulations, but they may be used as precedents. Unpublished rulings will not be relied on, used, or cited as precedents by Service personnel in the disposition of other cases. In applying published rulings and procedures, the effect of subsequent legislation, regulations, court decisions, rulings, and procedures must be considered, and Service personnel and others concerned are cautioned against reaching the same conclusions in other cases unless the facts and circumstances are substantially the same.

Revenue Procedures are published official statements of procedure issued by the IRS that affect either the rights or the duties of taxpayers or other members of the public under the Internal Revenue Code and related statutes and regulations. Revenue Procedures usually reflect the contents of internal management documents. A statement of the IRS position on a substantive tax issue will not be included in a Revenue Procedure. Revenue Procedures are directive and not mandatory.

Both Revenue Rulings and Revenue Procedures are originally published in the weekly issues of the Internal Revenue Bulletin, printed by the U.S. Government. However, through 2008, on a semiannual basis, the bulletins were compiled, reorganized by Code section classification, and published in a bound volume designated the Cumulative Bulletin. Once published in the Cumulative Bulletin, a Revenue Ruling or Revenue Procedure received a permanent citation as shown below:

After 2008, a Revenue Ruling, such as Rev. Rul. 2014-12, would be cited as Rev. Rul. 2014-12, 2014-15 I.R.B. 923. This is the 12th Rev. Rul. of 2014 in the 15th weekly issue of the Internal Revenue Bulletin on page 923. The citation for a Revenue Procedure is identical, except the abbreviation “Rev. Proc.” is used in place of “Rev. Rul.”

Other Administrative Pronouncements

In addition to substantive rulings (Revenue Rulings and Revenue Procedures) published to promote a uniform application of the tax laws, the IRS issues communications to individual taxpayers and IRS personnel in three primary ways: (1) Private Letter Rulings, (2) Determination Letters, and (3) Technical Advice Memoranda. These documents are part of the IRS rulings program, which is discussed in detail at  ¶2225 .

Digests of Private Letter Rulings may be found in Private Letter Rulings (published by Thomson Reuters), Bloomberg BNA Daily Tax Reports, and Tax Analysts Tax Notes. IRS Letter Rulings Reports (published by Wolters Kluwer) contains both digests and the full texts of all Private Letter Rulings. These documents may also be accessed electronically through Wolters Kluwer's IntelliConnect® or CCH® AnswerConnect. Determination Letters are not published; however, the IRS is now required to make individual rulings available for public inspection. Technical Advice Memoranda are available similar to Private Letter Rulings.

IRS List of Substantial Authority for Taxpayer Reliance

The IRS has provided guidance on (1) adequate disclosure of items and positions taken on tax returns for purposes of avoiding the accuracy related penalty for understatement of tax, Rev. Proc. 94-36, 1994-1 CB 682, and (2) a listing of substantial authority that may be relied on to avoid imposition of that penalty. Reg. §1.6662-4(d)(3). In addition, the IRS issues a list of positions for which there is not substantial authority. This list must be issued by the Secretary of the Treasury (and revised not less frequently than annually) and published in the Federal Register. Code Sec. 6662(d)(3).

The purpose of the list is to assist taxpayers in determining whether a position should be disclosed in order to avoid the substantial understatement penalty. House Committee Report, Revenue Reconciliation Act of 1989. Thus, a taxpayer could choose to disclose that position to avoid the imposition of the accuracy-related penalty. However, inclusion of a position on this list is not conclusive as to whether or not substantial authority exists with respect to that position.

Prior to 1990, the list of substantial authority was restricted to: (1) the Internal Revenue Code, (2) final and temporary regulations, (3) court cases, (4) IRS administrative pronouncements, (5) tax treaties, and (6) congressional intent reflected in committee reports accompanying legislation. Reg. §1.6661-3.

The list of substantial authority now includes (1) the Joint Committee on Taxation’s General Explanation of tax legislation (i.e., the “Blue Book”); (2) proposed regulations; (3) information or press releases; (4) notices, announcements, and other similar documents published in the Internal Revenue Bulletin; (5) private letter rulings; (6) technical advice memoranda; (7) actions on decisions; and (8) general counsel memoranda. Reg. §1.6662-4(d)(3)(iii). “Authority” does not include conclusions reached in treatises, legal periodicals, and opinions rendered by tax professionals.

With respect to the test for “substantial authority,” the IRS continues to apply the principle that there is substantial authority for the tax treatment of an item only if the weight of authorities supporting such treatment is substantial in relation to the weight of authorities supporting contrary tax treatment. The type of document providing the authority affects the weight to be accorded an authority. Reg. §1.6662-4(d)(3)(i) and (ii).

¶2055

JUDICIAL AUTHORITY

The ultimate test in the interpretation of the Code, in determining the validity of Regulations, and in applying the “law” to the facts of a given case takes place in the courts. The court system provides the taxpayer with the opportunity to test before a neutral forum both the position taken by the taxpayer and that taken by the Commissioner with respect to any issue. The courts historically have played a substantial role in the interpretation, application, and enforcement of the tax law.  Exhibit 2  outlines the trial and appellate court alternatives for federal tax litigation.

Trial Court System

There are three tribunals that have original jurisdiction to hear and decide tax cases arising under the Internal Revenue Code. A taxpayer can file a petition with the United States Tax Court, in which event assessment and collection of the deficiency will be stayed until the Tax Court’s decision becomes final. But, the taxpayer may, if he or she prefers, pay the deficiency and then sue for a refund in a U.S. District Court or the United States Court of Federal Claims.

Exhibit 2. JUDICIAL APPEALS ALTERNATIVES

U.S. Tax Court

The U.S. Tax Court’s jurisdiction is limited to cases concerning the Internal Revenue Code, and would include income tax law, estate tax law, excess profits, but not employment taxes. The Tax Court consists of 19 judges appointed by the President for 15-year terms. It is a special court whose jurisdiction is limited almost exclusively to litigation under the Internal Revenue Code. Prior to 1943, the Tax Court was known as the Board of Tax Appeals. Although the Tax Court is a single court located in Washington, D.C., hearings are held in several cities throughout the nation, usually with only a single judge present who submits his opinion to the chief judge. Only rarely does the chief judge decide that a full review is necessary by all 19 judges.

Decisions of the Tax Court are issued as either “regular” or “memorandum” decisions. “Regular” decisions are those that require an interpretation of the law. In theory, “memorandum” decisions concern only well-established principles of law and require only a determination of facts. However, on occasion, the courts have cited “memorandum” decisions. Hence, both kinds of Tax Court decisions should be regarded as having precedent value.

Viewing itself as a national court hearing cases from all parts of the country, for many years the Tax Court had followed a policy of deciding cases on what it thought the result should be. The Tax Court has abandoned its “national law” view, under which it applied its own rule on a nationwide basis without limitation by rules of the circuits in which tax controversies arose. The Tax Court has adopted the position that it will follow precedents of the Circuit Court of Appeals of jurisdiction (known as the Golsen rule). As a result, it is entirely possible that the Tax Court will rule differently on identical fact patterns for two taxpayers residing in different circuits in the event of inconsistent holdings between the various Circuit Courts.

The Tax Court is the only court to which a taxpayer may take a case without first paying the tax. Consequently, taxpayers resort to it in many instances. Because it is a court of limited jurisdiction dealing primarily with tax matters, its decisions are accorded considerable weight. This is particularly true of decisions in which the Commissioner of Internal Revenue has acquiesced.

Historically, the policy of the IRS has been to announce in the Internal Revenue Bulletin the determination of the Commissioner to acquiesce or not acquiesce in most of the regular decisions of the Tax Court. An announcement of acquiescence (cited Acq.) indicates that the IRS has accepted the conclusion reached in the case but not necessarily the reasons given by the court in its opinion. An announcement of nonacquiescence (cited Nonacq.) usually means that the IRS will continue to litigate the issue if it arises again. Since 1991, the IRS has indicated acquiescences or nonacquiescences for memorandum decisions of the Tax Court as well as for decisions of other courts. An announcement of acquiescence is not legally binding on the IRS and, thus, can be retroactively withdrawn at any time. If a case is being relied upon, it is important to determine whether it has been acquiesced in by the Commissioner, the extent of the acquiescence (if any), and whether the initial acquiescence may have been withdrawn at a later date.

Additionally, a procedure is used in the Tax Court for cases involving disputes of $50,000 or less. The taxpayer who uses the “small tax case” procedures should be aware that the decision may not be appealed. The advantage to using this procedure is the fact that the formal procedures of the Tax Court are relaxed and made informal.

Judicial Citations—Tax Court Regular Decisions. Regular and memorandum decisions of the Tax Court are reported separately. The Government Printing Office publishes bound volumes of only the regular decisions under the title United States Tax Court Reports (cited TC).

Permanent Citation: Microsoft Corporation, 115 TC 228 (2000).

Thus, the decision appears in Volume 115 of the United States Tax Court Reports, page 228, issued in 2000.

Because there is usually a time lag between the date a decision is rendered and the date it appears in bound form, a temporary citation is used until a permanent citation can be substituted.

Temporary Citation: Gilda A. Petrane v. Commissioner, 129 TC —, No. 1 (July 2007).

Thus, the temporary citation identified that the decision appeared in Volume 129 of the United States Tax Court Reports, page left blank, 1st regular decision issued by the Tax Court since Volume 128 was issued. Once Volume 129 was issued, the permanent citation incorporating the page was substituted and the number of the case is not used.

Permanent Citation: Gilda A. Petrane v. Commissioner, 129 TC 1 (2007).

Judicial Citations—Tax Court Memorandum Decisions. The government provides only photocopies of the memorandum decisions. However, memorandum decisions are published by both Wolters Kluwer and Thomson Reuters in bound volumes separate from those in which they report other tax cases. The Tax Court memorandum decisions are published by Wolters Kluwer under the title Tax Court Memorandum Decisions (cited TCM), while the Thomson Reuters series is called Thomson Reuters Memorandum Decisions (cited TC Memo).

Wolters Kluwer Citation: Harvey D. Perry, Jr. v. Commissioner, 84 TCM 1, T.C. Memo. 2002-165 (2002).

Thomson Reuters Citation: Harvey D. Perry, Jr. v. Commissioner, 2002 TC Memo ¶2002-165.

Although presented in a different way, the reference in both citations indicates that the memorandum decision was the 165th memorandum decision issued by the Tax Court in 2002.

Both regular and memorandum decisions for years prior to 1943 were published by the government under the title United States Board of Tax Appeals Reports.

Citation: J.E. Burke, 19 BTA 743 (1930).

Thus, the decision appears in Volume 19 of the United States Board of Tax Appeals Reports, page 743, issued in 1930.

U.S. District Courts

The U.S. District Courts were the main courts of original jurisdiction for tax cases prior to the establishment of the Board of Tax Appeals which later became the Tax Court. A taxpayer can take a case to the U.S. District Court for the district in which the taxpayer resides only if the taxpayer first pays the tax deficiency assessed by the IRS and then sues for a refund. Each state has at least one District Court in which both tax and nontax litigation are heard. Only in a District Court can one obtain a jury trial, and even there a jury can decide only questions of fact—not those of law.

Judicial Citations—U.S. District Courts Decisions. Published decisions of the U.S. District Courts, including both tax and all other types of litigation, are reported in the Federal Supplement (cited F.Supp.) published by West Publishing Company. In addition, the tax decisions of the District Courts are also published in the two special tax reporter series, Wolters Kluwer United States Tax Cases (cited USTC) and Thomson Reuters American Federal Tax Reports (cited AFTR).

West Citation:  Eugene B. Glick, 96 F.Supp. 2d 850 (DC Ind., 3/14/00).

The order of citation is volume number, reporter, page number.

Wolters Kluwer Citation:  Eugene B. Glick, 2000-1 USTC ¶50,372 (DC Ind., 3/14/00).

Paragraph reference rather than a page number gives the location of the case.

Thomson Reuters Citation:  Eugene B. Glick, 86 AFTR 2d 2000-5083 (DC Ind., 3/14/00).

The prefix “2000” preceding the page number indicates the year the case was decided.

U.S. Court of Federal Claims

The U.S. Court of Federal Claims is a single court consisting of 16 judges appointed by the President. The court resides in Washington, D.C. and the decision to travel is made on a case-by-case basis and is heard by the trial judge to whom the case has been assigned. Prior to October 29, 1992, the court was known as the U.S. Claims Court, and prior to October 1, 1982, the court was known as the U.S. Court of Claims whose decisions were appealed directly to the U.S. Supreme Court.

In federal tax matters, the U.S. Court of Federal Claims has concurrent jurisdiction with the U.S. District Courts. The Court of Federal Claims is a constitutional court and has jurisdiction in judgment on any claim against the United States that is:

1. Based on the Constitution

2. Based on any Act of Congress

3. Based on any regulation of an executive department

Judicial Citations—U.S. Court of Federal Claims Decisions. Since 1992, decisions of the Court of Federal Claims have been reported by West Publishing Company in the Federal Claims Reporter (cited FedCl). The decisions of the Claims Court from October 1982 until 1992 were reported by West Publishing Company in a series designated the U.S. Claims Court Reporter (cited ClCt). Decisions of the predecessor Court of Claims were published by the U.S. Government Printing Office in a separate series of volumes entitled the U.S. Court of Claims Reports (cited CtCl). The decisions of the predecessor Court of Claims were also published by West Publishing Company from May 1960 through September 1982 in the Federal Reporter 2d Series (cited F.2d), while decisions between 1932 and 1960 were reported in the Federal Supplement (cited F.Supp.).

In addition, the tax decisions of the Court of Federal Claims (and the predecessor Claims Court and Court of Claims) are also published in the Wolters Kluwer United States Tax Cases (cited USTC) and Thomson Reuters American Federal Tax Reports (cited AFTR).

West Citation:	Katz v. U.S., 22 ClCt 714 (ClCt, 1991).
	Scott v. U.S., 354 F.2d 292 (CtCl, 1965).
	Betz v. U.S., 40 Fed Cl 286 (Fed Cl, 1998).
Wolters Kluwer Citation:	Katz v. U.S., 91-1 USTC ¶50,289 (ClCt, 1991).
	Scott v. U.S., 66-1 USTC ¶9169 (CtCl, 1965).
	Betz v. U.S., 98-1 USTC ¶50,199 (Fed Cl, 1998).
Thomson Reuters Citation:	Katz v. U.S., 67 AFTR2d 91-733 (ClCt, 1991).
	Scott v. U.S., 16 AFTR2d 6087 (CtCl, 1965).
	Betz v. U.S., 81 AFTR2d 98-611 (Fed Cl, 1998).

Appeals Court System

If either the taxpayer or the IRS is not satisfied with a trial court decision, an appellate court may be asked to review that decision. There are two levels of courts that handle appeals from the three courts of original jurisdiction. Appeals may be taken to the U.S. Courts of Appeals of jurisdiction or the U.S. Court of Appeals for the Federal Circuit. As a final step, the controversy may be appealed from the appellate courts to the Supreme Court.

The authority of decisions of all Courts of Appeals stands above that of the Tax Court, a District Court, or the Court of Federal Claims. The U.S. Supreme Court is, of course, the final authority as to what a statute means or as to any question of federal law.

U.S. Circuit Courts of Appeals

Appeals in tax cases may be taken from the U.S. District Courts or the Tax Court by either the IRS or the taxpayer to the U.S. Courts of Appeals of jurisdiction. Jurisdiction is based upon the location of the taxpayer’s residence. There are eleven numbered circuits and additional unnumbered circuits for the District of Columbia Circuit and the Federal Circuit. See  Exhibit 3 .

Normally, a Circuit Court’s review, made by a panel of three judges is limited to the application of law—not the determination of facts. In this process, the appellate court of any circuit is obligated to follow the findings of the U.S. Supreme Court but not those of the other Circuit Courts. When conflicts develop between circuits, District Courts of each individual circuit are required to follow any precedent set by the appellate court of their own circuit (i.e., the Circuit Court to which their decisions may be appealed). Also, as noted earlier, pursuant to the Golsen rule, the Tax Court follows the policy of observing precedent set by the appellate court of the circuit in which the taxpayer resides. In this way, consistency in the application of law is maintained between the Tax Court and the District Court of jurisdiction, even though there may exist an inconsistency in the law’s application to taxpayers residing in various circuits.

Judicial Citations—U.S. Circuit Courts of Appeals Decisions. All U.S. decisions, both tax and nontax, of the various Circuit Courts are published by West Publishing Company in the Federal Reporter including 2nd and 3rd Series (cited F.2d and F.3d). In addition, tax decisions of the Circuit Courts are also contained in Wolters Kluwer's United States Tax Cases (cited USTC) and Thomson Reuters American Federal Tax Reports (cited AFTR). Citations indicate not only the volume and page, but also the particular court.

West Citation:  Diane S. Blodgett v. Commissioner, 394 F.3d 1030 (CA-8, 2005).

Wolters Kluwer Citation:  Diane S. Blodgett v. Commissioner, 2005-1 USTC ¶50,146 (CA-8, 2005).

Thomson Reuters Citation:  Diane S. Blodgett v. Commissioner, 95 AFTR2d 2005-448 (CA-8, 2005).

U.S. Court of Appeals for the Federal Circuit

On October 1, 1982, the seven judges of the Court of Claims and the five judges of the Court of Customs and Patent Appeals became the 12 judges of the newly created Court of Appeals for the Federal Circuit (CA-FC). The IRS and taxpayers appeal decisions from the U.S. Court of Federal Claims to this court. The court is empowered to sit in various locations around the country and can be expected to make an effort to hold sessions in the major cities where its business arises.

Exhibit 3. FEDERAL JUDICIAL CIRCUITS

U.S. Supreme Court

Appeals to the U.S. Supreme Court from the Circuit Courts of Appeals and the Court of Appeals for the Federal Circuit may be made generally by a petition for certiorari. The Supreme Court may grant certiorari at its discretion; further, the Supreme Court is not required to give reasons for its refusal to review. However, past experience has shown that the Court generally grants certiorari only if:

1. The issue has resulted in conflicting decisions in the Circuit Court of Appeals or

2. The issue involved raises an important and continuing problem in the administration of the tax law.

If the Supreme Court declines to review the decision, it will formally deny the petition for certiorari.

Judicial Citations—U.S. Supreme Court Decisions. All U.S. Supreme Court decisions are published by the U.S. Government Printing Office in the United States Supreme Court Reports (cited U.S.), West Publishing Co. in the Supreme Court Reporter (cited S.Ct.), and the Lawyer’s Co-Operative Publishing Co. in the United States Reports, Lawyer’s Edition (cited L.Ed.). Like all other federal tax cases (except those rendered by the U.S. Tax Court), tax-related Supreme Court decisions are reported by Wolters Kluwer in United States Tax Cases (cited USTC) and Thomson Reuters in American Federal Tax Reports (cited AFTR).

GPO Citation:	Drye, Jr. v. U.S., 528 U.S. 49 (1999).
West Citation:	Drye, Jr. v. U.S., 120 S.Ct. 474 (1999).
Lawyer’s Ed. Citation:	Drye, Jr. v. U.S., 145 L.Ed.2d 466 (1999).
Wolters Kluwer Citation:	Drye, Jr. v. U.S., 99-2 USTC ¶51,006 (1999).
Thomson Reuters Citation:	Drye, Jr. v. U.S., 84 AFTR2d 99-7160 (1999).

Secondary Source Materials

¶2075

ANALYSIS OF TAX LAW SOURCES

The voluminous bulk and complexity of our tax law make it extremely difficult to systematically research all of the statutory and administrative provisions associated with a given set of tax issues. The problem is further compounded when one also attempts to analyze, evaluate, and update the leading court cases that impact on these issues. Fortunately, secondary reference materials provide a convenient cross-referenced and continuously updated road map to guide the practitioner in the complicated task of wading through a growing maze of primary tax authority.

Tax Research Services

There are various tax research services that are published with the specific purpose of providing comprehensive reference information on the ever-changing tax law and on-going developments in administrative rulings and case decisions. The use of any particular tax research service is best described in materials made available to users by the representatives of the tax research services. However, there are some general points to be made on the use of these tax research services. First, it is important to check for the latest developments on any topic, issue, or case being researched under a specific statute, regulation, or ruling. Second, editorial analysis, be it a synopsis or digest, provided by the tax research services for case decisions or administrative rulings is an interpretative commentary. Such editorial commentary, no matter how knowledgeable, is not intended to be a substitute for the authoritative primary source document.

Internet Based Research Systems

The role of electronic research systems cannot be overstated. To say that most print materials are also available online does not describe the increasingly integrated and comprehensive search capabilities of online research systems. Users can access computerized tax law data banks with their personal computers by using various tax research publisher’s online internet-based research systems. Whatever format the researcher uses, all data bases are now integrated with primary and secondary source materials from which the researcher can retrieve full text documents or search for key words or phrases. Publishers’ computerized tax research systems can also be used to access citation information to locate all judicial decisions that have cited a particular decision or statute. These online citators are more current than is possible in print format.

Wolters Kluwer Tax Products on the Internet

As examples of electronic tax research systems, Wolters Kluwer’s CCH® AnswerConnect and CCH® IntelliConnect ® offer a completely integrated suite of tax research materials including primary source documents, i.e., the Internal Revenue Code, Treasury Regulations, Revenue Rulings, tax case decisions, administrative guidance and more. In addition to primary source material, both AnswerConnect and IntelliConnect include editorial analysis and content.

AnswerConnect and IntelliConnect include many tax research resources encompassing Federal Tax, State Tax, International Tax, Financial and Estate Planning, Accounting, etc. Within each category, various resources and products are available for research and practice assistance. The electronic format of the internet-based tax research services provides an opportunity to include automated tools and calculators, which makes the tax research systems ideal not only for tax research, but also to find quick answers and practice aids. Both AnswerConnect and IntelliConnect include Smart Charts on many topics, as well as calculators, decision tools, and more. In addition to these features, the internet-based research systems provide an opportunity for the most current information that can be updated more frequently than the print resources. Both include the Wolters Kluwer daily news service, Tax Day, current journals and newsletters, the latest Wolters Kluwer briefings on major tax developments, a Case Citator that is current to date and many other electronic products including Wolters Kluwer's well-regarded Law, Explanation and Analysis books on current legislation. Subscribers to internet-based tax research systems receive log in information providing access to the full array of resources anytime and virtually anyplace.

In addition to the internet-based tax research systems, new applications are being continuously developed by most tax research services. Wolters Kluwer offers tax research information specifically designed for mobile devices including iPhones and iPads. Some of these applications include CCH Mobile, eBooks, current journals, and newsletters.

It must be noted here that despite the encompassing nature of electronic research and search methods, students are well advised to have a firm understanding of the nature, basis and authority of the documents they are using to support a tax position and how the various sources of authority are interrelated and linked. Therefore, following the internet screen shots below on the Wolters Kluwer internet-based system, a more detailed description of the organization of various tax research products is included with the understanding that these original research resources are still available in print format and are now also available through the electronic research systems.

Complete, current, and reliable tax information is on the Internet from Wolters Kluwer at  https://taxna.wolterskluwer.com . Many tax research products are also available on mobile applications.

Researching a Topic

Using IntelliConnect, as a research illustration, in the Internet browser’s Address bar, go to  http://intelliconnect.cch.com . You will be taken to the Log In page where you can enter your User ID and Password where you can initiate a search.

Type your search term or phrase in the navigation bar at the top of the screen. For purposes of illustration look for the “nanny tax threshold for 2020” and click Go. On the left side of the screen you can choose to Narrow Your Results. For this example click the plus next to “by Document Type” and when the list expands, click on Explanations.

This screen displays the results that best match your query. Click on the first document and the screen will split so that the document will appear at the bottom.

Review the document to see if it contains the information with respect to the nanny tax threshold for 2020. In this example the first item listed contains information on the nanny tax threshold for both 2019 and 2020. The nanny tax was $2,100 for 2019. In 2020 it will be $2,200. Cash amounts paid for a nanny are not subject to FICA taxes if less than $2,200 during 2020.

Once you have found the information you were searching for you can choose to save the document as a pdf or text, email it to someone, or print it using the options in the middle of the tri screen.

Wolters Kluwer’s CCH AnswerConnect electronic search service is available for subscribers at:  http://answerconnect.cch.com .

From the home screen, enter your search term or phrase in the navigation bar at the top of the screen. For purposes of illustration, look for “nanny tax” and click on the magnifying glass icon to the right.

When you click on the first document in the list of results that best match your query, the information appears on the screen:

In this example, the first item listed is from the Master Tax Guide and contains information on Household Employees (Nanny Tax). The nanny tax is $2,200 for 2020. Cash amounts paid for a nanny are not subject to FICA taxes if less than $2,200 during 2020.

Once you have found the information you were searching for you can choose to print, save the file as a Word or pdf document, or email it to someone by clicking on the corresponding icon above the Contents box on the right side of the page.

The only way to become proficient at using an electronic data base is through practice and experience. The tax student is encouraged to experiment with Wolters Kluwer's online tax research systems, CCH® Answer Connect and CCH® IntelliConnect, by searching for the answer to a tax question. Once the art of electronic searching is mastered, it will be obvious how much more comprehensive and efficient it is than a traditional paper search. For example, what authority can you find to justify a deduction for home office expense by a college professor? What authority can you find that would deny the deduction?

IRS Homepage

The IRS homepage on the World Wide Web ( http://www.irs.gov ) went online on January 8, 1996. During its first 24 hours of operation, close to one million “hits” were recorded. Features on the IRS homepage include the following: Do Your Taxes for Free, Get Your Refund Status, Get Your Tax Record, Make a Payment, Get Answers to Your Tax Questions, Forms and Instructions, News, and Help.

One very useful aspect of the IRS homepage is the ability to retrieve the latest in tax news. In the “search” box type in “newsroom” to access information on important topics (as shown below). From the IRS homepage, click on News.

Across the top of the page the tabs provided are: File, Pay, Refunds, Credits & Deductions, and Forms & Instructions. Besides retrieving tax news from the IRS, tax forms and instructions may be downloaded. The fifth item listed across the top of the page is Forms and Instructionss. By clicking on Forms and Instructions, the Forms and Instructions page appears. All IRS tax forms may be retrieved from this site. Please note that forms and publications from prior years are available back to 1992.

By clicking on the “List All Current Forms & Instructions” link,  https://apps.irs.gov/app/picklist/list/formsPublications.html  appears. All IRS tax forms may be retrieved from this site.

Searching the Internet

A good way to search the Internet is by using search engines. A search engine allows you to type in a term or phrase that describes your area of interest. For example, open your Internet browser’s search screen and type in the pxhrase “tax history.” Once the search is complete, all of the finds are listed and linked to millions of useful sources (sample screens shown below).

Standard Federal Tax Reporter, Wolters Kluwer

Wolters Kluwer publishes in all major federal tax areas. These publications are available on Wolters Kluwer’s online tax research systems, CCH® AnswerConnect and CCH® IntelliConnect® and in print.

The most comprehensive of these tax reference publications is the Standard Federal Tax Reporter, frequently referred to as the Standard or Fed. Other specialized tax services include the Federal Excise Tax Reporter and the Federal Estate and Gift Tax Reporter.

The Standard Reporter consists of 24 coordinated and cross-referenced loose-leaf volumes that provide comprehensive coverage of the income tax law. The service also provides weekly supplements presenting current federal court decisions, new rulings, and changes in the law or regulations, digests of Tax Court decisions, as well as reviews of the significant legislative changes, and editorial comments that provide tax planning ideas related to current developments.

The major portion of the Standard, Volumes 1 through 18, compiles the legislative, administrative, and judicial aspects of the income tax law. The volumes are arranged in Code Section order and reflect the current income tax law and accompanying related regulatory texts (including proposed amendments to the Regulations), as well as legislative Committee Reports, followed by “Explanations” and supplemented with digests of associated administrative rulings and judicial decisions. Volume 19, “New Matters,” is used to retain current developments, such as digests of Tax Court decisions, full texts of rulings, current tables of decisions and rulings, and the Supreme Court Docket.

The Standard also includes the “U.S. Tax Cases Advance Sheets” Volume in which are reported the full texts of new income tax decisions from the federal courts, including the U.S. Supreme Court and the U.S. Court of Federal Claims. In the three Internal Revenue Code Volumes may be found the current internal revenue statutes. The Index Volume leads to the basic contents by subject through the Topical Index and also features a tax calendar, rate tables and tax rate schedules, tax planning information, checklists, and special tables.

United States Tax Reporter, Thomson Reuters

United States Tax Reporter, published by Thomson Reuters, consists of 18 coordinated loose-leaf volumes organized by Code sections and updated on a weekly basis. The service is similar to Wolters Kluwer’s and also includes a two-volume Internal Revenue Code, a seven-volume Citator, a one-volume Index, a one-volume Table of Cases, Rulings, and Tax Tables, a Recent Developments volume, an Advance Sheets volume for AFTR2d cases and a volume of proposed amendments to Federal Tax Regulations. Thomson Reuters also publishes loose-leaf tax services for excise taxes and for estate and gift taxes. This service is included in the Thomson Reuters Checkpoint online service.

Mertens, Law of Federal Income Taxation, Thomson Reuters

Merten’s Treatise on the Law of Federal Income Taxation, published by Thomson West, is an intensive, annotated work, providing excellent in-depth discussions of general concepts of tax law. However, unlike services such as those of Wolters Kluwer and Thomson Reuters, Mertens is not generally used as a comprehensive, self-contained reference service. Rather, it is typically regarded as a useful complement to the traditional reference services.

Tax Management Portfolios, Bloomberg BNA

Tax Management Portfolios, published by Bloomberg BNA, is a useful supplement to a tax library. Each portfolio ranges in length from 50 to 200 pages and deals exclusively with a special tax topic, covering Code, Regulations, reference to primary authorities, and extensive editorial discussion, including numerous tax planning ideas. Bloomberg BNA Portfolios are available online.

Federal Tax Coordinator, Thomson Reuters

The Federal Tax Coordinator, published by Thomson Reuters, is somewhat similar in organization to Wolters Kluwer’s Standard Federal Tax Reporter and Thomson Reuters's United States Tax Reporter, with compilation volumes and an elaborate cross-reference system of indexation. However, this service is organized by topic rather than by Code section. Popular features of the Tax Coordinator are the editorial explanations, illustrations, planning ideas, and warnings of potential tax traps. This service is included in the Thomson Reuters Checkpoint online service.

The Citator

Probably the most comprehensive method for evaluating and updating case law is through the use of a citator. The Wolters Kluwer Citator contains an alphabetical listing of the Tax Court (formerly the Board of Tax Appeals) and federal court decisions since 1913. It is updated currently online in CCH® AnswerConnect and CCH® IntelliConnect®. Additionally, the Wolters Kluwer Citator indicates a paragraph reference where each case is digested in the Compilation Volumes of the Standard Federal Tax Reporter. More than one paragraph reference will be given if a case involves several tax issues. The Citator is available on CCH® AnswerConnect and CCH® IntelliConnect® and offers instant linking to the cases cited.

Each listing outlines the judicial history of a selected case beginning with the highest court to have ruled on that issue. Then, in descending order, the actions of lower courts are also cited and described. Finally, under each listing, the Citator refers to other court cases, which helps to evaluate a given decision as a precedent.

The Citator 2nd, published by Thomson Reuters, is a service with monthly and annual cumulative supplements organized in a manner somewhat consistent with that of the Wolters Kluwer Citator. Essentially, Thomson Reuters provides an alphabetical list of court cases followed by a descriptive legislative history of each case. However, in those cases involving more than one issue, the Thomson Reuters citator also cross-references its descriptive system of judicial references according to the various issues. Citators are included in the online services of Wolters Kluwer and Thomson Reuters.

To illustrate the usefulness of the citator to the researcher, the Wolters Kluwer Citator will be explained in greater detail. Refer to  Exhibit 4 , a sample taken from the Wolters Kluwer Citator and locate the Atlas Life Insurance Co. case. The case name is followed by paragraph (¶) references to the Compilation Volumes in which the decision appears as an annotation to the law, regulations, and other cases in point. The black dot preceding each court action in the case permits the researcher to quickly scan the judicial history of the case. Atlas Life Insurance Co. was decided on appeal in the Supreme Court in 1965, which reversed the decision of the Court of Appeals for the Tenth Circuit. The Court of Appeals decision reversed the ruling of the District Court of Oklahoma.

Exhibit 4. WOLTERS KLUWER CITATOR—COURT CASES SAMPLE SECTION

In addition to the historical record of the case, citations are given for the court actions taken in a particular case which show where the full text of the decision may be found. A citation to U.S. Tax Cases (USTC), for example, refers to an expansive series of volumes published by Wolters Kluwer that cover tax-related court opinions issued since 1913. The volumes, published twice a year, cover Supreme Court, Courts of Appeals, District Courts, and Court of Federal Claims cases. The Thomson Reuters citator would refer to the American Federal Tax Reports (AFTR), the comparable Thomson Reuters series of federal court cases. Memorandum decisions of the Tax Court are published by Wolters Kluwer under the title Tax Court Memorandum Decisions (cited TCM), while the Thomson Reuters series is called TC Memorandum Decisions (cited TC Memo).

The Citator typically gives even further research information than already discussed. For each case listed in the Citator there is given the “cited record” of that case. These “cited records” list the names and citations of later cases which discussed and distinguished the main case. Thus, the “cited record” permits the researcher to evaluate the judicial authority of the related case.

For the very latest developments in any case, the researcher using the Wolters Kluwer Citator should also check the “Case Table” (for the current year) in Volume 19, the “New Matters” volume of the Standard. Appeals to higher courts, IRS acquiescences or nonacquiescences, and government decisions on whether to appeal federal court cases are shown in the “Case Table” (for the current year) for all cases. (Where Supreme Court action is indicated in the Case Table, more information on the case may be obtained from the Supreme Court Docket located in the New Matters Volume.)

Books

In addition to the loose-leaf reference services and the bound volumes of tax-related court cases published in the special reporter series U.S. Tax Cases (USTC) available from Wolters Kluwer or the American Federal Tax Reports (AFTR) available from Thomson Reuters, a well-equipped tax library should contain numerous leading tax textbooks.

Following are selected, highly recommended tax books:

Price on Contemporary Estate Planning, John R. Price and Samuel A. Donaldson (Wolters Kluwer)

Federal Tax Practitioner's Guide, Susan Flax Posner (Wolters Kluwer)

Federal Income Taxation of Corporations and Shareholders, Boris I. Bittker and James I. Eustice (Thomson Reuters)

S Corporation Taxation, Robert W. Jamison (Wolters Kluwer)

Practical Guide to Partnerships and LLCs, Robert Ricketts and Larry Tunnell (Wolters Kluwer)

Practical Guide to U.S. Taxation of International Transactions, Robert J. Misey, Jr. and Michael S. Schadewald (Wolters Kluwer)

Partnership Taxation, Arthur Willis, Philip Postlewaite, and Jennifer Alexander (Thomson Reuters)

Tax Institutes

Current tax topics are discussed and technical papers presented at the various tax institutes and symposia held annually at universities and other locations throughout the United States. The well-known tax institutes, such as New York University and the National Tax Association—Tax Institute of America, publish their annual proceedings. The papers presented at the annual University of Chicago Federal Tax Conference are published every year in the March issue of TAXES—The Tax Magazine. The papers presented at the annual UCLA Tax Controversy Institute and the New York University Tax Controversy Forum are published each year in the December-January and August-September issues of the Journal of Tax Practice and Procedure.

Tax Periodicals

Several monthly and quarterly journals contain current articles dealing exclusively with technical tax matters. Some of these magazines cover a broad range of tax topics, while others specialize in a particular area of taxation.

Following are some of the more popular tax periodicals:

Corporate Taxation (Thomson Reuters)

CPA Journal (New York State Society of Certified Public Accountants)

Estate Planning (Thomson Reuters)

International Tax Journal (Wolters Kluwer)

Journal of the American Taxation Association (American Taxation Association)

Journal of Tax Practice and Procedure (Wolters Kluwer)

Journal of Taxation (Thomson Reuters)

Journal of Taxation of Financial Products (Wolters Kluwer)

National Tax Journal (National Tax Association)

Practical Tax Strategies (Thomson Reuters)

Tax Adviser (American Institute of Certified Public Accountants)

Tax Executive (Tax Executives Institute)

Tax Law Review (New York University School of Law)

Tax Lawyer (American Bar Association)

TAXES—The Tax Magazine (Wolters Kluwer)

Trusts and Estates (Penton Media, Inc.)

Newsletters

The practitioner needs to stay on top of current developments in the tax field and for this purpose finds that weekly and even daily updates of pertinent tax law information is needed. Daily reporting is available both electronically through online computer legal research systems from tax publishers and through the mail. There is the daily Tax Day News and Federal Tax Weekly, published by Wolters Kluwer; the Bloomberg BNA Daily Tax Report, available from Bloomberg BNA; and Tax Analysts’ Tax Notes Today.

Research Methodology

¶2125

TYPES OF TAX RESEARCH SITUATIONS

Essentially, there are two types of tax research cases or situations. The “closed-fact” case, sometimes referred to as ex post facto research, involves the legal interpretation of historical events. In such cases, the taxable transactions have already occurred and can no longer be altered, although various tax elections and alternatives might still be available. Two common examples of “closed-fact” situations are preparation of a tax return after the taxable year is completed and representation of a taxpayer before the Audit Division of the IRS on the examination of a previously filed tax return.

In contrast, the “open-fact” case typically involves events that have not yet been finalized (i.e., controllable facts). Thus, this type of research relates primarily to future planning decisions. However, whether the primary focus of a research engagement is for tax compliance or tax planning, the underlying methods and techniques should be systematic, thorough, properly documented, and effectively communicated to the client.

¶2135

RESEARCH MODEL

The following research model presents a five-step systematic format that can be applied to a “closed-fact” or an “open-fact” case:

1. Gathering the facts and identifying the tax issues to be researched.

2. Locating and studying the primary and secondary authorities relevant to the enumerated tax issues.

3. Updating and evaluating the weight of the various authorities.

4. Reexamining various facets of the research.

5. Arriving at conclusions and communicating these conclusions to the client.

STEP 1: Gathering the Facts and Identifying the Tax Issues to Be Researched

During this difficult part of the research process it is necessary to elicit a comprehensive, unbiased report from the client. Difficulty stems from the fact that taxpayers often tend to have a simple perspective of the tax issues related to their problem. They fail to see the multiple issues that might be involved in what they perceive as a single, straightforward issue.

EXAMPLE 2.1

Mary Jones, a single taxpayer, moved from New York to Miami in 2020. Accordingly, she sold her residence in New York at a gain well in excess of $400,000. In preparation of her 2020 tax return, since the gain on the sale of this residence is quite substantial, the researcher must examine the facts and explore the tax-savings elections.

Mary is asked to provide all information related to these events, and she supplies the real estate closing statement reflecting the sale of the New York residence. As far as Mary is concerned, she has supplied “all” information necessary to resolve this issue. However, the following facts must still be ascertained:

1. What was the cost of the New York residence?

2. Should any improvements be capitalized as part of the basis of the New York residence?

3. Were there any selling costs involved with the sale?

4. Over the years, were there any property assessments that should be capitalized as part of the basis of the New York residence?

5. Was any portion of the New York residence depreciated as a home office deduction on prior tax returns?

6. Is Mary eligible for the $250,000 tax-free exclusion?

STEP 2: Locating and Studying the Secondary and Primary Authorities Relevant to the Enumerated Tax Issues

For each issue enumerated in Step 1, the research might begin with a thorough reading of the compilation materials found in the tax services whether in print format (loose-leaf and books) or electronic format. The editorial explanations and observations provide useful insights and help direct the research process. Additionally, the research should continue with a review of the applicable Code sections, Regulations, and digests of selected judicial decisions. Those cases which seem particularly appropriate to the research should be cited to facilitate reference for subsequent follow-up study. Finally, before leaving the tax services, it is imperative to refer to the “Current Developments” section to examine the impact of recent actions.

STEP 3: Updating and Evaluating the Weight of the Various Authorities

The statutory and administrative authorities selected in Step 2 must now be evaluated to determine relative weight. Additionally, the relevant court cases must be assessed in terms of their value as judicial precedent. Before relying upon a particular decision, it is essential to refer to one of the citator services and review the history and current status of that case.

It is not uncommon to discover conflicting interpretations of similar issues by different courts. In place of a national law policy, the Tax Court has adopted the position that better judicial administration requires it to follow a Court of Appeals decision. Nevertheless, courts at the same level of jurisdiction may issue conflicting opinions; whereas, the Internal Revenue Service is not obligated to adhere to either decision on a nationwide basis. Accordingly, a District or Circuit Court decision favorable to a taxpayer has significant precedent value only within that district or circuit.

STEP 4: Reexamining Various Facets of the Research

After studying and evaluating the various statutory, administrative, and judicial authorities, it often becomes necessary to reexamine the original tax problem. It may even become necessary to seek additional facts and modify or expand the research process.

Additionally, if there are any authorities in conflict with the projected conclusions, it is essential to study them carefully. The researcher must not only be able to support his or her own research conclusions, but also must be prepared to defend these conclusions in light of conflicting authorities.

During this phase of the research, it may sometimes be useful to clarify the meanings of unfamiliar or highly technical words or terms. A standard dictionary may provide some guidance, but if the words are not generally used in a nonlegal context, Black’s Law Dictionary should be consulted.

STEP 5: Arriving at Conclusions and Communicating the Conclusions to the Client

Communicating the conclusions of the tax research to the client requires professional judgment. The client should be advised of the potential benefits and risks associated with the recommended actions. Since the communication will be in writing, it is essential to determine how much or how little detail should be noted. Additionally, the communication must be expressed at the client’s level of sophistication. This sometimes presents a difficult task, especially when the research involves complex issues and highly technical reasoning.

Essentially, the communication should be concise, well-structured, and should follow an organized format that includes:

1. A review of the facts

2. An enumeration of the various tax issues

3. The conclusions

4. A discussion of the reasoning and authorities supporting the conclusions

While the client might be concerned only with the section dealing with conclusions, the professional substance of the communication is contained in the reasoning and authority. It is in this section of the report that the various authorities are discussed and evaluated. Finally, it is in this section that the client is supplied with authoritative support, should it ever become necessary to defend against a challenge by the Internal Revenue Service.

Tax Administration

¶2211

ORGANIZATION OF THE IRS

The administration and enforcement of federal internal revenue taxes are required to be performed under the supervision of the Secretary of the Treasury. Code Sec. 7801(a). The Internal Revenue Service, a division of the Department of the Treasury, has been delegated the operational aspects of the determination, assessment, and collection of all internal revenue taxes. The Commissioner of Internal Revenue, the official in charge, is appointed by the President and serves under the Secretary of the Treasury. Code Sec. 7802.

The Internal Revenue Service (IRS) consists of a National Office, headquartered in Washington, D.C., and an extensive field organization composed of over a hundred thousand revenue agents, revenue officers, and support personnel. The main task of the National Office is to develop uniform policies for the nationwide administration of the tax law and coordinate the various operations of the IRS.

Internal Revenue Service Restructuring and Reform Act of 1998

In accordance with the Internal Revenue Service Restructuring and Reform Act of 1998, the IRS modified its entire structure. The structure divides the IRS into four operating divisions. Each operating division is responsible for serving a group of similar taxpayers. The structure is organized to reflect specific types of taxpayers and common issues associated with these taxpayers. See  Exhibit 5 .

Exhibit 5. IRS ORGANIZATION CHART

The IRS’s mission is to:

Provide America’s taxpayers top quality service by helping them understand and meet their tax responsibilities and by applying the tax law with integrity and fairness to all.

The four operating divisions are supported by two agency-wide service organizations: (1) Services and Enforcement; and (2) Operations Support. In addition, the IRS Appeals Office, the Taxpayer Advocate Service, the Office of the Chief Counsel and Criminal Investigation are nationwide organizations that provide separate specialized services.

The Operating Divisions

Wage and Investment Division (W&I)

W&I covers individual taxpayers who only receive wage and/or investment income, which includes approximately 88 million filers. Most of these taxpayers only deal with the IRS when filing their tax returns each year. Compliance matters are limited to such issues as dependency exemption, credits, filing status, and deductions. Much of the income earned by W&I taxpayers is reported by third parties (such as employers, banks, brokerage firms) and the income is generally collected through third-party withholding. Thus, this group is generally highly compliant. Most of these taxpayers earn under $50,000 a year.

Small Business and Self-Employed Division (SB/SE)

SB/SE is comprised of fully or partially self-employed individuals and small businesses. It includes corporations and partnerships with assets less than or equal to $10 million. Also, estate and gift taxpayers, fiduciary returns and all individuals who file international returns are examined by this group, which includes approximately 57 million filers. Typical taxpayers from this group interact with the IRS 4 to 60 times per year.

Large Business and International Division (LB&I)

LB&I includes businesses with assets over $10 million. Many complex matters, such as tax law interpretation, accounting and regulation issues, are common. The largest taxpayers in this group deal with the IRS on an almost continuous basis. The LB&I is organized into support and practice areas. There are five practice areas and three compliance practice areas.

Tax-Exempt Organizations and Governmental Entities Division (TE/GE)

TE/GE includes pension plans, exempt organizations and the governmental entities, and is comprised of about 24 million filers.

Other Units

Criminal Investigation (CI)

CI’s mission is to the serve the public by investigating potential criminal violations of the Internal Revenue Code and related financial crimes. Its investigative jurisdiction includes tax, money laundering, and Bank Secrecy Act laws. It is comprised of three interdependent programs: Legal Source Tax Crimes; Illegal Source Financial Crimes; and Narcotics Related and Counterterrorism Financial Crimes.

Appeals

The IRS Appeals Office is headquartered in Washington, D.C. and serves as the administrative forum for any taxpayer contesting an IRS compliance action. It encompasses numerous programs, including Alternative Dispute Resolution, Technical Guidance-International, Art Appraisal Services, among others.

Taxpayer Advocate Service (TAS)

The TAS helps taxpayers who have problems with the IRS, and who were not able to get them resolved through the normal administrative process. The TAS is organized around two major functions: (1) the casework function—to resolve all individual taxpayer problems; and (2) the systemic analysis and the advocacy function—to work with the operating divisions to identify systemic problems, analyze root causes, implement solutions, and proactively identify potential problems with new systems and procedures. The TAS has offices in every state, the District of Columbia, and Puerto Rico.

Office of Chief Counsel

The Chief Counsel serves as the chief legal advisor to the IRS Commissioner regarding matters pertaining to the operation, administration and enforcement of the internal revenue laws. The Chief Counsel provides legal guidance and interpretative advice to the IRS, the Treasury Department, and taxpayers

Office of Professional Responsibility

The Office of Professional Responsibility establishes and enforces consistent standards of competence, integrity, and conduct for tax professionals. It issues Circular 230.

Whistleblower Office

The IRS Whistleblower Office processes tips received from individuals who spot tax problems in their workplace, while conducting day-to-day personal business or anywhere else they may be encountered. The Whistleblower Office is responsible for assessing and analyzing the tips and, after determining their degree of credibility, the case is assigned to the appropriate IRS office for further investigation. An award worth 15 to 30 percent of the total proceeds that the IRS collects could be paid if the IRS moves ahead based on the information provided.

Communications and Liaison

The Communications and Liaison Division attempts to ensure that communications with customers, Congress, and stakeholders are consistent and coordinated. The Division also attempts to ensure that there is a quality work environment that is operationally efficient and effective, including an emphasis on automating business processes. It attempts to ensure that there is appropriate collection, use, and protection of information to accomplish IRS business objectives.

Office of Privacy, Governmental Liaison and Disclosure

This Division is intended to preserve and enhance public confidence by advocating for the protection and proper use of identity information. It administers the IRS’s privacy and records policy and initiatves and coordinates privacy and records-related actions across the IRS.

Return Preparer Office

This office’s mission is to improve compliance by providing comprehensive oversight and support of tax professionals. Its goal is to improve the compliance and accuracy of tax returns prepared by tax return preparers. It oversees preparer tax identification numbers (PTINs), enrollment programs, IRS-approved continuing education providers, and the Annual Filing Season Program for tax return preparers.

Office of Equity, Diversity & Inclusion (EDI)

The EDI Office oversees the Internal Revenue Service' compliance with federal legislation, statutory requirements and executive orders and to uphold taxpayer civil rights. It also fosters workplace equality by ensuring that the IRS follows Equal Employment Opportunity (EEO) principles throughout the agency.

¶2215

REPRESENTATION OF TAXPAYERS

Rules for persons representing taxpayers before the IRS are published in Treasury Department Circular No. 230. See 31 CFR Part 10. The phrase “practice before the IRS” includes all matters connected with presentation to the IRS relating to a client’s rights, privileges, or liabilities under laws or regulations administered by the IRS. Circular No. 230, Sec. 10.2.

Neither the preparation of a return nor the appearance as a witness for the taxpayer is considered practice before the IRS. Attorneys or certified public accountants who are not under suspension or disbarment may practice before the IRS, as may any person enrolled as an agent. The latter individual, however, must demonstrate special competence in tax matters by written examination administered by the IRS. Treasury Department Circular No. 230, Sec. 10.4.

In certain situations, other persons may represent taxpayers. Individuals may appear on their own behalf, and, in addition, Treasury Department Circular No. 230, Sec. 10.7, states a number of situations where individuals may appear on behalf of others without enrollment:

1. An individual may represent another individual who is his or her full-time employer, a partnership of which he or she is a general partner or a full-time employee, or a family member.

2. Corporations, associations, or organized groups may be represented by bona fide officers or full-time employees.

3. Trusts, receiverships, guardianships, or estates may be represented by their trustees, receivers, guardians, administrators, or executors or full-time employees.

4. Governmental units, agencies, or authority may be represented by an officer or regular employee of such governmental unit, agency or authority.

5. An individual may represent any individual or entity that is outside the United States before IRS personnel when such representation takes place outside the United States.

6. An individual who prepares the taxpayer’s return as a preparer and who has completed the Annual Filing Season Program (AFSP) may represent the taxpayer before officers and employees of the Examination Division of the IRS.

EXAMPLE 2.2

Sam Spaulding is being audited by the IRS for tax years 2018 and 2019. He prepared his own 2018 return, but ABC Tax Return Preparation Service prepared his 2019 return. ABC could represent Sam on matters relating to the 2019 return but only at the agent or examining officer level, not at the higher level of the Appeals Division and only if ABC meets the AFSP requirements.

Circular No. 230, Secs. 10.20 to 10.37, states a number of rules relative to practice before the IRS by tax preparers:

1. They shall not neglect or refuse promptly to submit records or information requested by the IRS.

2. They shall advise the client promptly of any noncompliance, error, or omission that may have been on any return or document submitted to the IRS.

3. They shall exercise due diligence in preparing returns and documents and in determining the correctness of oral or written representations made by them to the IRS and to clients.

4. They shall not unreasonably delay the prompt disposition of any matter before the IRS.

5. They shall not in any IRS matter knowingly and directly or indirectly employ or accept assistance from any person who is under disbarment or suspension from practice before the IRS.

6. They shall not charge an unconscionable fee for representation of a client in any matter before the IRS.

7. They shall not represent clients with conflicting interests.

8. They shall not use or participate in the use of any form of public communication containing false, fraudulent, misleading, or unfair statements or claims.

¶2225

RULINGS PROGRAMS

Since passage of the first income tax laws, the IRS has engaged in major publication efforts to provide taxpayers and their advisors with the most current interpretive views of all areas of federal income tax law. The Internal Revenue Bulletin is the authoritative instrument of the IRS for announcing official rulings (Revenue Rulings and Revenue Procedures) and for publishing Treasury Decisions, Executive Orders, Tax Conventions, legislation, and other items of general interest. Since publication invites reliance, taxpayers must be aware of the degree of authoritative weight that may be accorded such documents. See detailed discussion at  ¶2035 .

In addition, Technical Information Releases (TIRs) and Announcements are periodically distributed by the IRS to advise the public of various technical matters. While these pronouncements are published weekly in the Internal Revenue Bulletin, they were not usually included in the Cumulative Bulletin.

The IRS also issues communications to individual taxpayers and IRS personnel in three primary ways: (1) letter rulings, (2) determination letters, and (3) technical advice memoranda. These documents are part of the IRS Rulings Program, which includes published rulings appearing in the Internal Revenue Bulletin, although letter rulings are not published in the Internal Revenue Bulletin.

Letter Rulings

A letter ruling is a “written determination issued to a taxpayer that interprets and applies the tax laws to that taxpayer’s specific set of facts.” Rev. Proc. 2020-1, Sec. 2.01, IRB 2020-1. Letter rulings generally are issued on uncompleted, actual (rather than hypothetical) transactions or on transactions that have been completed before the filing of the tax return for the year in question. Thus, the emphasis of the letter rulings program is upon the questions or problems of the taxpayer, in contrast to the published rulings program, where the emphasis is centered on uniformity of interpretation of the tax law.

It is the policy of the IRS, however, not to issue letter rulings in a number of general areas:

1. Results of transactions that lack bona fide business purposes or have as their principal purpose the reduction of federal taxes.

2. Matters on which a court decision adverse to the government has been handed down and the question of following the decision or litigating further has not yet been resolved.

3. Matters involving the prospective application of the estate tax to the property or the estate of a living person.

4. Matters involving alternate plans of proposed transactions or involving hypothetical situations.

5. Matters involving the federal tax consequences of any proposed federal, state, local, or municipal legislation.

6. Whether a proposed transaction would subject the taxpayer to a criminal penalty.

Further, it is the policy of the IRS to provide revised lists of those areas of the Internal Revenue Code in which advanced rulings or determination letters will not or will “not ordinarily” be issued. (“Not ordinarily” connotes that unique and compelling reasons must be demonstrated to justify a ruling or determination letter.) Additions or deletions to the revised lists are made as needed to reflect the current policy of the IRS and are set out in several Revenue Procedures. For example, no ruling will be issued to determine whether compensation is reasonable in amount and therefore allowable as a deduction under Code Sec. 162. This is but one of over 130 areas identified by the IRS for nonissuance of letter rulings. There is also a listing of over 60 areas in which rulings will not ordinarily be issued. Rev. Proc. 2020-3, Sec. 3 and 4, 2020-1 IRB. Areas in international transactions for which rulings will not be issued are also listed. Rev. Proc. 2020-7, Sec. 3, 2020-1 IRB.

The issuance of rulings serves to reduce the number of disputes with revenue agents. A favorable ruling generally will avoid any controversy with an agent in the event of a later audit. For the taxpayer, rulings reduce the uncertainty of tax consequences of a particular action. On the other hand, a ruling request has some disadvantages. Cost is a factor since, under the IRS user fee program, a taxpayer will have to pay fees to have a request prepared. Code Sec. 7805. Rev. Proc. 2020-1, Appendix A, 2020-1 IRB. Also, there is often delay in obtaining a ruling, which could be difficult for the taxpayer if time is a significant factor.

Detailed instructions as to the information that a taxpayer should submit in requesting a ruling are given in Rev. Proc. 2020-1, supra.

PLANNING POINTER

Although there may be advantages to obtaining a ruling, it may not always be desirable to request a ruling. If the tax results are uncertain but the taxpayer wants to go ahead with a proposed transaction, it might be unwise to request a ruling. Also, if time is a crucial factor and the proposed transaction is so complex that a long time might pass before a response to a ruling request would be given, it might be unwise to request a ruling.

Determination Letters

The determination letter program is part of the letter rulings program. Determination Letters are not published; however, the IRS is now required to make individual rulings available for public inspection. A determination letter is a written statement issued by a Director in response to an inquiry by an individual or an organization. It applies to the particular facts involved and is based upon principles and precedents previously announced by the National Office to a specific set of facts. Rev. Proc. 2020-1, Sec. 2.03, supra. Determination letters are issued in response to taxpayers’ requests submitted to the Director, whereas letter rulings are issued by the National Office. The most important use of determination letters in prospective transactions is in the qualification of pension plans and the determination of the tax-exempt status of an organization.

PLANNING POINTER

It is advisable for taxpayers to request a determination letter in connection with pension plans; otherwise, the taxpayer may later find out that the plan does not qualify and deductions might be disallowed.

A Director may not issue a determination letter in response to an inquiry relating to a question specifically covered by statute, regulations, rulings, etc. published in the Internal Revenue Bulletin where (1) it appears that the taxpayer has directed a similar inquiry to the National Office; (2) the identical issue involving the same taxpayer is pending in a case before the Appeals Office; (3) the determination letter is requested by an industry, trade, or similar group; or (4) the request involves an industry-wide problem. Reg. §601.201(c)(4). The form for a request for a determination letter is the same as that for a ruling. Rev. Proc. 2020-1, supra.

Technical Advice Memoranda

A technical advice memorandum is advice or guidance furnished by the National Office upon request of a District or an Appeals Office in response to any technical or procedural question that develops during the examination or appeals process. Rev. Proc. 2020-2, Sec. 3, 2020-1 IRB. Both the taxpayer and the District or Appeals Office may request technical advice. The taxpayer may request advice where there appears to be a lack of uniformity in the application of law or where the issue is unusual or complex. Technical advice adverse to the taxpayer and furnished to an Appeals Office does not preclude the possibility of settlement. Technical advice can also be advantageous from the IRS’s viewpoint in that it serves to establish consistent holdings in field offices. Responses to requests for technical advice memoranda sometimes become the basis for a Revenue Ruling.

PLANNING POINTER

A revenue agent sometimes tends to resolve issues against the taxpayer, even though the agent may actually believe the taxpayer’s viewpoints are valid. Thus, the agent may actually welcome a taxpayer’s request for technical advice because the advice may coincide with what the agent actually believed and yet the agent will not have to be the one who made the decision in favor of the taxpayer.

User Fee Program

The payment of user fees is required for all requests to the IRS for rulings, opinion letters, determination letters, and similar requests. The IRS issues schedules of fees and procedures for the collection of the fees along with other guidelines as prescribed by the Revenue Act of 1987. The fee schedules range from $275 to $181,500 (for pre-filing agreements). Rev. Proc. 2020-1, Appendix A, 2020-1 IRB.

¶2245

TAXPAYER COMPLIANCE ASSISTANCE

In order to assist taxpayers, individuals, corporations, partnerships, and other legal entities to be in compliance with requirements of the Internal Revenue Code and regulations, the IRS develops and issues IRS Publications that address a variety of general and special topics of concern to taxpayers. A typical IRS Publication highlights changes in the tax law in a specific area (for example, Pub. No. 970, Tax Benefits for Education), explains the purpose of the law, defines terminology, lists exemptions, provides several examples, and includes sample worksheets and filled-in forms. As to taxpayer reliance, the IRS warns in every IRS Publication that information provided covers only the most common tax situation and is not intended to replace the law or change its meaning. Even though IRS Publications do not bind the IRS, the information contained in IRS Publications provides essential guidance for tax law compliance, particularly in technical or specialized areas.

Tax Practice and Procedure

¶2301

EXAMINATION OF RETURNS

Selection of Returns

The selection of returns for examination begins at the service centers. Returns can be selected by computer programs or by manual selection. The IRS uses the Discriminant Inventory Function (DIF) system, which involves computer scoring using mathematical formulas to select tax returns with the highest probability of errors. Returns with the highest scores are then manually examined by district classifiers, who determine whether a return should be subject to examination. Internal Revenue Manual, Sec. 4.1.5.1.1. Taxpayers are divided into classes, including such classifications as business versus nonbusiness; total positive income of varying amounts for nonbusiness returns; and total gross receipts of varying amounts for business returns. Total Positive Income (TPI) is defined as the sum of positive income items on the return, such as wages, interest, dividends, and other income items, with losses treated as zero.

Returns are sometimes chosen at random for the National Research Program (NRP). NRP is a program for measuring taxpayer compliance through specialized audits of individual tax returns. The principal uses of NRP data are to measure the levels of compliance and tax administration gaps necessary for formulation of the IRS’s long-term enforcement policies, to determine changes in compliance levels over a period of time in order to properly direct enforcement programs, to develop and improve return selection procedures and changes in the DIF scores, to identify alternative methods of operation, and to achieve greater operating economies.

Other events that might give rise to an examination are:

1. Total positive income is above specified amounts.

2. Another IRS office or a non-IRS party might provide information (e.g., a tip from a bitter former spouse).

3. A claim for refund may result in a closer examination of the return.

4. A return of a related party (family member, partner) might be examined to determine the correctness of the taxpayer’s return.

EXAMPLE 2.3

Arthur and Beverly Saunders were divorced in 2020. During their marriage, Arthur had not reported some consulting income he received beyond his regular salary. Beverly, still upset about the divorce, reports Arthur to the IRS. This may result in an audit.

EXAMPLE 2.4

In 2020, Charles Regus files an amended return with a sizeable refund claim as a result of educational expense deductions that he could have taken on his 2018 return, but which he failed to take because he was uncertain as to whether they would qualify. It is possible that close examination of his 2018 return might occur as a result of this claim for refund. However, if Charles believes he has a good case, he should file the amended return.

Correspondence Examinations

Correspondence examinations involve relatively simple problems that can generally be resolved by mail. These examinations would include mathematical errors, broadly defined in Code Sec. 6213(g)(2) to mean (1) an error in addition, subtraction, multiplication, or division shown on any return; (2) an incorrect use of any IRS table if such incorrect use is apparent from other information on the return; (3) inconsistent entries on the return; (4) an omission of information required to be supplied on the return to substantiate a return item; and (5) a deduction or credit that exceeds a statutory limit that is either a specified monetary amount or a percentage, ratio, or fraction—if the items entering into the application of such limit appear on the return.

EXAMPLE 2.5

James Judson, single, incorrectly determines his tax liability because he used the joint rate schedule rather than the single rate schedule. This correction and adjustment can be resolved by mail.

The Service Center personnel might also question specific items under the Unallowable Items Program. For example, a deduction of Social Security taxes by the taxpayer would result in notification by the Service Center. Such a contact is considered to be an examination in contrast to a mathematical/clerical error notification, which is not considered to be an examination. (If it is an examination, one is entitled to a notice of deficiency and to administrative appeal.) The IRS also matches information returns of some taxpayers with income tax returns. If there is a discrepancy, the return will be corrected, or the file might be referred for examination and possibly criminal investigation.

District Office Examinations

A District Office examination of a return is conducted by a tax auditor of the Audit Division either by correspondence or by interview. Sometimes the matters are so simple they can be handled by correspondence. Verification of particular itemized deductions, such as interest, taxes, or charitable contributions might be handled by correspondence. Internal Revenue Manual, Sec. 4.10.2 and 3.

Returns selected for interview examinations generally require some analysis and judgment as well as verification. Examples of types of issues that lend themselves to interview examinations are income items that are not subject to withholding, deductions for travel and entertainment, items, such as casualty and theft losses, that involve the use of fair market value, education expenses, deductions for business-related expenses, and determination of basis of property. Also, if the taxpayer’s income is low in relation to financial responsibilities as indicated on the return through the number of dependents or interest expense, or if the taxpayer’s occupation is of the type that required only a limited formal education, an office interview might be deemed appropriate. Certain business activities or occupations reported may lend themselves to office interview examinations (e.g., auto repair shops, restaurants, service stations, professional persons, farmers, motels, and others).

EXAMPLE 2.6

Edward Egars, an outside salesperson, reports 2017 income of $25,000 and takes travel and entertainment deductions before application of the 50 percent limit on meals and entertainment of $15,000. Edward could be called in for an office examination to verify his travel and entertainment expenses for 2017.

EXAMPLE 2.7

Jane Judson has adjusted gross income of $15,000 and gives $7,000 in cash contributions to her church. Since her contributions exceed the norm for her bracket and approach the maximum limitation for her income level, she could be called in to verify her charitable contributions.

PLANNING POINTER

In an office examination, the taxpayer or a representative should provide only information or support for items that are requested of the taxpayer by the IRS; otherwise, the tax auditor might open up other areas for investigation. Situations may vary, but some practitioners believe that it is better for the taxpayer, assuming there is a representative, such as a CPA or a lawyer, not to be present because the representative can keep better control over the interview and also maintain a less emotional atmosphere.

When there is a disagreement after an office examination, if practicable, the taxpayer is given an opportunity for an interview with the tax auditor’s immediate supervisor or for a conference with an Appeals Officer. Reg. §601.105(c)(1)(ii). If these actions are not feasible, the taxpayer will be sent a 30-day letter from the District Office indicating the proposed adjustments and the courses of action. If the taxpayer agrees with the adjustment, the taxpayer can sign the agreement form. If the taxpayer disagrees, an Appeals Office conference may be requested within 30 days or the taxpayer may ignore the 30-day letter and wait for the 90-day letter, which allows the taxpayer to file a petition in the Tax Court. Reg. §601.105(c)(1)(ii) and (d)(1)(iv).

Field Examinations

Field examinations are conducted by revenue agents and involve more complex issues than do office examinations. Field audits take place in the taxpayer’s or the taxpayer’s representative’s office or home (in the case of clear need, such as the taxpayer’s advanced age). The revenue agent must identify items that may need adjustment, gather the appropriate evidence, and apply the applicable Code provisions, Regulations, and other interpretative rulings. Techniques have been developed by the IRS to try to ensure that revenue agents consider all areas necessary for a proper calculation of the tax liability. An agent has power to subpoena all books and records and to compel the attendance of witnesses. Code Sec. 7602.

The agent completes a report called the Revenue Agent Report (RAR). In agreed cases, a copy of the RAR is sent to the taxpayer before review. If the taxpayer agrees with the revenue agent’s adjustments and proposals, the taxpayer can sign Form 870 (Waiver of Restrictions on Assessment and Collection of Deficiency in Tax and Acceptance of Overassessment). In unagreed cases, the taxpayer does not receive the RAR until after review by the Review Staff.

PLANNING POINTER

The revenue agent should be treated courteously and should be promptly furnished information and substantiation relating to applicable tax return items. Although the cooperation of the taxpayer (or the taxpayer’s representative) is important, the taxpayer should respond only to questions asked by the agent. Disclosing unnecessary information could cause problems for the taxpayer.

There are some advantages to settling with the revenue agent. In addition to being less costly than settling at higher levels, negotiations with the revenue agent are generally more informal than negotiations at higher levels and less demanding on technical aspects. Also, if questionable issues exist but were not raised at the agent level, it may be wise to settle at that level in order to avoid the possibility of persons at higher levels raising those questionable issues. Similarly, there is an advantage to the revenue agent to have an agreed case because it involves more effort and time to write a report on an unagreed case than on an agreed case.

Audit Reconsideration

The audit reconsideration is a procedure that is used when a taxpayer has ignored a statutory notice of deficiency or where there has been a breakdown in communication between the taxpayer and the IRS. Internal Revenue Manual, Sec. 4.13.4.4. An audit reconsideration is permitted when a new notice was not sent to the taxpayer’s new address, the taxpayer had not received any notification from the IRS on any assessment, and the taxpayer had not been given an opportunity to submit any required substantiation or necessary documentation.

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APPEALS PROCESS

Administrative Process

If the taxpayer and the agent do not agree, the taxpayer will be sent a 30-day letter that explains the appellate procedures and urges the taxpayer to reply within 30 days either by signing the waiver or by requesting a conference. If the taxpayer does not respond to the 30-day letter, a statutory notice of deficiency (90-day letter) will be sent giving the taxpayer 90 days to file a petition with the Tax Court. Thus, if the taxpayer and agent do not agree, the taxpayer has several options:

1. The taxpayer may request a conference in the IRS Appeals Office.

2. After receiving the statutory notice of deficiency, the taxpayer may file a petition in the Tax Court within the 90-day period.

3. The taxpayer could wait for the 90-day period to expire, pay the assessment, and start a refund suit in the District Court or the Court of Federal Claims.

 

If the IRS and the taxpayer agree, the statutory notice of deficiency issued by the IRS (90-day letter) may be rescinded. The rescinded notice voids the limitations regarding credits, refunds, and assessments, and the taxpayer will have no right to petition the Tax Court based on such notice. Rescinding the deficiency notice will allow for resolution of the controversy within the IRS.

IRS Appeals Office

If an appeal is made within the IRS, an appropriate request must be made. The request must be accompanied by a written protest unless:

1. The proposed increase or decrease in tax or claimed refund is not more than $2,500 for any of the tax periods involved in field examination cases.

2. The examination was conducted by a tax auditor (i.e., an office examination) or by correspondence. (See IRS Publication No. 5, Your Appeal Rights and How to Prepare a Protest If You Don't Agree.)

If a protest is required, it should be sent within the 30-day period granted in the letter containing the examination report. The protest should contain:

1. A statement that the taxpayer wants to appeal the findings of the examiner to the Appeals Office

2. Taxpayer’s name and address

3. The date and symbols from the letter transmitting the proposed adjustments and findings the taxpayer is protesting

4. The tax periods or years involved

5. An itemized schedule of the adjustments with which the taxpayer does not agree

6. A statement of facts supporting the taxpayer’s position in any contested factual issue

7. A statement outlining the law or other authority on which the taxpayer is relying

A taxpayer may go to the Appeals Office at two different times: (1) if the protest is filed within the 30-day period as stated in the 30-day letter, or (2) if the 30-day period passes and the taxpayer files a petition in the Tax Court within 90 days after receipt of a statutory notice of deficiency.

Exhibit 6  shows graphically the income tax appeal procedures within the IRS (as described above) and through the court system (as described on the following pages).

Exhibit 6. INCOME TAX APPEAL PROCEDURE

There are a number of important factors to consider in filing a protest and going to the Appeals Office. It is less expensive than litigation and yet the taxpayer leaves open the opportunity to file a petition in the Tax Court or to sue for refund in a District Court or the Court of Federal Claims. In addition, a taxpayer is often able to gather more information about the IRS position in the event the taxpayer needs to carry the case further, and there may be a chance that the taxpayer can convince the Appeals Officer that the IRS was incorrect at the agent level. The Appeals Officer may be at some disadvantage in that the case was not personally prepared and the Appeals Officer is relying on the information presented by the revenue agent, which could be an advantage to the taxpayer.

On the other hand, there may be some disadvantages to having an Appeals Conference. New issues might be raised in an Appeals Conference, although the IRS’s policy is to avoid raising an issue unless the grounds for such action are “substantial” and the potential effect upon tax liability is “material.” Reg. §601.106(d)(1). The Appeals Officer must have a strong reason for raising an issue.

Taxpayers may represent themselves at the Appeals Conference or be represented by an attorney, CPA, or person enrolled to practice before the IRS. The Appeals Officer, who actually handles the appeals, reports to the Regional Director of Appeals who, in turn, reports to the Regional Commissioner. Proceedings before the Appeals Officer are informal and are held in the District Office. The Appeals Officer may request that the taxpayer submit additional information, which could involve additional conferences.

The Appeals Officer may resolve controversies between the taxpayer and the IRS by considering the “hazards of litigation.” The Internal Revenue Manual, Sec. 8.8.6.4, states that a fair and impartial resolution “reflects on an issue-by-issue basis the probable result in event of litigation, or one which reflects mutual concessions for the purpose of settlement based on the relative strength of the opposing positions where there is a substantial uncertainty of the result in event of litigation.” If there is uncertainty as to the application of the law, the Appeals Officer will consider a settlement in view of the hazards that would exist if the case were litigated. Thus, the Appeals Officer, in evaluating a case for settlement, will objectively assess how a court might look at the case rather than attempt to obtain the best results for the IRS. The Appeals Officer considers the value of the evidence that would be presented, the witnesses, the uncertainty as to an issue of fact and the uncertainty as to a conclusion considering the court in which the case might be litigated or appealed.

If a satisfactory settlement of the issue is reached after consideration by the Appeals Office, the taxpayer will be requested to sign Form 870-AD. By signing Form 870-AD, the taxpayer waives restrictions on the assessment and collection of any deficiency. Form 870-AD does not stop the running of interest when filed. It is merely the taxpayer’s offer to waive restrictions, and interest will run until 30 days after the IRS has accepted the offer. If the taxpayer does not agree with the decision at the Appeals level, a notice of deficiency will be issued by the Appeals Office after consideration by the Regional Counsel of the memorandum recommending a notice of deficiency.

Taxpayer’s Rights

The Taxpayer Bill of Rights is a series of provisions that require the Treasury Department to outline in “simple and nontechnical terms the rights of a taxpayer and the obligations of the IRS during an audit.” Additionally, the IRS is required to inform taxpayers of their administrative and appeals rights in the event of an adverse decision, as well as the procedures related to refund claims, taxpayer complaints, collection assessments, levies, and tax liens. The IRS has adopted a Taxpayer Bill of Rights, as proposed by the Taxpayer Advocate Service. See  www.IRS.gov/taxpayer-bill-of-rights  or IRS Publication No. 1, Your Rights as a Taxpayer.

Most significantly, the law requires abatement of penalties resulting from reliance on erroneous written IRS advice, authorizes recovery of damages for failure of the IRS to remove a lawful lien, permits the filing of an application for hardship relief with the IRS Taxpayer Advocate, and outlines provisions whereby a taxpayer, who substantially prevails in an administrative or court proceeding against the IRS, may recover reasonable administrative and litigation costs. Additionally, the law allows a taxpayer or an IRS representative to make an audio recording of an in-person interview regarding the determination or collection of any tax.

Appeal Through the Court System

Within 90 days of mailing of a notice of deficiency, the taxpayer may petition the Tax Court for redetermination of the deficiency. Code Sec. 6213(a). If the 90-day deficiency notice was issued by the Appeals Office, it is possible to arrange for pretrial settlement with the Regional Counsel of the IRS, even after the case has been docketed in the Tax Court. Taxpayers filing a petition with the Tax Court may have their cases handled under less formal rules applicable to “small tax cases” if the amount of the deficiency or claimed overpayment is not greater than $50,000. However, “small tax cases” are not appealable and are not to be treated as precedents for any other cases. Code Sec. 7463(a) and (b). If the taxpayer does not file a petition with the Tax Court within 90 days, the opportunity to appeal to the Tax Court is lost.

The taxpayer can pay the deficiency and file a claim for refund by filing Form 1040X (Amended U.S. Individual Income Tax Return) and mailing it to the IRS Center where the taxpayer filed the original return. A claim for refund must be filed within three years from the date the return was filed or within two years from the date the tax was paid, whichever is later. Code Sec. 6511(a). If the return was filed before the due date, the three-year period starts to run from the date the return was due.

A suit to recover may not be started until after six months from the date the taxpayer filed the claim for refund, unless a decision on the claim for refund was made before then. A suit for refund must be started before the end of two years from the date of mailing of a notice to the taxpayer disallowing part or all of the claim. Code Sec. 6532(a).

Federal Court System

There are three trial courts or courts of original jurisdiction: the U.S. Tax Court, the U.S. District Courts, and the U.S. Court of Federal Claims. Appeal from a decision of the Tax Court or the U.S. District Court may be taken by either side to the federal Court of Appeals for the circuit in which the taxpayer resides or the corporation has its principal place of business. A review of a decision of the U.S. Court of Federal Claims is taken to the U.S. Court of Appeals for the Federal Circuit. The U.S. Supreme Court has jurisdiction to hear appeals or review decisions of the federal Court of Appeals and the U.S. Court of Appeals for the Federal Circuit. (See  Exhibit 2 .) For a detailed discussion of the trial court system, see  ¶2055 .

Choice of Tax Forum

There are a number of factors to consider in deciding whether to litigate a case and where to litigate.

1. Jurisdiction. The Tax Court handles only income, estate, gift, and excess profits tax cases. The District Court and the Court of Federal Claims can litigate all areas of internal revenue taxes.

2. Payment of tax. In the Tax Court, payment of tax is not generally allowed. Section 6213(b)(4) allows the taxpayer to pay the tax after receiving a 90-day letter and still sue in the Tax Court. This feature can be used by the taxpayer to stop the accrual of interest on the deficiency while still choosing the Tax Court forum. In the District Court and the Court of Federal Claims, payment of tax is required. Thus, whether the taxpayer has the money to pay the tax may be a factor in the choice of tax forum.

3. Jury trial. A jury trial is available only in the District Court. Often, tax cases do not make good jury cases because of their complexity. Also, sometimes jurors may be prejudiced against a taxpayer who is wealthier than they are.

4. Rules of evidence. The rules of evidence are most strict in jury trials where efforts must be made to keep the jurors from hearing inappropriate evidence. The evidence rules are more lenient in the Tax Court.

5. Expertise of judges. Since the Tax Court hears only tax cases, the judges are all very knowledgeable in tax law. The District Court judges generally have the least tax expertise since the District Court hears many types of cases.

6. Publicity. There will likely be more publicity in the District Court since such suit is brought in the district in which the taxpayer lives.

7. Legal precedent. The court decisions by which the particular forum will be bound may also be a consideration. The Tax Court is bound by Tax Court decisions (unless the Court of Appeals of the circuit to which the case might be appealed held differently), by the Court of Appeals to which the case might be appealed, and by the U.S. Supreme Court. (See J.E. Golsen, 54 TC 742, Dec. 30,049 (1970), aff’d, 71-2 USTC ¶9497, 445 F.2d 985 (CA-10 1971), cert. denied, 404 U.S. 940, 92 S.Ct. 284.) The District Court is bound by decisions of the Court of Appeals for the circuit to which the decision would be appealed, and by the U.S. Supreme Court. The Court of Federal Claims is bound by decisions of the Court of Appeals for the Federal Circuit and by U.S. Supreme Court decisions.

8. Factual precedent. In certain types of cases, one court may be more favorable to the taxpayer than another court. For example, regarding the characterization of voluntary payments to employees’ widows as a gift or as compensation, the Tax Court decisions have consistently been unfavorable to the taxpayer, while results in the Courts of Appeals have been more balanced. 2020 CCH STANDARD FEDERAL TAX REPORTS ¶5507.4741.

9. Statute of limitations. The statute of limitations is suspended in a filing in the Tax Court whereas suit in the Court of Federal Claims and the District Court does not suspend the statute of limitations. Suspension of the statute of limitations means that the IRS can raise new issues and claims for additional taxes.

10. Discovery. In the District Court and the Court of Federal Claims, both parties (i.e., taxpayer and IRS) have available to them discovery tools that allow them access to the other party’s evidence prior to trial. In the Tax Court, the parties are expected “to attain the objectives of discovery through informal consultation or communication” and no depositions are permitted (except in very limited circumstances). Tax Court Rule 70.

PLANNING POINTER

It is important for taxpayers to be aware of the characteristics of the courts so that an appropriate choice can be made if the taxpayer decides to go to court. A taxpayer, having made a decision to go to the District Court, for example, cannot later decide to go to the Tax Court.

The taxpayer must think very seriously before taking a case to court. Not only may the economic costs be high, but the psychological and emotional costs may be high. The taxpayer must consider whether the tax savings will be worth the legal fees, time, and psychological costs.

A taxpayer, in deciding to which court to take a case, should not look simply at the statistics on taxpayer winnings in the various courts. Statistics like that have some value only if winnings by taxpayers on similar issues are being examined.

KEYSTONE PROBLEM

If a taxpayer is called up for an office examination, what should the taxpayer do? If the taxpayer and the tax auditor do not agree, what steps should be taken? What factors would be considered in deciding whether or not to pursue the matter?

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SETTLEMENT AGREEMENTS

Where a taxpayer and the appeals officer have reached an agreement as to some or all of the issues in controversy, generally the appeals officer will request that the taxpayer sign a Form 870, the same agreement that is used at the district level. However, when neither party with justification is willing to concede in full the unresolved area of disagreement and a resolution of the dispute involves concessions for the purposes of settlement by both parties, a mutual concession settlement is reached, and a Form 870-AD type of agreement is to be used. Form 870 becomes effective as a waiver of restrictions and assessment when received by the Internal Revenue Service, whereas the Form 870-AD is effective upon acceptance by or on behalf of the Commissioner of Internal Revenue.

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REFUNDS

Claims for refund of individual income taxes are to be made on Form 1040X (Amended U.S. Individual Income Tax Return) and on Form 1120X for corporate income tax refunds. The claim for refund must be filed no later than three years from the date the return was filed or no later than two years from the date the tax was paid, whichever period expires later. Code Sec. 6511(a). If the return was filed before the due date, the three-year period starts to run from the date the return was due. There is a special seven-year period of limitation on a claim for refund based on a debt that became wholly worthless or on a worthless security. If the refund claim relates to a net operating loss, capital loss, or credit carryback, the refund claim may be filed within three years after the time for filing the tax return for the year of the loss (or unused credit). Code Sec. 6511(d).

Any tax deducted or withheld at the source during any calendar year is deemed to be paid on the 15th day of the fourth month following the close of the taxable year. Code Sec. 6513(b). Thus, a refund for taxes withheld must be filed within three years of the due date of the return (including extensions). Code Sec. 6511(b).

EXAMPLE 2.8

In 2020, Joe, a college student, worked part-time during the summer. He earned $3,000 and had income tax withheld of $400. He did not file a 2020 tax return by April 15, 2021. If he does not file his 2020 tax return by April 15, 2024, he cannot obtain the refund of $400.

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INTEREST ON UNDER/OVERPAYMENTS

The interest rate that taxpayers must pay for underpayment of taxes is equal to the federal short-term rate plus three percentage points. In the case of overpayment of taxes, the amount of interest owed by the Treasury is equal to the federal short-term rate plus three percentage points. Code Sec. 6621(a). These interest rates are adjusted quarterly, with the new rates becoming effective two months after the date of each adjustment.

Interest is also paid by the IRS on overpayments of tax. However, if any overpayment of tax is refunded within 45 days after the due date of the return (or filing date if later), no interest is allowed. If any overpayment results from a carryback (net operating loss, capital loss, or credit) through filing an amended return, interest is paid only if the overpayment is not refunded within the 45-day period. Code Sec. 6611(e) and (f).

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STATUTE OF LIMITATIONS

Assessment of any tax must be made within three years after the return was filed or after the due date for filing, whichever is later. Code Sec. 6501(a). After making an assessment of tax, the IRS has 10 years in which to initiate collection proceedings. Code Sec. 6502(a).

EXAMPLE 2.9

Fred Forbes filed his 2020 return on February 20, 2021. The government may not assess any additional tax for 2020 after April 15, 2024. If, on the other hand, he had filed his 2020 return on October 8, 2021, the statute of limitations would expire on October 8, 2024.

There are some exceptions to the general rule:

1. There is no limitation on the period for assessment in three cases: (1) false return, (2) willful attempt to evade tax, and (3) no return. Code Sec. 6501(c)(1)-(3).

EXAMPLE 2.10

Linda Lord failed to file tax returns in 2009 and 2010 when she had $20,000 gross income. If the government discovered in 2020 that the returns were not filed, it could assess 2009 and 2010 taxes against Linda.

2. If the taxpayer omits from gross income or overstates expenses an amount that is in excess of 25 percent of the amount of gross income stated on the return, the tax may be assessed at any time within six years after the return is filed or the due date for filing, if later. In computing gross income, revenues from the sale of goods or services are not to be reduced by cost of goods sold. Code Sec. 6501(e)(1). Gross income also includes capital gains but is not reduced by capital losses.

EXAMPLE 2.11

On her 2019 return filed on March 20, 2020, Vera Vaughn reported her salary of $35,000 and taxable interest of $5,000. She failed to report a $9,000 capital gain. Since the $9,000 omission does not exceed $10,000 (25 percent of $40,000), the statute of limitations expires on April 15, 2023. If the omitted capital gain had been $11,000, the statute of limitations would expire on April 15, 2026.

EXAMPLE 2.12

As a sole proprietor, George Ganger had $50,000 sales and $20,000 cost of goods sold, which were reported on his 2019 tax return filed on March 14, 2020. Through an oversight he failed to report $8,000 interest. Since $8,000 interest does not exceed $12,500 (25 percent of $50,000), the statute of limitations expires on April 15, 2023.

3. Where both the taxpayer and the IRS agree, the statute of limitations may be extended for a specific period. The extension must be executed before the expiration of the applicable limitation period. Code Sec. 6501(c)(4).

4. Certain taxpayers may request a prompt assessment. The period of assessment may be shortened to 18 months in the case of a decedent, the estate of a decedent, or a corporation that is dissolved or contemplating dissolution. Code Sec. 6501(d). The purpose of this rule is to allow an estate or corporation to settle its affairs early without having to make contingent plans for later possible tax assessments.

5. If a personal holding company fails to file with its return a schedule regarding its status as a personal holding company, the tax may be assessed at any time within six years after the return is filed. Code Sec. 6501(f).

6. In the case of a deficiency attributable to the application of a carryback (capital loss, net operating loss, or credit), the statute of limitations runs from the year of the loss rather than the carryback year. Code Sec. 6501(h) and (j).

Code Secs. 1311 through 1314 contain provisions to mitigate the effect of the statute of limitations where inequitable results might occur.

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PENALTIES

Penalties are treated as additions to federal internal revenue taxes and are, therefore, not deductible for federal income tax purposes.

Delinquency Penalties

The penalty for failure to file a return on the due date (determined with regard to any extension of time for filing) is 5 percent of the amount of tax due if the failure is for not more than one month, with an additional 5 percent for each additional month or fraction thereof, but not exceeding 25 percent in the aggregate. Code Sec. 6651(a)(1). The penalty is imposed on the net amount due—the difference between (1) the amount required to be shown on the return and (2) the amount paid on or before the due date and the amount of credit that may be claimed on the return. In the case of a fraudulent failure to file a return, the failure to file penalty is increased to 15 percent if the net amount of tax due for each month the return is not filed up to a maximum of five months or 75 percent. Code Sec. 6651(f). The failure to file penalty is reduced by the 0.5 percent failure to pay penalty for any month in which both apply.

The penalty for failure to pay the amount of tax due on a tax return or for failure to pay an assessed tax within 10 days of the date of notice is one-half of one percent of the tax for one month or less and an additional one-half of one percent per month or part thereof until the penalty reaches 25 percent. An additional one-half of one percent per month is assessed if the taxpayer fails to pay a deficiency within 10 days after a notice is issued. Code Sec. 6651(a)(2) and (3) and (d). The penalty is imposed on the net amount due.

Either or both of the penalties can be avoided if the taxpayer can show that failure to file and/or pay was due to reasonable cause and not to willful neglect. Code Sec. 6651(a)(1), (2), and (3). The burden of establishing these facts is on the taxpayer. The Internal Revenue Manual, Sec. 20.1.1.3.2, gives some indication of what would be considered as reasonable cause for purposes of the delinquency penalties:

1. A return mailed in time but returned for insufficient postage.

2. A return filed within the legal period but in the wrong district.

3. Death or serious illness of the taxpayer or in the immediate family.

4. Unavoidable absence of the taxpayer.

5. Destruction of the taxpayer’s business or business records by fire or other casualty.

6. Erroneous information given the taxpayer by an IRS official, or a request for proper blanks or returns not furnished by the IRS in sufficient time to permit the filing of the return by the due date.

7. The taxpayer made an effort to obtain assistance or information necessary to complete the return by a personal appearance at an IRS office but was unsuccessful because the taxpayer, through no fault, was unable to see an IRS representative.

8. The taxpayer is unable to obtain the records necessary to determine the amount of tax due for reasons beyond the taxpayer’s control.

9. The taxpayer contacts a competent tax adviser, furnishes the necessary information, and then is incorrectly advised that the filing of a return is not required.

If the cause does not fall within one of the reasonable causes listed above, the District Director will decide whether the taxpayer established a reasonable cause for delinquency.

Accuracy-Related and Fraud Penalties

The penalties relating to the accuracy of tax returns are consolidated into one accuracy-related penalty equal to 20 percent of the portion of the underpayment to which the penalty applies. The penalty applies to the portion of underpayment attributable to one or more of the following:

1. Negligence

2. Substantial understatement of income tax

3. Substantial valuation misstatement

4. Substantial overstatement of pension liabilities

5. Substantial estate or gift tax valuation understatement

6. Understatements resulting from listed and reportable transactions

The penalty does not apply to any portion of an underpayment attributable to a penalty for fraud. Code Sec. 6662(a) and (b).

For purposes of the consolidated penalty, “underpayment” means the amount by which any tax exceeds the excess of (1) the sum of (a) the amount shown as the tax by a taxpayer on the return, plus (b) amounts not shown as tax that were previously assessed, over (2) the amount of rebates made. Code Sec. 6664(a).

The accuracy-related penalties will not be imposed if it is shown that there was a reasonable cause for the underpayment and that the taxpayer acted in good faith with respect to the underpayment. Code Sec. 6664(c)(1).

Negligence Penalty

A 20-percent penalty is imposed for underpayment of tax due to negligence or disregard of rules and regulations. Code Sec. 6662(a).

EXAMPLE 2.13

Due to negligence, Steven Stover underpaid his taxes for 2020 by $30,000. His penalty is $6,000 (20% × $30,000).

The term “negligence” includes any failure to make a reasonable attempt to comply with the provisions of the Code, and the term “disregard” includes any careless, reckless, or intentional disregard. The definition of negligence is not limited only to the items specified. Thus, all behavior that is considered negligent under present law continues to be within the scope of the negligence penalty. Also, any behavior that is considered negligent by the courts but that is not specifically included within the definition is subject to the penalty.

In an effort to provide guidance as to the scope of the term “negligence,” the Internal Revenue Manual, Sec. 4.10.6.2.1, states that it is “the omission to do something which a reasonable person, guided by those considerations which ordinarily regulate the conduct of human beings, would do, or doing something which a reasonable person would not do.” According to the Manual, Sec. 4.10.6.2.1, the following are examples of cases in which negligence may exist:

1. Taxpayer continues year after year to make substantial errors in reporting income and claiming deductions even though these mistakes have been called to the taxpayer’s attention in previous reports.

2. Taxpayer fails to maintain proper records after being advised through inadequate record procedures to do so and subsequent returns containing substantial errors are filed.

3. Taxpayer took careless and exaggerated deductions unsubstantiated by facts.

4. Taxpayer failed to give any explanation for the understatement of income and for failure to keep books and records.

 

Substantial Understatement of Tax Liability

If there is a substantial understatement of income tax, an amount equal to 20 percent of the amount of the understatement can be assessed. A substantial understatement of income tax occurs when the understatement exceeds the greater of 10 percent of the tax required to be shown on the return or $5,000. Code Sec. 6662(d)(1). In the case of a corporation (except for an S corporation or a personal holding company), the understatement must exceed the greater of 10 percent of the tax required to be shown on the return or $10,000. The amount of the understatement is equal to the excess of the tax required to be shown on the return over the amount of tax that is actually shown on the return.

The penalty can be avoided if there was substantial authority for the tax treatment; if relevant facts affecting the treatment are adequately disclosed in the return or a statement attached to the return; and in the case of tax shelter items, if the taxpayer reasonably believed that the tax treatment of such item was more likely than not the proper treatment. Code Sec. 6662(d)(2)(B) and (C). The penalty can be waived on showing of reasonable cause and that the taxpayer acted in good faith. Code Sec. 6664(c).

Substantial Valuation Misstatement Penalty

All taxpayers having an underpayment of tax attributable to a valuation misstatement are subject to this 20-percent penalty. Code Sec. 6662(e). There is a substantial valuation misstatement if the value of any property (or the adjusted basis of any property) is 150 percent or more of the amount determined to be the correct amount of the valuation or adjusted basis of the property. If the portion of the underpayment that is subject to the penalty is attributable to one or more gross valuation misstatements, the penalty will be applied at the rate of 40 percent. A gross valuation misstatement occurs if the value of the property (or the adjusted basis) was 200 percent or more of the correct amount of the valuation of the adjusted basis of the property. Code Sec. 6662(h)(2)(A). No penalty will be imposed on a taxpayer for a substantial valuation misstatement unless the portion of the underpayment attributable to substantial valuation misstatements exceeds $5,000, or $10,000 in the case of a corporation other than an S corporation or a personal holding company.

EXAMPLE 2.14

Bert Barge gives a painting he purchased three years ago to his alma mater and takes a charitable contribution deduction in the amount of $50,000, the value placed on it by his art professor friend. If the actual value was only $20,000 and if the tax underpayment is $10,000, Bert would be subject to a $4,000 valuation misstatement penalty (40 percent of $10,000). The valuation was more than 200 percent of the correct valuation.

Although valuation misstatements of charitable property resulting in understatements of tax are subject to the accuracy penalty provisions, the charitable deduction penalty waiver for qualified appraisers is still possible. No penalty will be imposed for an underpayment of tax resulting from a substantial or gross misstatement of charitable deduction property if it can be shown that there was a reasonable cause for the underpayment and that the taxpayer acted in good faith.

Substantial Overstatement of Pension Liabilities

The 20-percent penalty for substantial overstatement of pension liabilities applies only if the actuarial determination of pension liabilities is 200 percent or more of the amount determined to be correct. Code Sec. 6662(f). If a portion of the substantial overstatement to which the penalty applies is attributable to a gross valuation misstatement of 400 percent or more, the penalty is doubled to 40 percent of the underpayment. Code Sec. 6662(h). No penalty is imposed if the underpayment for the tax year attributable to substantial overstatements of pension liabilities is $1,000 or less.

Estate or Gift Tax Valuation Understatements

A 20-percent penalty is imposed for estate or gift tax valuation understatement if the value of any property claimed on an estate or gift tax return is 65 percent or less of the amount determined to be the correct amount of the valuation. Code Sec. 6662(g). If the understatement is attributable to a gross valuation misstatement of 40 percent or less of the correct amount, the penalty amount is 40 percent of the underpayment. Code Sec. 6662(h)(2)(C). This penalty applies only if the underpayment attributable to the understatement exceeds $5,000 for a tax period with respect to gift tax (or with respect to the estate in the case of estate tax).

Understatements Resulting from Listed and Reportable Transactions

An accuracy-related penalty is imposed for understatements resulting from listed and reportable transactions. Code Sec. 6662A. The penalty applies to understatements attributable to (1) any listed transaction, and (2) any reportable transaction with a significant tax avoidance purpose. The penalty is generally 20 percent of the understatement if the taxpayer disclosed the transaction, and 30 percent if the transaction was not disclosed.

The listed and reportable transactions penalty is coordinated with three other penalties; (1) The Code Sec. 6662 accuracy-related penalty; (2) Code Sec. 6663 fraud penalty; and (3) the valuation misstatement penalties under Code Sec. 6662(e) and 6662 (h). There is a “reasonable cause” exception, although it is more demanding than the reasonable cause exception to the accuracy-related (Code Sec. 6662) and fraud (Code Sec. 6663) penalties.

Penalty for Aiding Understatement of Tax Liability

Any person who aids in the preparation or presentation of any tax document in connection with matters arising under the internal revenue laws with the knowledge that the document will result in the understatement of tax liability of another person is subject to a penalty of $1,000 ($10,000 for a corporation) for a taxable period. Code Sec. 6701.

Civil Fraud Penalty

If any part of an underpayment is due to fraud, the penalty imposed is 75 percent of the underpayment (the “civil fraud” penalty). Code Sec. 6663(a). Once the IRS establishes that any portion of an underpayment is due to fraud, the entire underpayment is assumed to be attributable to fraud, unless the taxpayer proves otherwise. Code Sec. 6663(b). The 20-percent accuracy-related penalty does not apply to any portion of an underpayment on which the fraud penalty is imposed. However, the accuracy-related penalty may be applied to any portion of the underpayment not attributable to fraud.

EXAMPLE 2.15

Beth Barrett owes a $50,000 deficiency, all due to civil fraud. In addition to the $50,000 tax deficiency, Beth will be liable for a $37,500 (75 percent of $50,000) civil fraud penalty.

Criminal Fraud Penalty

In addition to the civil fraud penalty, criminal fraud penalties may be imposed. Section 7201 provides that “any person who willfully attempts in any manner to evade or defeat any tax imposed by this title or the payment thereof shall, in addition to other penalties provided by law, be guilty of a felony. . . .” In order for there to be criminal fraud, the attempt to evade or defeat tax must be willful, which implies a “voluntary intentional violation of a known legal duty.” C.J. Bishop, 73-1 USTC ¶9459, 412 U.S. 346, 93 S.Ct. 2009 (1973). Thus, an individual’s behavior could not be willful if the actions are done through carelessness, or genuine misunderstanding of what the law requires.

A taxpayer convicted of criminal fraud is subject to a fine of up to $100,000 ($500,000 in the case of a corporation) or imprisonment of up to five years, or both, together with the costs of prosecution. Code Sec. 7201. The more important fraud provisions include the following:

1. Any person who willfully fails to collect or pay over withholding tax is guilty of a felony and, upon conviction, will be fined not more than $10,000, or imprisoned not more than five years, or both, together with the costs of prosecution. Code Sec. 7202.

2. Any person who willfully fails, when required, to pay estimated tax, to file a return, to keep records, or to supply information will be guilty of a misdemeanor and, upon conviction, will be fined not more than $25,000 ($100,000 in the case of a corporation) or imprisoned not more than one year, or both, together with the costs of prosecution. Code Sec. 7203.

3. Any person who willfully furnishes a false or fraudulent statement or who willfully fails to supply an employee with a statement of wages and withholdings will, if convicted, be fined not more than $1,000 or imprisoned not more than one year, or both. Code Sec. 7204.

4. Any person who willfully supplies false or fraudulent information regarding exemptions will, if convicted, be fined not more than $1,000 or imprisoned for not more than one year, or both. Code Sec. 7205.

5. Any person who is convicted under the fraud and false statement statute will be fined not more than $100,000 ($500,000 in the case of a corporation) or imprisoned not more than three years, or both, together with the costs of prosecution. Code Sec. 7206. This statute includes:

a. Making a false declaration that is made under the penalties of perjury

b. Aiding or assisting in preparation or presentation of returns, claims, or other documents that are false as to any material matter

c. Simulating or falsely executing any bond or other document required by the internal revenue laws

d. Removing, depositing, or concealing any property with intent to evade or defeat assessment or collection of any tax

e. Concealing property or withholding, falsifying, or destroying records relating to the financial condition of the taxpayer in connection with an offer in compromise or a closing agreement

6. Any person who willfully delivers or discloses any list, return, statement or other document known to that person to be fraudulent or false as to any material matter will be fined not more than $10,000 ($50,000 in the case of a corporation) or imprisoned not more than one year, or both. Code Sec. 7207.

Estimated Taxes and Underpayment Penalties

All taxpayers are generally required to make interim tax payments of substantially all of their accrued tax liability for the current year. For individuals, this is generally accomplished through withholding. Where withholding is insufficient, however, as is frequently the case with self-employed individuals, the taxpayer must file a declaration of estimated tax and may have to make quarterly estimated tax payments. The specific requirements are set forth in  ¶9165 .

If the total amount of tax paid through withholding and estimated tax payments is not enough, an underpayment penalty is imposed. The underpayment is computed on a quarterly basis and the interest penalty is then applied to these quarterly underpayments. Code Sec. 6654(d)(1). The charge runs until the amount is paid or until the due date of the return, whichever is earlier. An individual taxpayer can avoid the penalty for underpayment if the payments of estimated tax are at least as large as any one of the following:

1. 90 percent of the tax shown on the return or 100 percent (110 percent if adjusted gross income for 2002 and later exceeds $150,000) of the tax shown on the return for the preceding taxable year (assuming it showed a tax liability and covered a taxable year of 12 months). Code Sec. 6654(d)(1)(A) and (B).

2. An amount equal to 90 percent of the tax for the taxable year computed by annualizing the taxable income received for the months in the taxable year ending before the month in which the installment is required to be paid. Code Sec. 6654(d)(2).

The underpayment penalty can be waived if the underpayment is due to casualty, disaster, or other unusual circumstances, or occurs during the first two years after a taxpayer retired after reaching age 62, or became disabled. Code Sec. 6654(e)(3).

A penalty is also imposed on corporations by Code Sec. 6655 for any underpayment of estimated corporate tax. However, no penalty is imposed if the corporation pays estimated tax at least as large as any one of the following:

1. The tax shown on the return of the corporation for the preceding year

2. The tax based on the prior year’s income but determined under the current year’s rates

3. The tax shown on the return of the corporation for the current year.

4. An amount equal to at least 100 percent of the tax due on the current year’s taxable income for specified cutoff periods and on an annualized basis. Code Sec. 6655(d)(1)(B)(ii) and (e).

Note: Large corporations (those with taxable income of $1 million or more in any one of the three preceding tax years) do not qualify for the first two exceptions.

Failure to Make Deposits of Taxes

Employers are liable for payment of the tax that must be withheld. Code Sec. 3402. Unless underpayment is due to reasonable cause and not due to willful neglect, a penalty of as much as 15 percent of the amount of the underpayment may be imposed. Code Sec. 6656(a) and (b).

Tax Preparer Penalties

If an income tax return preparer, in preparing a tax return with an understatement of tax liability, takes a frivolous position or one for which there is not a realistic possibility of being sustained on its merits, the penalty is the greater of $1,000 or 50 percent of the income derived by the tax return preparer with respect to the return. Code Sec. 6694(a). An “income tax return preparer” is any person who prepares for compensation or who employs one or more persons to prepare for compensation any return of tax or any claim for refund of tax. Code Sec. 7701(a)(36). No more than one individual associated with a firm will qualify as a preparer with respect to the same return or refund claim. Under the “one-preparer-per-firm” rule, should more than one member of a firm be involved in providing advice, the individual with supervisory responsibility for the matter will be subject to the penalty as a nonsigning preparer. Reg. §1.6694-1. A preparer is not subject to penalty for failure to follow a rule or regulation if the preparer in good faith and with a reasonable basis takes the position that the rule or regulation does not accurately reflect the Code.

A penalty of the greater of $5,000 or 75 percent of the income derived by the tax return preparer with respect to the return applies if any part of any understatement of liability as to a return or claim for refund is due to a willful attempt to understate the liability or to any reckless or any intentional disregard of the rules or regulations. Code Sec. 6694(b).

EXAMPLE 2.16

A guarantee of a specific amount of refund by a preparer is an example of an action that would give rise to this penalty. Or if the preparer intentionally disregards information given by the taxpayer in order to reduce the taxpayer’s liability, the preparer is guilty of a willful attempt to understate tax liability.

PLANNING POINTER

This does not mean that the preparer may not rely in good faith on the information furnished by the taxpayer. However, the preparer must make reasonable inquiries if the information furnished by the taxpayer appears to be incorrect or incomplete.

A $50 penalty applies each time a preparer (1) fails to furnish a copy of the return to the taxpayer, (2) fails to sign the return, or (3) fails to furnish an identifying number. Code Sec. 6695(a)-(c). The maximum amount for each of these penalties is limited to $27,000 (as adjusted for inflation). Any preparer who fails to retain a copy of the returns prepared or a list of the returns prepared is liable for a penalty of $50 for each such failure, with a maximum fine of $27,000 (as adjusted for inflation) applicable to any one return period. Code Sec. 6695(d). A penalty of $50 applies for each failure to retain and make available to the IRS upon request a list of the preparers employed during a return period and $50 for each failure to set forth a required item in the information list (to a maximum of $27,000 (as adjusted for inflation) for any single return period). Code Sec. 6695(e). Any preparer who endorses or otherwise negotiates a refund check issued to a taxpayer for a return or claim for refund prepared by the preparer is liable for a penalty of $540 (as adjusted for inflation) with respect to each such check. Code Sec. 6695(f).

¶2370

DISCLOSURE OF A POSITION ON A RETURN

The taxpayer may avoid the substantial-understatement penalty and the tax return preparer may avoid the penalty for taking a position for which there is not a realistic possibility of being sustained on its merits by disclosing the item on Form 8275, Disclosure Statement. To avoid the accuracy-related penalty, the taxpayer must disclose any nonfrivolous position for which there is not substantial authority but which has a reasonable basis. Code Sec. 6662(d)(2)(B)(ii). Similarly, the tax return preparer may avoid the $1,000 Code Sec. 6694(a) penalty if any nonfrivolous position that does not have a realistic possibility of being sustained on its merits is disclosed on Form 8275. The “realistic possibility” standard is treated in the regulations as being identical to the “substantial authority” standard in Code Sec. 6662(d)(2)(B)(i). Reg. §1.6694-2(b)(1). Thus, the requirement for disclosure in order to avoid the accuracy-related penalty is identical for both taxpayers and tax preparers, even though the statutory language differs somewhat. Once adequate disclosure has been made, tax preparers are not subject to the penalty as long as the position taken is not frivolous (i.e., not patently improper). Reg. §1.6694-2(c)(1) and (2). For taxpayers, however, the position taken must have a “reasonable basis,” in order to avoid the penalty. Code Sec. 6662(d)(2)(B)(ii)(II). The regulations treat this standard as “significantly higher than the not frivolous standard applicable to preparers.” Reg. §§1.6662-3(b)(3)(ii) and 1.6662-4(e)(2)(i).

¶2375

ETHICS RULES FOR PRACTITIONERS

CPAs and attorneys must practice according to the code of professional ethics of their professions. The codes are similar to Treasury Department Circular No. 230. The Tax Committee of the American Institute of Certified Public Accountants (AICPA) also issued 10 statements on selected topics between 1964 and 1977. The first two statements were withdrawn in 1982. The eight remaining statements were revised in 1988 and in 2001. Prior to 2001, they were advisory opinions of the Committee as to what are appropriate standards of conduct in certain situations. Effective October 31, 2001, the Statements are enforceable standards for AICPA members. Effective January 1, 2010, the sixth and seventh standards were combined resulting in seven standards. Summaries of the current seven “Statements on Standards for Tax Services” follow.

1. With respect to tax return positions, a CPA should comply with the following standards:

a. A CPA should not recommend to a client that a position be taken with respect to the tax treatment of any item on a return unless the CPA has a good faith belief that the position has a realistic possibility of being sustained administratively or judicially on its merits if challenged.

b. A CPA should not prepare or sign a return if the CPA knows that the return takes a position that the CPA could not recommend under the standard expressed in paragraph 1(a).

c. A CPA may recommend a position that the CPA concludes is not frivolous so long as the position is adequately disclosed on the return.

d. In recommending tax return positions and in signing returns, a CPA should, where relevant, advise the client as to the potential penalty consequences of the recommended tax return position, and the opportunity, if any, to avoid such penalties through disclosure.

The CPA should not recommend a tax return position that exploits the Internal Revenue Service audit selection process or serves as a mere “arguing” position solely to obtain leverage in the bargaining process of settlement negotiation with the Internal Revenue Service.

 

2. The CPA should make a reasonable effort to obtain from the client, and provide, appropriate answers to all questions on a tax return before signing as a preparer.

Statement No. 2 indicates that reasonable grounds may exist for omitting an answer:

a. The information is not readily available and the answer is not significant in terms of taxable income or loss or the tax liability shown on the return.

b. Genuine uncertainty exists regarding the meaning of a question in relation to the particular return.

c. The answer to the question is voluminous; in such cases, assurance should be given on the return that the data will be supplied upon an examination.

3. In preparing a return, the CPA may in good faith rely without verification upon information furnished by the client. The CPA should make reasonable inquiries if the information furnished appears to be incorrect, incomplete, or inconsistent either on its face or on the basis of other facts known to the CPA. The CPA should refer to the client’s returns for proper years whenever feasible.

Where the Internal Revenue Code or income tax regulations impose a condition with respect to deductibility or other tax treatment of an item, the CPA should make appropriate inquiries to determine whether such condition has been met.

 

4. A CPA may prepare tax returns involving the use of the taxpayer’s estimates if it is impracticable to obtain exact data, and the estimated amounts are reasonable under the facts and circumstances known to the CPA. When estimates are used, they should be presented in a way that avoids the implication of greater accuracy than exists. Estimated amounts should not be presented in a manner which provides a misleading impression as to the degree of factual accuracy.

There are unusual circumstances where disclosure that an estimate is used is necessary to avoid misleading the Internal Revenue Service regarding the degree of accuracy of the return. Some examples of unusual circumstances are as follows:

a. The taxpayer has died or is ill at the time the return must be filed.

b. The taxpayer has not received a K-1 for a flow-through entity at the time the return must be filed.

c. There is litigation pending that bears on the return.

d. Fire, natural disaster, or computer failure destroyed relevant records.

5. The recommendation of a position to be taken concerning the tax treatment of an item in the preparation of a tax return should be based upon the facts and the law as they are evaluated at the time the return is prepared. Unless the taxpayer is bound as to tax treatment in a later year, the disposition of an item in an administrative proceeding does not govern the taxpayer in the treatment of a similar item in a later year’s return. Therefore, if the CPA follows the standards of Statement No. 1, the CPA may recommend a tax return position, or prepare a tax return that departs from the treatment of an item as concluded in an administrative proceeding or a court decision regarding a prior year’s return.

 

6. The CPA should inform the client promptly upon learning of an error in a previously filed return, an error in a return that is the subject of an administrative proceeding, or upon learning of a client’s failure to file a required return. The CPA should recommend the measures to be taken and such recommendation may be given orally. The CPA should not inform the IRS, and may not do so without the client’s permission, except where required by law.

If the CPA is requested to prepare the current year’s return and the client has not taken appropriate action to correct an error in a prior year’s return, the CPA should consider whether to withdraw from preparing the return. If the CPA does prepare the current year’s return, the CPA should take reasonable steps to ensure that the error is not repeated.

When the CPA is representing a client in an administrative proceeding with respect to a return which contains an error known to the CPA, the CPA should require the client’s agreement to disclose the error to the IRS. Lacking such agreement, the CPA should consider whether to withdraw from representing the client and whether to continue a professional relationship with the client.

 

7. In providing tax advice to clients, the CPA should use professional judgment to ensure that the advice reflects competence and appropriately serves the client’s needs. No standard format or guidelines need be followed in communicating written or oral advice to a client.

The CPA may communicate with a client when subsequent developments affect advice previously provided with respect to significant matters. However, the CPA cannot be expected to communicate later developments except while assisting a client in implementing procedures or plans associated with the advice provided or unless the CPA undertakes this obligation by specific agreement with the client.

TAX BLUNDERS

1. Laura Lerner found out that taxpayers have either partially or completely won around 50 percent of cases brought to the Tax Court. Therefore, she decides on litigation in the Tax Court, where she thinks she has a fairly good chance of being successful. However, in looking at the tax issue with which Laura is concerned, a tax researcher discovers that the taxpayer has never won a case like hers. Laura should not have relied on the overall statistics.

2. Edward Enders decides to take his case to the Tax Court because then he does not have to pay the tax before litigation. After some time has passed, someone tells him that a jury would probably have looked favorably on his case, and now he wants to go to District Court. Having gone to the Tax Court, Edward cannot now take his case to District Court.

3. Vera Vokel, known for her temper, her frugality, and her dislike for the IRS, is requested to come in to the local IRS office for an office examination. Although she had a CPA prepare her return, she decides she would like to save the fees it might cost her to have the CPA represent her and, therefore, decides to go in alone for the examination. In the course of the discussion, she becomes furious at the auditor and is disallowed her items at issue. Vera should have had her CPA represent her and she should probably not have been present herself so that the audit could be conducted in a businesslike and unemotional manner.

SUMMARY

· The primary authoritative sources of the law are statutory, administrative, and judicial.

· The taxpayer can appeal within the IRS and/or decide to go to Tax Court, a U.S. District Court, or the U.S. Court of Federal Claims, and then attempt to appeal to a U.S. Court of Appeals and the U.S. Supreme Court.

· A tax researcher can use tax services, a citator, other types of secondary reference materials, or electronic tax research systems and the internet in the research process.

· The Internal Revenue Service consists of the national office, and an extensive organization consisting of 4 operating divisions and other units.

· The examination of tax returns can be as simple as a correspondence examination or a more involved office examination or field examination.

· A tax practice can involve tax compliance and tax planning.

· Communications between the IRS and taxpayers can include private letter rulings, determination letters, and technical advice.

· There are numerous penalties to which taxpayers and tax preparers may be subject.

· The knowledge and use of ethics is very important for the tax practitioner.

Chapter 3

Individual Taxation—An Overview

OBJECTIVES

After completing  Chapter 3 , you should be able to:

1. Understand the components of the tax formula.

2. Apply the standard deduction to each filing status.

3. Determine whether an individual qualifies as a dependent.

4. Distinguish among the five different filing statuses.

5. Apply the tax tables and the tax rate schedules to taxable income.

OVERVIEW

This chapter discusses the components of the tax formula and studies the implications of the standard deduction to the taxpayer. Additionally, the qualifications for the dependency exemption are analyzed. Finally, the basic filing statuses are examined as well as the role of the tax tables and the tax rate schedules.

¶3001

COMPONENTS OF THE TAX FORMULA

Taxable income is computed using one of the two overall accounting methods, the cash method or the accrual method. It is also possible to use a combination of the two overall methods. Under the cash method, income is reported when it is received and deductions are taken when the expense is paid. The accrual method requires income to be reported when all the events necessary to fix the right to receive payment have occurred and there is reasonable certainty regarding the amount. Likewise, accrual basis taxpayers usually claim a deduction in the year in which all events that fix the liability have occurred, provided the amount of the liability is reasonably determinable.

A basic understanding of the method used to calculate the tax liability is a necessity in the study of federal income taxation. That method is as follows:

	Gross Income
–	Deductions for Adjusted Gross Income
=	Adjusted Gross Income
–	Greater of Itemized Deductions or Standard Deduction
–	Qualified Business Income Deduction
=	Taxable Income
×	Tax Rate
=	Tax Liability
–	Tax Credits and Prepayments
=	Net Tax Due or Refund

¶3011

GROSS INCOME

Gross income includes all items of income from whatever source unless specifically excluded. Examples of gross income include compensation for services, interest, rents, royalties, dividends, and annuities. An individual’s income from business is included in gross income after deducting the cost of goods sold.

The receipt of income can be in different forms such as cash, property, services, or even a forgiveness of an indebtedness. However, income is not reported by a taxpayer until it is realized.

Gross income and inclusions and exclusions will be discussed in further detail in  Chapters 4  and  5 .

¶3015

DEDUCTIONS FOR ADJUSTED GROSS INCOME

To arrive at adjusted gross income, all deductions specifically allowed by law are subtracted from gross income. Some of the items allowed as deductions for adjusted gross income include:

1. Trade or business expenses, such as advertising, depreciation, and utilities.

2. Certain reimbursed employee expenses, such as travel, and transportation expenses.

3. Losses from sale or exchange of property.

These deductions are sometimes referred to as “deductions from gross income” or, since almost all the allowable deductions in this section are business expenses, the deductions are sometimes referred to as “business deductions.” These deductions are discussed in  Chapter 6 .

¶3025

ADJUSTED GROSS INCOME

In the tax formula there are deductions for adjusted gross income and then deductions from adjusted gross income. It is important to take these deductions in the proper categories. Adjusted gross income is an important subtotal because certain other items are based on the amount of adjusted gross income. The credit for child and dependent care expenses along with itemized deductions for medical expenses and charitable contributions, are all based on adjusted gross income.

¶3035

ITEMIZING V. STANDARD DEDUCTION

Itemized deductions are certain expenses of a personal nature that are specifically allowed as a deduction. Items included in this group are: medical expenses, state and local income taxes, property taxes, home mortgage interest, and charitable contributions.

Taxpayers receive the benefit of a minimum amount of itemized deductions called the standard deduction. The standard deduction is a fixed amount used to simplify the computation of the tax liability. It is also designed to eliminate lower-income individuals from the tax rolls. All taxpayers subtract the larger of their itemized deductions or the standard deduction.

The standard deduction is based on the filing status of the taxpayer and is made up of the “basic standard deduction” plus any “additional standard deduction.” The standard deduction is adjusted annually, if necessary, for inflation.

Filing Status	Basic Standard Deduction 2020
Single	$12,400
Married Filing Jointly	24,800
Married Filing Separately	12,400
Head of Household	18,650
Surviving Spouse	24,800

The standard deduction is of principal benefit to moderate and low income level taxpayers since the amount is usually more than the total itemized deductions, which means that such taxpayers need not report their itemized deductions. Thus, the need to audit such returns by the IRS is substantially reduced since the opportunities for error or misstatement of taxable income are lessened.

Additional Standard Deduction for Age and Blindness

An additional standard deduction is allowed for aged or blind taxpayers. The additional standard deduction is the total of the additional amounts allowed for age and blindness. The dollar value of an additional amount will depend on the taxpayer’s filing status. The extra standard deductions effective for 2020 are shown below. The amounts are adjusted for inflation.

Filing Status	Dollar Value of One Additional Filing Status Amount 2020
Single	$1,650
Married Filing Jointly	1,300
Married Filing Separately	1,300
Head of Household	1,650
Surviving Spouse	1,300

Taxpayers can receive an additional standard deduction for being both aged and blind. Thus, a married couple, both of whom are aged and blind, receive an additional standard deduction of $5,200 ($1,300 × 4).

EXAMPLE 3.1

Rebecca Greene, 55, qualifies as a head of household in 2020. Her basic standard deduction is $18,650. She is not entitled to an additional standard deduction.

EXAMPLE 3.2

Assume the same facts as in  Example 3.1 , except that Rebecca is 67 and legally blind. Her basic standard deduction for 2020 is $18,650. She is also entitled to an additional standard deduction of $3,300 ($1,650 for her age and $1,650 for her blindness). Her total standard deduction is $21,950.

EXAMPLE 3.3

Jeffrey and Donna Dirk are both 72 and file a joint return for 2020. Donna is blind. Their basic standard deduction is $24,800. They are entitled to an additional standard deduction of $3,900 ($1,300 × 2 for their age plus $1,300 for Donna’s blindness). Their total standard deduction is $28,700.

To qualify for the old-age additional standard deduction, the taxpayer and/or spouse must be age 65 before the close of the year. For purposes of the old-age additional standard deduction, an individual attains the age of 65 on the day preceding the 65th birthday. Thus, an individual whose 65th birthday falls on January 1 in a given year attains the age of 65 on the last day of the calendar year immediately preceding.

A person is considered blind for the extra standard deduction if that person’s central visual acuity does not exceed 20/200 in the better eye with correcting lenses, or if visual acuity is greater than 20/200 but is accompanied by a limitation in the fields of vision such that the widest diameter of the visual field subtends an angle no greater than 20 degrees.

If the taxpayer or spouse dies during the year, the number of additional standard deduction amounts for age or blindness is determined as of the date of death. Thus, the additional standard deduction for age will not be allowed for an individual who dies before attaining the age of 65 even though the individual would have been 65 before the close of the year.

The additional standard deductions for age 65 or older and blindness apply only to taxpayers and their spouses. No additional standard deduction amounts are allowed to taxpayers who claim an exemption for dependents who are aged or blind.

EXAMPLE 3.4

Darren Davidson is single and fully supports his 70-year-old father. Darren qualifies as a head of household. Darren’s regular standard deduction is $18,650 for 2020. Darren may not claim the additional standard deduction amount for his dependent father.

Married Taxpayers Filing Separately

All taxpayers may not be able to take the larger of itemized deductions or the standard deduction. Rules require both spouses to either itemize or use the standard deduction. If one spouse takes itemized deductions the other spouse is required to also itemize even if itemized deductions are less than the standard deduction for married individuals filing separately.

EXAMPLE 3.5

Joe and Mary Bloome are married but decide to file separate returns for 2020. Joe has adjusted gross income of $50,000 and $15,900 of itemized deductions, while Mary has $25,000 of adjusted gross income and $9,400 of itemized deductions. Joe and Mary can elect not to itemize, in which case they will each use the standard deduction of $12,400. However, if they decide to itemize, Joe will have itemized deductions of $15,900 and Mary will have $9,400 of itemized deductions. Since Joe itemizes, Mary is also required to itemize.

PLANNING POINTER

In situations where total itemized deductions are approximately equal to the standard deduction, it is possible for cash basis taxpayers to obtain a deduction for itemized deductions in one year and to use the standard deduction the next year by proper timing of payments. For example, an individual may pay two years’ church pledges in one year and nothing the next year. It may also be possible to pay real estate or city and state income tax estimated payments prior to the end of the year.

¶3055

TAX RATES

The tax formula implies that the “Taxable Income” figure is multiplied by the appropriate tax rate to arrive at the “Tax Liability.” In reality, the “Tax Liability” is either derived from the appropriate column of the tax tables or is computed from the appropriate line in the tax rate schedules.

Prior to 1986 the maximum tax rate was 50 percent. The tax rate schedules for 1987 ranged from 11 percent to 38.5 percent. The tax rate schedules (reproduced in the Appendix) include seven tax brackets for 2020: 10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 percent, and 37 percent.

¶3065

TAX CREDITS AND PREPAYMENTS

Any tax credits are applied against the income tax. It is significant to note the difference between a credit and a tax deduction. A deduction reduces income to which the rate applies and indirectly reduces the tax liability. A credit directly reduces the tax liability.

The principal credits include the earned income credit, child tax credit, credit for the elderly, general business credit, dependent care credit, education credits, and foreign tax credit. These credits will be discussed in further detail in  Chapter 9 .

The tax liability is further reduced by the amounts withheld on income and by any estimated payments made during the year. Income taxes may be withheld on the various sources of income that a taxpayer receives during the year. Employers are required to withhold income tax on compensation paid to their employees. In addition, estimated payments may be necessary if enough taxes have not been withheld.

¶3075

NET TAX DUE OR REFUND

The tax result after applying the credits and prepayments to the “Tax Liability” is the amount that must be paid to the Internal Revenue Service or the amount overpaid and to be refunded to the taxpayer.

¶3085

CLASSIFICATION OF TAXPAYERS

The Internal Revenue Code defines the term “taxpayer” as any person subject to any internal revenue act. The term “person” includes an individual, a trust, estate, partnership, association, company, or corporation. A “partnership” includes a syndicate, group, pool, joint venture, or other unincorporated venture, through or by means of which any business, financial operation, or venture is carried on and which is not a trust or estate or a corporation. The term “corporation” is not defined but is stated to include associations, joint-stock companies, and insurance companies.

A proper classification of taxpayers is essential in determining the type of tax return to be filed. Individuals have little trouble choosing the right tax return, but problems often arise with artificial entities such as trusts, estates, partnerships, corporations, and associations.

Taxpayers are usually classified according to the type of tax return that they are required to file. Excluding most information returns (which are not tax returns in the strict sense of the term) and returns for organizations exempt from income tax, almost all tax returns will fall into one of the following four categories:

Type Of Return	Form	Filed By
Individual	1040	Every natural person with income of statutory minimums
Corporation	1120	Corporations, including organizations taxed as corporations
Fiduciary	1041	Trusts and estates with income in excess of statutory minimums
Partnership	1065	Partnerships or joint ventures (information return only)

Personal Exemptions

A deduction for personal exemptions is not taken on tax returns for the period of 2018 through 2025. Technically, the personal exemption amount is reduced to $0. However, the definition of personal exemptions and dependents is still important. The determination of head of household filing status is determined by whether a taxpayer has a dependent or a qualifying child. The child tax credit is determined based on the number of qualifying children. The family credit is based on the number of dependents other than qualifying children. The dependent care credit is based on the number of dependents.

No personal exemption is allowed on the return of an individual who is eligible to be claimed as a dependent on another taxpayer's return. However, the proposed regulations provide that a person is not considered a dependent of another individual, if the other individual has no filing requirement.

¶3201

TAXPAYER AND SPOUSE

Two taxpayers are allowed on a joint return even though there may be only one individual earning income. Where a joint return is filed by the taxpayer and spouse, no other person is allowed an exemption for the spouse even if the spouse otherwise qualifies as a dependent of another person.

¶3225

DEPENDENTS

Taxpayers are allowed to claim a personal exemption for each dependent.

The statutory definition of a dependent categorizes each dependent as a qualifying child or a qualifying relative. The definition also creates a uniform definition of child for dependency exemption, child credit, earned income tax credit, dependent care credit, and head of household filing status.

Qualifying Child

A child is a qualifying child of a taxpayer if the child satisfies each of four tests:

Principal Abode. The child has the same principal place of abode as the taxpayer for more than one half the taxable year. Temporary absences due to special circumstances, including absences due to illness, education, business, vacation, or military service, are not treated as absences.

Relationship. The child has specified relationship to the taxpayer. The child must be the taxpayer’s son, daughter, stepson, stepdaughter, brother, sister, stepbrother, stepsister, or a descendant of any such individual. An individual legally adopted by the taxpayer, or an individual who is lawfully placed with the taxpayer for adoption by the taxpayer, is treated as a child of such taxpayer by blood. A foster child who is placed with the taxpayer by an authorized placement agency or by judgment, decree, or other order of any court of competent jurisdiction is treated as the taxpayer’s child.

Age. The child has not yet attained a specified age. In general, a child must be under age 19 (or 24 in the case of a full-time student) in order to be a qualifying child. In general, no age limit applies with respect to individuals who are totally and permanently disabled at any time during the calendar year. The prior-law requirements are retained that a child must be under age 13 for purposes of the dependent care credit, and under age 17 for purposes of the child tax credit.

A tie-breaking rule applies if more than one taxpayer claims a child as a qualifying child. First, if only one of the individuals claiming the child as a qualifying child is the child’s parent, the child is deemed the qualifying child of the parent. Second, if both parents claim the child and the parents do not file a joint return, then the child is deemed a qualifying child first with respect to the parent with whom the child resides the longest period of time, and second with respect to the parent with the highest adjusted gross income. Third, if the child’s parents do not claim the child, then the child is deemed a qualifying child with respect to the claimant with the highest adjusted gross income.

The prior-law support and gross income tests (discussed below) for determining dependency do not apply to a child who meets the requirements of the uniform definition of qualifying child.

Support. A child who provides over half of his or her own support is not considered a qualifying child of another taxpayer.

Qualifying Relative

Taxpayers generally may claim an individual who does not meet the uniform definition of qualifying child with respect to any individual who is a qualifying relative. A qualifying relative must meet all of the following tests:

1. Relationship or member of household

2. Gross income

3. Support

4. Not a qualifying child

Relationship or Member of the Household Test

The dependent must be a relative of the taxpayer or a member of the taxpayer’s household. Individuals considered to be related to the taxpayer and eligible for the dependency exemption include: a child or a descendant of a child; a brother, sister, stepbrother, or stepsister; the father or mother, or an ancestor of either; a stepfather or stepmother; a son or daughter of a brother or sister of the taxpayer; a brother or sister of the father or mother of the taxpayer; and a son-in-law, daughter-in-law; father-in-law, mother-in-law, brother-in-law, or sister-in-law. A nonrelated person must be a member of the taxpayer’s household for the entire year to qualify as a dependent. The taxpayer must maintain and occupy the household. An individual is not a member of the taxpayer’s household if any time during the year the relationship between the individual and the taxpayer is in violation of local law.

Gross Income Test

This test does not allow a dependent to have more than $4,300 of gross income for the year.

EXAMPLE 3.6

Colleen Drew, age 21, earned $4,500 working part-time while attending school full-time. Colleen’s lives the entire year with her friend who pays more than one-half of Colleen’s support. Colleen’s friend will not be able to consider Colleen as a dependent since Colleen exceeded $4,300 of gross income.

The gross income amount is determined before the deduction of any expenses, such as materials, taxes, and depreciation. Thus, a taxpayer would not be able to claim his grandmother for 2020 if she received $4,650 in rental income, even though her expenses reduced the net income to less than $4,300. However, cost of goods sold is subtracted from gross receipts to determine gross income. Receipts which are excludable from gross income are not counted in applying the gross income test.

Support Test

Over one-half of the support of a dependent must be furnished by the taxpayer. In determining whether the taxpayer has provided over half of the support, the support received from the taxpayer as compared to the entire amount of support which the individual receives from all sources, including support which the individual supplies, will be taken into account.

In computing the amount which is contributed for the support of an individual, there must be included any amount which is contributed by the individual for his or her own support, including receipts which are excludable from gross income, such as benefits received under Social Security or money withdrawn from a savings account. However, it is only the amount actually spent on support which is taken into consideration, not the total amount available for support.

The term “support” includes food, shelter, clothing, medical and dental care, education, and similar items. Generally, the amount of an item of support will be the amount of expense incurred by the one furnishing the item. If the item of support furnished by an individual is in the form of property or lodging, it will be necessary to measure the amount of the item of support in terms of its fair market value. The value of personal services is not included in support determination. F. Markarian, 65-2 USTC ¶10,755, 352 F.2d 870 (CA-7 1965), cert. denied, 384 U.S. 988, 86 S.Ct. 1886.

Where the taxpayer owns the home in which the dependent lives, the fair rental value of the lodging furnished is part of the total support. However, this does not mean an equal allocation between taxpayers and dependents. It is recognized that an adult has certain minimum base housing costs which cannot be treated as equal to the minimum housing costs of minor children. In one case, the court allocated 60 percent of the housing costs to the mother and 40 percent to be divided equally among three children. J.D.M. Cameron, 33 TCM 725, Dec. 32,654(M), T.C. Memo. 1974-166. Amounts paid to others to care for children while working are included as part of support. T. Lovett, 18 TC 477, Dec. 19,018 (1952), Acq., 1952-2 CB 2. The amount paid may also qualify for the dependent care credit.

Some capital expenditures may qualify as items of support. The cost of an automobile is counted in determining who furnished over half of a dependent’s support. A television set furnished and set apart in the child’s bedroom is also an item of support. Rev. Rul. 77-282, 1977-2 CB 52.

Welfare payments made by a state agency to or on behalf of a dependent are attributable to the taxpayer. Amounts expended by a state for training and education of handicapped children are not taken into account in determining support. This rule applies only if the institution qualifies as an “educational institution” and the residents qualify as “students.” Rev. Rul. 59-379, 1959-2 CB 51, clarified by Rev. Rul. 60-190, 1960-1 CB 51. Social Security Medicare benefits are disregarded in the computation of support. Rev. Rul. 79-173, 1979-1 CB 86.

Amounts received as scholarships for study at an educational institution are not considered in determining whether the taxpayer furnishes more than one-half the support of the student. Amounts received for tuition payments and allowances by a veteran are not considered scholarships in determining the support test.

EXAMPLE 3.7

John has a cousin who lives with John and who receives a $5,000 scholarship to Academic University for one year. John contributes $4,100, which constitutes the balance of the cousin’s support for that year. John may claim the cousin as a dependent, as the $5,000 scholarship is not counted in determining the support of the cousin and, therefore, John is considered as providing all the support of the cousin.

Not a Qualifying Child Test

An individual who is a qualifying child of the taxpayer or of any other taxpayer cannot be a qualifying relative.

Special Rules Applying to Dependents

The taxpayer and the dependent will be considered as occupying the household for the entire year notwithstanding temporary absences from the household due to special circumstances. A nonpermanent failure to occupy the common abode by reason of illness, education, business, vacation, military service, or a custody agreement under which the dependent is absent for less than six months in the tax year, will be considered temporary absence due to special circumstances.

The fact that the dependent dies during the year will not deprive the taxpayer of qualifying the decreased as a dependent if he or she lived in the household for the entire part of the year preceding death. Similarly, the period during the year preceding birth of an individual will not prevent the individual from qualifying as a dependent.

A dependent cannot file a joint return with the dependent’s spouse. However, the dependency consideration will still be allowed where a joint return is filed by a dependent and spouse merely as a claim for refund and where no tax liability would exist for either spouse on the basis of separate returns. Rev. Rul. 65-34, 1965-1 CB 86.

The term “dependent” does not include an individual who is not a citizen or national of the United States unless such individual is a resident of the United States or a country contiguous to the United States. This exception does not apply to any child that has the same principal place of abode as the taxpayer and is a member of the taxpayer’s household and the taxpayer is a citizen or national of the United States.

The term “student” means an individual who, during each of five calendar months during the calendar year, is a full-time student at an educational institution, or is pursuing a full-time course of instructional on-farm training. A full-time student is one who is enrolled for some part of five calendar months for the number of hours or courses which is considered to be full-time attendance. The five calendar months need not be consecutive. School attendance exclusively at night does not constitute full-time attendance. However, full-time attendance may include some attendance at night in connection with a full-time course of study.

An individual will not be allowed to claim exemptions for dependents in any year they are themselves a dependent.

Social Security numbers are required for all individuals who are claimed as dependents. Failure to include the Social Security number or other required information can result in the loss of the exemption.

Multiple Support Agreements

Special rules allow a taxpayer to be treated as having contributed over half of the support of an individual where two or more taxpayers contributed to the support of the individual if (1) no one person contributed over half of the individual’s support, (2) each member of the group which collectively contributed more than half of the support of the individual would have been entitled to claim the individual as a dependent except for the fact that they did not contribute more than one-half of the support, (3) the member of the group claiming the individual as a dependent contributed more than 10 percent of the individual’s support, and (4) each other person in the group who contributed more than 10 percent of the support files a written declaration that they will not claim the individual as a dependent for the year.

EXAMPLE 3.8

Brothers Alfred, Bill, Chuck, and Don contributed the entire support of their mother in the following percentages: Alfred, 30 percent; Bill, 20 percent; Chuck, 29 percent; and Don, 21 percent. Any one of the brothers, except for the fact that he did not contribute more than half of her support, would have been entitled to claim his mother as a dependent. Consequently, any one of the brothers could consider the mother as a dependent provided a written declaration from each of the brothers is attached to the return of the individual considering mother as a dependent. If, on the other hand, Don were a neighbor instead of a brother, he would not qualify as a member of the group for multiple support agreement purposes. He would not be eligible to claim the mother since she was not a member of Don’s household. Don would not be required to sign the multiple support agreement.

Divorced or Separated Parents

When taxpayers are divorced, legally separated, or never married, special rules apply to determine which one is entitled to exemptions for their children. These rules may result in a taxpayer who did not provide more than half of the support of the child being entitled to the exemption.

To qualify, the parents must be divorced or legally separated under a decree of divorce or separate maintenance, separated under a written separation agreement, or lived apart at all times during the last six months of the year. In addition, both parents together must provide more than one-half of the child’s support. The child must be in the custody of one or both parents for more than one-half of the calendar year. Thus, a dependency exemption may not be claimed by one of the parents if a person other than the parents provides one-half or more for the support of the child during the year or has custody of the child for one half or more of the year.

As a general rule, a child will be treated as receiving over half of the support from the parent having custody for the greater number of nights for the year. If the parents of the child are divorced or separated for only a portion of a year after having joint custody for the prior portion of the year, the parent who has custody for the greater number of nights of the remainder of the year after divorce or separation will be treated as having custody for a greater portion of the year.

EXAMPLE 3.9

Bill, a child of Jim and Cathy Durell, who were divorced on June 1, received $5,000 for support during the year, of which $2,200 was provided by Jim and $1,950 by Cathy. No multiple support agreement was entered into. Prior to the divorce, Jim and Cathy jointly had custody of Bill. For the remainder of the year, Jim had custody of Bill for the months of October through December, while Cathy had custody of Bill for the months of June through September. Since Cathy had custody for four of the seven months following the divorce, she had custody for the greater number of nights and is the custodial parent for the year and is allowed to consider Bill as a dependent.

Post-1984 Divorces

For divorces taking place in years after 1984, the custodial parent is entitled to the exemption in all cases unless he or she expressly waives the right to the exemption. This may be done by the custodial parent signing a written declaration that he or she will not claim the exemption. The noncustodial parent is required to attach this declaration to his or her tax return each year when claiming the exemption. Failure to attach Form 8332, Release of Claim to Exemption for Child of Divorced or Separated Parents, means that the noncustodial parent cannot claim the exemption, regardless of the amount of support furnished.

EXAMPLE 3.10

Mike and Jennifer are divorced. Mike pays over half of the support of their child, Amanda. Amanda resides with Jennifer for the greater part of the year. Mike is unable to claim Amanda as a dependent on his return because he does not have a signed Form 8332 from Jennifer.

The individual claiming the child as a dependent also qualifies for the child tax credit provided other requirements are met.

KEYSTONE PROBLEM

The personal exemption qualifies the taxpayer for certain benefits such as the child tax credit. In certain situations, such as multiple support agreements and children of divorced parents, it is possible to assign the personal exemption for a dependent to one of the eligible parties. What should be taken into consideration in determining which party should receive the personal exemption?

Filing Status and Requirements

The tax liability of an individual not only varies with the amount of income but also depends upon marital status.

Taxpayers must determine their income tax liability from among five different filing statuses:

1. Married individuals filing jointly

2. Married individuals filing separate returns

3. Single individuals

4. Heads of households

5. Surviving spouses (Qualifying widow(er))

Source: Form 1040

A married taxpayer meeting the “abandoned spouse” requirements may be considered as an unmarried person for tax purposes. These requirements are: (1) the taxpayer must file a separate return, (2) the taxpayer’s spouse cannot be a member of the household during the last six months of the year, (3) the taxpayer must furnish over half the cost of maintaining the taxpayer’s home, and (4) the taxpayer’s home must be the principal residence of a dependent child for more than one-half of the year.

EXAMPLE 3.11

Melvin Moore left Esther and their two children on April 15, 2020, and has not been heard from since. Esther furnishes the entire cost of the household and the support of the two children for the remainder of the year. For 2020, Esther would qualify as an abandoned spouse and thus be considered as unmarried. If Melvin had left during the last half of the year, or if there were no children, Esther would not qualify as unmarried under the abandoned spouse rules. She would file as married filing separately.

An individual qualifying as an abandoned spouse will qualify for head of household status. Head of household status provides the spouse with a lower rate than the tax rate for a married person filing a separate return or a single individual.

Married persons are taxed at the lowest rate if they file jointly, and at the highest rates if they file separately. Unmarried taxpayers who are heads of households use a set of rates between those for single people and those for married couples filing jointly. Surviving spouses use the same rates as those married filing jointly. All unmarried taxpayers who do not qualify for another filing status must file as single taxpayers.

¶3301

MARRIED INDIVIDUALS FILING JOINTLY

A married couple may file a joint return including their combined incomes, or each spouse may file a separate return reflecting his or her income only. A joint return is not allowed if either the husband or wife is a nonresident alien at any time during the tax year, or if the husband and wife have different tax years. However, if at the end of a tax year one spouse is a U.S. citizen or a resident alien and the other spouse is a nonresident alien, a special election may be made to treat the nonresident spouse as a U.S. resident. If no election is made, the taxpayer’s status is married filing separately unless there is a dependent which would allow head of household status to be used.

Joint returns were originally enacted to establish equity for married taxpayers in common law states since in community property states married taxpayers are able to split their income. Therefore, the progressive rates are constructed upon the assumption that income is earned equally by the two spouses. A joint return may be filed and the splitting device may be used even if one spouse has no income.

If a joint return is filed, the income and deductions of both spouses are combined. The exemptions to which either spouse is entitled are combined, and both spouses sign the return. In a joint return, the general rule is that both spouses are jointly and severally liable for any deficiency in tax, interest, and penalties.

A joint return may be made for the survivor and a deceased spouse or for both deceased spouses. The tax year of such spouses must begin on the same day and end on different days only because of the death of either or both spouses. The surviving spouse must not remarry before the close of the tax year and the spouses must have been eligible to file a joint return on the date of death.

The determination of whether an individual is married is made as of the close of the tax year, unless the spouse dies during the year, in which case the determination will be made as of the time of death. A married couple does not have to be living together on the last day of the tax year in order to file a joint return, but an individual legally separated under a decree of divorce or separate maintenance will not be considered married.

¶3315

MARRIED INDIVIDUALS FILING SEPARATELY

If a husband and wife file separate returns, they should each report only their own income and claim only their own exemptions and deductions on their individual returns.

Separate returns will result in approximately the same tax liability as a joint return where both spouses have approximately equal amounts of income. However, when the incomes are unequal, it is generally advantageous for married taxpayers in noncommunity property states to file a joint return since the combined amount of tax on separate returns is higher than the tax on a joint return.

Special circumstances may warrant the use of separate returns. Where one spouse incurs significant medical expenses, the smaller adjusted gross income of a separate return results in a larger medical deduction since medical expenses are allowed only to the extent they exceed 7.5 percent of adjusted gross income. It may be desirable to file separate returns to protect against a potential deficiency on the other spouse’s return where there is some concern over the tax liability or there is a questionable item on the return itself.

In community property states, a married couple’s income is treated as earned equally by the two spouses. Income earned on capital investment made from a spouse’s separate property in most community property states remains the separate property of that spouse. There are three community property states in which income from separate property is treated as community property (Texas, Idaho, and Louisiana). See discussion of the “Texas Rule” at  ¶4215 . Community property income and deductions must be accounted for on the same basis. Deductions pertaining to the separate property of one spouse must be taken by that spouse. However, where the income from that property is taxable one-half to each spouse, the deductions must be divided between the husband and wife.

The Code places numerous limitations upon deductions, credits, etc., where married taxpayers file separately. If both husband and wife have income, they should generally figure their tax both jointly and separately to insure they are using the method resulting in less tax.

If an individual has filed a separate return for a year for which a joint return could have been filed and the time for filing the return has expired, a joint return by the husband and wife may still be filed. The joint return must be filed within three years of the due date of the original return for which a change is requested. All payments, credits, refunds, or other payments made or allowed on the separate return of either spouse are taken into account in determining the extent to which the tax based on the joint return has been paid.

If a joint return has been filed for a year, the spouses may not thereafter file separate returns for that year after the time for filing the return for that year has expired.

¶3325

SINGLE INDIVIDUALS

A single individual for tax purposes is an unmarried person who does not qualify as head of household. Generally, if only one of the two individuals is working, it is advantageous from a tax standpoint to enter into marriage. However, where the incomes are approximately equal, the total tax may be smaller if they are not married.

¶3345

HEADS OF HOUSEHOLDS

Unmarried individuals who maintain a household for qualifying children or dependents are entitled to use the head of household rates. The definition of a dependent for purposes of head of household status is the same as the uniform definition contained in the dependency exemption rules. The dependent must be a qualifying child or a qualifying relation of the taxpayer. Over one-half of the cost of maintaining the household must be furnished by the taxpayer. The household must be the principal abode for more than one-half of the year. A qualifying relative must qualify as the taxpayer’s dependent. A dependent relative who is a dependent only because of a multiple-support agreement cannot qualify a taxpayer for head of household status. A legally adopted child of a taxpayer is considered a child of the taxpayer by blood. A dependent foster child is treated like a dependent blood son or daughter, rather than as an unrelated individual. However, the foster child must be a dependent to enable the parent to use head of household status. Rev. Rul. 84-89, 1984-1 CB 5. A taxpayer with a qualifying child is not required to claim the qualifying child as a dependent, unless the child is married, in order to qualify for head of household status.

EXAMPLE 3.12

Sara Shuster is unmarried and maintains a household in which she and her son reside. The son is claimed by his father as a dependent. Since Sara is not required to claim the child as a dependent, she may use the head-of-household tax rate schedule. If the son is married, Sara must be able to claim him as a dependent in order to file as head of household.

The taxpayer’s dependent parents need not live with the taxpayer to enable the taxpayer to qualify as a head of household. The household maintained by the taxpayer must actually constitute the principal place of abode of the father or mother or both of them. The father or mother must occupy the household for the entire year. A rest home or home for the aged qualifies as a household for this purpose.

EXAMPLE 3.13

Meg Morgan, an unmarried individual living in Baltimore, maintains a household in Los Angeles for her dependent mother. Meg may use the head-of-household tax rate schedule even though her mother does not live with her.

Although generally a married couple cannot file a joint return if one of them is a nonresident alien, the taxpayer who is a U.S. citizen will qualify as a head of household if the taxpayer is the one providing the maintenance of the household and if there is a related dependent living with the taxpayer the entire year. The law provides that, for purposes of the head of household status, the taxpayer is treated as unmarried.

A taxpayer does not qualify for head of household status if the only other person living in his household is a nonresident alien spouse because the spouse does not qualify as a dependent. However, a taxpayer having a nonresident alien spouse may qualify if an unmarried dependent or unmarried stepchild lives with the taxpayer. Rev. Rul. 55-711, 1955-2 CB 13, amplified by Rev. Rul. 74-370, 1974-2 CB 7.

A physical change in the location of a home will not prevent a taxpayer from qualifying as a head of household. The fact that the individual qualifying the taxpayer for head of household status is born or dies within the tax year will not block a claim for head of household status. The household must have been the principal place of abode of the individual for the remaining or preceding part of the year.

A nonpermanent failure to occupy the common abode by reason of illness, education, business, vacation, military service, or a custody agreement under which a child or stepchild is absent for less than six months in a year will not bar the head of household status. However, it must be reasonable to assume that the household member will return to the household and the taxpayer continues to maintain the household or a substantially equivalent household in anticipation of such return.

The costs of maintaining a household are the expenses incurred for the mutual benefit of the occupants. They include property taxes, mortgage interest, rent, utility charges, upkeep and repairs, property insurance, and food consumed on the premises. Such expenses do not include the cost of clothing, education, medical treatment, vacations, life insurance, and transportation. In addition, the cost of maintaining a household does not include any amount which represents the value of services rendered in the household by the taxpayer or by a person qualifying the taxpayer as a head of household. The taxpayer, for example, cannot impute a value for services provided by the taxpayer for cooking, cleaning, and doing laundry.

It is possible for a household to be a portion of a home. The Tax Court held that a widow and her unmarried daughter occupying one level of a four-level house and sharing two levels constituted a household. J.F. Fleming Est., 33 TCM 619, Dec. 32,611(M), T.C. Memo. 1974-137. Since the widow paid more than one-half of the household maintenance expenses attributable to her and her daughter, she qualified as a head of household.

¶3355

SURVIVING SPOUSES

Special tax benefits are extended to a surviving spouse. In addition to the right to file a joint return for the year in which a spouse dies, a taxpayer whose spouse died in either of the two years preceding the tax year, and who has not remarried, may file as a surviving spouse provided the surviving spouse maintains a household for a dependent child or stepchild.

Surviving spouses use the same tax rate schedules and tax tables as married taxpayers filing joint returns. The surviving spouse provisions do not authorize the surviving spouse to file a joint return; they only make the joint return tax rates available.

The surviving spouse must provide over half the cost of maintaining the household in which both the surviving spouse and dependent live. Of course, an exemption for the deceased spouse is available in the year of death but is not available on the return of the surviving spouse in the two years following death.

EXAMPLE 3.14

Albert Olm’s wife died in 2020, leaving a child who qualifies as Albert’s dependent. In the year of death, Albert and his deceased wife are entitled to file a joint return and claim one dependent. If the child continues to live with Albert in a household provided by him and be his dependent, Albert will be allowed to file as a surviving spouse for 2021 and 2022.

¶3365

TAX RETURNS OF DEPENDENTS

For 2020, the standard deduction for an individual who can be claimed as a dependent on the tax return of another taxpayer is the greater of the individual’s earned income plus $350 (up to the maximum allowable standard deduction) or $1,100. However, an individual over 18 or a full-time student over 23 will not qualify as a dependent if they have income exceeding $4,300.

An individual may not claim a personal exemption for themself if the individual can be claimed as a dependent on another taxpayer’s return unless the other individual has no filing requirement. It does not matter whether the other taxpayer actually claims the exemption.

EXAMPLE 3.15

Michael Turner, who is single, is claimed as a dependent on his parents’ 2020 tax return. He receives $1,500 in interest income from a savings account. In addition, he earns $1,800 while working part-time after school. The standard deduction for a single individual for 2020 is $12,400. However, Michael is limited to a standard deduction of $2,150, the larger of his earned income of $1,800 plus $350 or $1,100.

EXAMPLE 3.16

Sonya Ross is single and is considered as a dependent by her parents’ in 2020. She has $1,200 in interest income and also earns $400 from part-time employment. Her standard deduction is limited to $1,100, the larger of her earned income of $400 plus $350 or $1,100.

EXAMPLE 3.17

Tom Moss, a 22-year-old, full-time college student, is considered as a dependent for his parents’ in 2020. Tom is married and files a separate return. Tom has $1,500 in interest income and wages of $12,600. His standard deduction is $12,400, because the greater of $1,100 or his earned income ($12,600) plus $350 is $12,950, but his standard deduction cannot be more than the $12,400 maximum allowable standard deduction.

Kiddie Tax

If a dependent child is subject to the kiddie tax and has more than $2,200 of net unearned (investment) income for the year, his or her net unearned income is taxed using the Estate and Trusts tax rate schedule.

The kiddie tax applies in the following circumstances:

1. 17-year old or younger—subject to the kiddie tax regardless of the amount of his or her earned income.

2. 18-year old—subject to the kiddie tax unless the child has earned income exceeding one-half of their support.

3. 19- to 23-year old full-time student—subject to the kiddie tax unless the child has earned income exceeding one-half of their support.

Net unearned income is unearned income (such as interest, dividends, capital gains, and certain trust income) less the sum of $1,100 (referred to as the first $1,100 clause) and the greater of: (1) $1,100 of the standard deduction or $1,100 of itemized deductions, or (2) the amount of allowable deductions which are directly connected with the production of unearned income. Thus, unearned income is reduced by $2,200 unless the child has itemized deductions connected with the production of unearned income exceeding $1,100. The amount of net unearned income cannot exceed taxable income for the year.

The child in each of the following examples is subject to the kiddie tax.

EXAMPLE 3.18

Amy Acorn has $300 of unearned income and no earned income. Amy will have no tax liability since her standard deduction of $1,100 will reduce taxable income to zero.

EXAMPLE 3.19

Bill Barnes has $1,350 of unearned income and no earned income. Bill will have $250 of taxable income ($1,350 gross income – $1,100 standard deduction). His net unearned income is reduced to zero by the first $1,100 clause and the $1,100 standard deduction. The $250 taxable income is taxed at Bill’s tax rate.

EXAMPLE 3.20

Charles Clewis has $2,400 of unearned income and no earned income. His $1,100 standard deduction reduces taxable income to $1,300. The $2,400 of unearned income is reduced by (1) the first $1,100 clause and (2) the $1,100 standard deduction, leaving $200 of net unearned income. The $200 of net unearned income is taxed using the parents’ marginal tax rate schedule while the remaining $1,100 of taxable income is taxed at Charles’s rate.

EXAMPLE 3.21

Dave Drummer has $800 of earned income and $400 of unearned income. Dave’s standard deduction is $1,150 (the amount of earned income plus $350). His taxable income is $50 ($1,200 gross income – $1,150 standard deduction). Since the unearned income is less than $2,200, there is no net unearned income. The taxable income is taxed at Dave’s tax rate.

EXAMPLE 3.22

Frank Fisher has $450 of earned income and $2,300 of unearned income. His taxable income is $1,650 ($2,750 gross income – $1,100 standard deduction). Frank’s $2,300 unearned income is reduced by $2,200 (the first $1,100 clause + the $1,100 standard deduction), leaving $100 of net unearned income. The $100 of net unearned income is taxed using the parents’ marginal tax rate. Frank is taxed at his rate on the remaining $1,550 taxable income ($1,650 taxable income – $100 taxed at the Estate and Trusts rate).

EXAMPLE 3.23

Gene Gambol has $1,200 of earned income plus $3,100 of unearned income. He has $1,150 of itemized deductions which are directly connected with the production of the unearned income. Gene has $450 of other itemized deductions. His taxable income is $2,700 ($4,300 gross income – $1,600 of itemized deductions). Gene’s net unearned income of $850 is taxed using the parents’ marginal tax rate. The unearned income is reduced by $2,250 (the first $1,100 clause + the entire $1,150 of deductions relating to the production of unearned income since it exceeds $1,100). Gene is taxed at his rate on $1,850 ($2,700 taxable income – $850 taxed at the Estate and Trusts rate).

PLANNING POINTER

Parents can avoid having a dependent’s income taxed at parents’ marginal tax rate by making gifts to children of assets that will not generate income until after the child’s income no longer qualifies for the kiddie tax. The tax on the income would then be taxed at the child’s tax rate. Examples of such assets include single premium ordinary life insurance policies, Series EE savings bonds, and property expected to appreciate over time.

A parent may elect to include on his or her return the unearned income of a child whose income is between $1,100 and $11,000. The child’s income must consist solely of interest and dividends. The child is treated as having no gross income and does not have to file a tax return if the election is made.

The electing parent must include the gross income of the child in excess of $2,200 on the parent’s tax return for the year, resulting in the taxation of that income at the parent’s highest marginal rate. There is an additional tax liability equal to the lesser of (1) $110 or (2) 10 percent of the child’s income exceeding $1,100. This liability reflects the child’s unearned income from $1,100 to $2,200 that would otherwise be taxed to the child at the 10 percent tax rate.

¶3375

FILING REQUIREMENTS

The obligation to file a return depends on the amount of gross income, marital status during the year, and age. Only income which is taxable is included in the computation of gross income in order to determine whether or not a return must be filed.

With certain exceptions, the gross income level at which taxpayers must file returns is determined by the standard deduction. Because married individuals filing separately must both itemize or both use the standard deduction, the standard deduction amount is not used to determine the gross income filing figure. The old-age additional standard deduction entitles an individual to increase the gross income level filing requirement by $1,300 or $1,650. However, no increase is permitted for blindness or for exemptions for dependents.

For 2020, Code Sec. 6012 requires a tax return to be filed if gross income for the year is at least as much as the amount shown for the categories in the following table.

Filing Status	Gross Income
Single
Under 65 and not blind	$12,400
Under 65 and blind	12,400
65 or older	14,050
Dependent with unearned income	1,100
Dependent with no unearned income	12,400
Married Filing Joint Return
Both spouses under 65 and neither blind	$24,800
Both spouses under 65 and one or both spouses blind	24,800
One spouse 65 or older	26,100
Both spouses 65 or older	27,400
Married Filing Separate Return
All—whether 65 or older or blind	5
Head of Household
Under 65 and not blind	$18,650
Under 65 and blind	18,650
65 or older	20,300
Surviving Spouse
Under 65 and not blind	$24,800
Under 65 and blind	24,800
65 or older	26,100

Even if the aforementioned gross income requirements are not met, a return nevertheless must be filed if an individual had net earnings from self-employment of $400 or more.

A return should be filed by any taxpayer eligible for the earned income credit even though the taxpayer does not meet any of the above filing requirements. A refund can result even if no income tax has been withheld.

Taxpayers must record their identifying number (Social Security number) on their returns. Returns filed by taxpayers claiming exemptions for dependents must include the dependents’ Social Security numbers.

¶3385

TAX TABLES

The tables are based on taxable income. The tables apply to taxpayers with taxable income of less than $100,000. Separate tables are provided for single taxpayers, married taxpayers filing jointly and surviving spouses, married taxpayers filing separately, and heads of households.

Each line of the tax tables represents an interval of taxable incomes. Under $3,050 the intervals are $25 and above $3,050 the intervals are $50. The tax given in the tables is based on the midpoint taxable income of each interval. Thus, the tax from the tables for the interval $40,000—$40,050 is the same as the tax determined from the tax rate schedules for $40,025.

The tax tables may not be used by the following taxpayers:

1. Estates or trusts

2. Taxpayers claiming the exclusion for foreign earned income

3. Taxpayers who file a short period return

4. Taxpayers whose income exceeds the ceiling amount

It is expected that 95 percent of all individual taxpayers will be able to determine their tax liability from the tables.

To find the income tax from the tax tables, the taxpayer must (1) find the line that includes the taxable income and (2) read down the column until the taxable income line is reached. For a married couple filing jointly with taxable income of $72,623, the income tax would be $8,320.

Sample Tax Table For 2019
At Least	But Less Than	Single	Married Filing Jointly	Married Filing Separately	Head of a Household
$72,600	$72,650	$11,768	$8,320	$11,768	$10,326
72,650	72,700	11,779	8,326	11,779	10,337
72,700	72,750	11,790	8,332	11,790	10,348
72,750	72,800	11,801	8,338	11,801	10,359

The 2019 Tax Tables are provided in the Appendix.

¶3395

TAX RATE SCHEDULES

Taxpayers using the tax rate schedules must compute their tax based on taxable income. The tax rate schedules are used by those not eligible to use the tax tables. The tax rate schedules are presented in the Appendix and inside the front cover.

¶3405

SELF-EMPLOYMENT TAX AND MEDICARE SURTAXES

The tax on net self-employment income is levied to provide the self-employed with the same benefits that employees receive through their payment of the Social Security tax (FICA). In general, the tax is levied, assessed, and collected as part of the regular income tax.

The tax is imposed for the purposes of insuring the self-employed individual for old-age, survivors, and disability benefits and for hospitalization benefits under the Social Security program. For 2020, the tax rate is 15.3 percent, made up of two parts: (1) an old-age, survivors, and disability insurance (OASDI) rate of 12.4 percent and (2) a Medicare hospital insurance (HI) rate of 2.9 percent. The self-employed individual is considered both the employer and the employee.

In general, net self-employment income equals the gross income derived by an individual from a trade or business carried on as a sole proprietor, less any allowable deductions, plus the distributive share of a partnership’s net income. If a self-employed individual has more than one business, the net self-employment income is the total of the net earnings of all businesses. A loss in one business is deductible from the earnings of the other businesses.

Not all self-employment income is subject to tax. Remuneration paid for the services of a newsboy under age 18 is exempt from the tax. Dividends are included only by a dealer in stock and securities. Interest is included only if on business loans. Rental income is included only by a real estate dealer or in cases in which services are rendered to the occupants. Generally, self-employment income does not include any item that is excluded from gross income. Wages received by a child under 18 from a parent are not subject to the self-employment tax.

The self-employment tax is imposed on “net earnings from self-employment.” Net earnings from self-employment is net self-employment income less a special deduction. The actual deduction, however, is not subtracted from a taxpayer’s net self-employment income in computing net earnings from self-employment. Instead, a taxpayer reduces net self-employment income by an amount (termed a “deemed deduction”) equal to net self-employment income multiplied by one-half of the self-employment tax rate, or 7.65 percent. This deduction is incorporated into Schedule SE by multiplying the net self-employment income by .9235. (This gives the same deduction as multiplying net self-employment income by .0765 and then subtracting the result.)

A taxpayer is allowed a deduction for the employer's portion of the self-employment tax (currently one-half) as a deduction from gross income.

EXAMPLE 3.24

In 2020, Pierre Painter, a self-employed artist, had $45,000 in self-employment income. His deductible business expenses amounted to $15,000. Pierre’s self-employment tax is computed as follows:

Gross income from self-employment	$45,000
Less: Business expense deductions	15,000
Net self-employment income	$30,000
Less: Deemed deduction ($30,000 × 7.65%)	2,295
Net earnings from self-employment	$27,705
Self-employment tax ($27,705 × 15.3%)	$ 4,239

On Form 1040, Schedule SE, Pierre would simply multiply his net self-employment income of $30,000 by .9235.

The cap on wages and self-employment income that is taken into account in calculating the portion of the FICA tax applicable to old-age, survivors, and disability insurance (OASDI) is $137,700 for 2020. This also applies to wages, self-employment income, and income derived under the Railroad Retirement Act. There is no longer a cap on wages and self-employment income that is taken into account in calculating the Medicare hospital insurance (HI) portion of the self-employment tax.

EXAMPLE 3.25

Katie Adams has $150,000 in self-employment income for the year. Her net earnings from self-employment is $138,525 ($150,000 × .9235). She will be subject to an OASDI tax of $17,075 ($137,700 × 12.4%) and an HI tax of $4,017 ($138,525 × 2.9%). Thus, her total self-employment tax is $21,092.

Thus, self-employment and Social Security (FICA) tax rate parity is achieved between self-employed persons and employees. Both employees and their employers are liable for Social Security tax and the employer must contribute 6.2 cents per dollar earned by the employee up to the cap limitation ($137,700 for 2020) for OASDI and another 1.45 cents per dollar without a cap for HI.

The net earnings from self-employment subject to the OASDI portion of the self-employment tax are limited to the self-employment base ($137,700 for OASDI and unlimited for HI in 2020) less any wages from which Social Security tax was withheld during the year. Thus, the tax is applied to the lesser of (1) the self-employment base ($137,700) minus income subject to Social Security taxes or (2) the net earnings from self-employment.

EXAMPLE 3.26

In 2020, Margaret Moore has $139,700 in income from self-employment and receives $8,900 in wages that are subject to Social Security taxes. Margaret’s net earnings from self-employment are $129,013 ($13139,700 × .9235). Her net earnings from self-employment subject to OASDI self-employment tax for the year are $128,800 ($137,700 – $8,900, the wages on which Social Security tax was withheld), which is less than net earnings from self-employment. Her net earnings from self-employment subject to the HI self-employment tax are $129,013, the full amount of the net earnings from self-employment. Thus, her total self-employment tax is $19,713 ($128,800 × 12.4% + $129,013 × 2.9%).

The employer portion of the self-employment tax liability for the year is allowed as a deduction on the tax return. This deduction is taken as a deduction from gross income on the front of Form 1040.

EXAMPLE 3.27

Jim Jergens has $40,000 in self-employment income. His net earnings from self-employment are $36,940 ($40,000 × .9235). The self-employment tax is $5,652 ($36,940 × 15.3%). The employer portion of this amount, $2,826 ($36,940 × 7.65%), is allowed as a deduction from gross income.

If the net earnings from self-employment are less than $400, there is no self-employment tax. However, this does not mean that the first $400 of net earnings from self-employment is not subject to the self-employment tax.

EXAMPLE 3.28

Sylvia Knight’s only source of income for 2019 is $433.14 from self-employment. The net earnings from self-employment are $400 ($433.14 × .9235). The self-employment tax is $61.20 ($400 × 15.3%). Sylvia has a deduction from gross income for the employer portion of the self-employment tax, or $30.60 ($400 × 7.65%). If Sylvia had managed to earn less than $433.14, there would have been no self-employment tax.

An optional method of computing self-employment income may be used by persons whose net income from a trade or business is relatively low. The details are omitted, but the method enables taxpayers to obtain greater credit for Social Security benefits than their income would normally allow.

Additional Medicare Tax on Earned Income

A 0.9% Additional Medicare Tax applies to wages and net self-employment income for tax years after 2012. The tax applies to wages exceeding $200,000 for single, head-of-household, or surviving spouse; $250,000 for married filing jointly; $125,000 for married filing separately. The applicable thresholds are not adjusted for inflation.

The tax applies to the employee's share of wages. The tax does not apply to the employer's employment taxes. Box 5 of the W-2 is used for determining the Additional Medicare Tax and withholding.

There are no special rules for nonresident aliens and U.S. citizens living abroad for purposes of the Additional Medicare Tax. Wages, other compensation, and self-employment income that are subject to Medicare tax will also be subject to the Additional Medicare Tax if in excess of the applicable threshold.

The threshold amount for the Additional Medicare Tax applies separately to the FICA and the Railroad Retirement Tax Act (RRTA). Therefore, the amount of RRTA compensation taken into account in determining the Additional Medicare Tax under the RRTA will not reduce the threshold amounts under Section 1401(b)(2)(A) for determining the Additional Medicare Tax under the SECA.

The Additional Medicare Tax on earned income is part of the employer's overall withholding. The employee reconciles the final total of any Additional Medicare Tax when they file their Form 1040 for the tax year.

Employers are required to apply the additional withholding at $200,000 of wages, including taxable fringe benefits, bonuses, tips, commissions, or other supplemental payments, the total amount of taxable Box 5. It does not matter what filing status is shown on Form W-4. The employer applies the $200,000 threshold to each spouse in applying the Additional Medicare Tax. In effect the employer disregards the amount of wages received by the other spouse in computing the Additional Medicare Tax for each spouse.

EXAMPLE 3.29

One spouse received $210,000 of wages, while the other spouse earns $35,000 of either W-2 wages or net self-employment income. The employer of the first spouse is required to withhold an additional 0.9% Additional Medicare Tax on the last $10,000 of taxable wages (i.e., $90) even though the couple will not owe the 0.9% Additional Medicare Tax when they file their 2020 Form 1040. They will receive a tax credit against any other type of tax that may be owed.

If an employer fails to withhold the 0.9% Additional Medicare tax, and the tax is subsequently paid by the employee, the IRS will not collect the tax from the employer. The employer will remain subject to any applicable penalties on additions to tax for failure to withhold the 0.9% Additional Medicare tax as required. Code Sec. 3102(f)(3). The employee is personally responsible if the employer fails to withhold the 0.9% additional Medicare tax. Code Sec. 3102(f)(2).

The self-employed does not receive an income tax deduction for one-half of the 0.9% Additional Medicare Tax on earned income. Any deduction comes from the employer’s portion of employment taxes.

EXAMPLE 3.30

A husband and wife each have "Box 5 Medicare wages" of $150,000 listed on their respective W-2s. The combined $300,000 "earned income" will be shown on Form 8959 for calculating the 0.9% Additional Medicare Tax. The couple will owe a 0.9% Additional Medicare Tax of $450 (($300,000 − $250,000 threshold) x 0.9%) which will be included as "Other Taxes" on page 2 of Form 1040.

EXAMPLE 3.31

A husband has $150,000 of "Box 5 Medicare wages" listed on his W-2. His wife has a K-1 from her law firm listing Box 14 net earnings from self-employment of $162,426 ($150,000 net self-employment income). The couple will owe $450 of Additional Medicare Tax on their collective earned income.

EXAMPLE 3.32

A husband has $150,000 of "Box 5 Medicare wages" listed on his W-2. His wife has a K-1 from her law firm with net earnings from self-employment of $150,000. The wife also has a $50,000 loss from the start-up of a new Schedule C business. Since the self-employment income of the wife would now be only $100,000, when it is added to the $150,000 in W-2 wages of the husband, the couple is not above the "applicable threshold" of $250,000 for married filing jointly. Therefore, no Additional Medicare Tax on their collective earned income would be due..

EXAMPLE 3.33

A husband and wife each have "Box 5 Medicare wages" of $150,000 listed on their respective W-2s. The wife also has a $50,000 loss from the start-up of a new Schedule C business. The couple would still owe $450 of Additional Medicare Tax. The self-employment loss is not permitted to offset W-2 wages.

EXAMPLE 3.34

The husband has $190,000 in wages subject to Medicare tax and the wife has $150,000 in compensation subject to RRTA taxes. The husband and wife do not combine their wages and RRTA compensation to determine whether they are in excess of the $250,000 threshold for a joint return. The husband and wife are not liable to pay Additional Medicare Tax because the husband’s wages are not in excess of the $250,000 threshold and the wife’s RRTA compensation is not in excess of the $250,000 threshold.

EXAMPLE 3.35

C, a single filer, has $130,000 in wages and $145,000 in net earnings from self-employment. C’s wages are not in excess of the $200,000 threshold for single filers, so C is not liable for the Additional Medicare Tax on these wages. Before calculating the Additional Medicare Tax on self-employment income, the $200,000 threshold for single filers is reduced by C’s $130,000 in wages, resulting in a reduced self-employment income threshold of $70,000. C is liable to pay the Additional Medicare Tax on $75,000 of self-employment income; $145,000 in self-employment income minus the reduced threshold of $70,000.

Net Investment Income Tax

After 2012, a 3.8% "Net Investment Income Tax" is imposed on individuals and estate and trusts. Code Sec. 1411. The Net Investment Income Tax will be calculated on Form 8960 and shown as "Other Taxes" on page 2 of Form 1040.

For individuals, the tax is imposed on the lesser of:

a. An individual's "net investment income" for the tax year, or

b. Any excess of "modified adjusted gross income" (MAGI) for the tax year over a threshold amount. Code Sec.1411(a)(1).

The "threshold amount" is $200,000 for single taxpayers and heads-of-households; $250,000 for married filing jointly and surviving spouses; $125,000 for married filing separately. Code Sec. 1411(b). MAGI means an individual's adjusted gross income for the tax year increased by otherwise excludable foreign earned income or foreign housing costs under Sec. 911 as reduced by any deduction, exclusion, or credits properly allocable to or chargeable against such foreign earned income. Code Sec. 1411(d).

EXAMPLE 3.36

Elmer, a single individual, earns $190,000 in wages and/or net self-employment income and also has $40,000 of "net investment income" for the year. Assuming a $230,000 MAGI, he will have to pay a 3.8% Net Investment Income Tax on the lesser of his (1) $40,000 of net investment income, or (2) $30,000 ($230,000 MAGI − $200,000 threshold). Elmer will pay a $1,140 ($30,000 × 3.8%) Net Investment Income Tax for the year.

EXAMPLE 3.37

During the year, an unmarried taxpayer received no wages or self-employment income, but lives strictly off of her $1 million in "net investment income" from a stock and bond portfolio. Assuming a $1 million MAGI, she will have to pay a 3.8% Net Investment Income Tax on the lesser of her (1) $1 million net investment income or (2) $800,000 ($1 million − $200,000 threshold). As a result, she will pay a $30,400 ($800,000 x 3.8%) Net Investment Income Tax for the year.

The Net Investment Income Tax does not apply to a non-resident alien or to a trust "all the unexpired interests in which are devoted to charitable purposes." The tax does not apply to a trust that is exempt under Sec. 501 or a charitable remainder trust exempt from tax under Sec. 664.

"Net investment income" is defined as: [Code Sec. 1411(c)(1) and (c)(2)]

1. Gross income from interest, dividends, annuities, royalties, and rents (unless such income is "derived in the ordinary course of any trade or business”);

2. Other gross income from any passive trade or business; or

3. Net gain included in computing taxable income that is attributable to the disposition of property other than property held in any trade or business that is not a "passive trade or business."

"Income derived in the ordinary course of a trade or business" does not include any trade or business that is either a passive activity of the taxpayer, or involves trading in financial instruments and commodities. The passive activity and trading in financial instruments and commodities are defined as "passive business investment income" for purposes of the 3.8% Medicare tax.

Financial Instruments include: Equity interest such as stock, Proof of indebtedness, Options, Notional principal contracts, Other derivatives, and Other evidence of an interest in one of the foregoing items.

A passive investor's share of Form 1065 or Form 1120S from Box 1 on Schedule K-1 would be "other gross income from any passive trade or business.”

A Sec. 1231 gain reported on a K-1 from the sale of assets used in a trade or business that the taxpayer "materially participates" would not be treated as "net investment income" subject to the 3.8% Net Investment Income Tax. However, it would be "net investment income" to a passive investor.

"Net investment income" includes any income, gain, or loss that is attributable to an investment of working capital. Income or gain from investment in working capital is treated as not derived in the ordinary course of a trade or business. Code Sec. 1411(c)(3). For example, a business puts some of its excess working capital into an income-producing investment such as a certificate of deposit or interest-bearing account, or stocks that pay dividends or result in capital gains or losses when sold.

Net investment income does not include: Code Sec. 1411(c)(6).

1. Any distribution from qualified employee benefit plan or retirement arrangements;

2. Any distributions from a regular IRA or Roth IRA;

3. Social security benefits;

4. Any item excluded from gross income.

5. Any item taken into account in determining self-employment income for the tax year on which an individual pays self-employment tax under Sec. 1401(b).

The K-1 profits reported in Box 1 of a materially participating shareholder are not considered "unearned income" for purposes of the 3.8% Medicare tax.

EXAMPLE 3.38

John is an owner of a business that rents equipment and machinery. He also materially participates in that business. Regardless of the business being operated as an S corporation, LLC/partnership, or a sole proprietorship, any net income or loss therefrom would not be considered for purposes of the 3.8% Net Investment Income Tax calculation. However, a Schedule C sole proprietor or the K-1 recipient of "Box 1—Trades or Business Income” from an LLC/partnership would still have the potential for the 0.9% Medicare tax on earned income.

EXAMPLE 3.39

John leases a building to his rental business. This is a self-rental situation and self-rentals are not classified as passive income. The gross rental income will be deemed to be derived in the ordinary course of a trade or business and, therefore, exempt from the Net Investment Income Tax. Gain or loss from the property will also be treated as gain or loss from the disposition of property held in a nonpassive trade or business.

If a taxpayer is a "real estate professional" and they also "materially participate" in their rental activities, then Sec. 469 passive loss rules do not apply. Any rental income or loss derived from such rental activities will not factor into the taxpayer's calculation of the 3.8% Net Investment Income Tax if they meet the definition of trades or business for Section 162. The IRS has provided a safe harbor for the trades or business definition: If a taxpayer qualifies as a real estate professional and also spends more than 500 hours participating in either a separate or grouped rental activity, the IRS will treat those rental activities as trades or businesses. Reg. §1.1411-4(g)(7)(i).

EXAMPLE 3.40

John is a "real estate professional" for purposes of the passive loss rules. He also "materially participates" in the rental activities that he owns. The Net Investment Income Tax would not apply to the rental activities if his "rental activities" are treated as "trades or business" under Sec. 162. The income would not be subject to any self-employment tax under Sec. 1402. However, assume the rental activities are not “trades or business" for Sec. 162. As a result, any net rental income or loss would be part of his 3.8% Net Investment Income Tax calculation.

For purposes of the Net Investment Income Tax, the definition allows the reduction for any otherwise allowable deductions "properly allocable to such income or gain."

1. Deductions under Sec. 62 related to gross income

2. Itemized deductions under Sec. 63

3. Loss deductions under Sec. 165

A large capital loss in excess of any capital gain for a particular tax year can only offset up to $3,000 of other "net investment income." Investment interest expense can only be used to offset "net investment income" to the extent otherwise allowed on Form 4952. Any state or local tax attributable to the sources of net investment income may be deducted in computing net investment income. Any otherwise allowable deductions must also be reduced by the itemized deduction phaseout.

Employment Taxes for Household Employers

If a taxpayer hires someone to do household work and was able to control what work he or she did and how he or she did it, the taxpayer has a household employee. The taxpayer has to have an employer identification number (EIN) and pay employment taxes.

A Form W-2, Wage and Tax Statement, must be filed for each household employee paid $2,200 or more in cash wages in 2020 that are subject to social security and Medicare taxes. If the wages were not subject to these taxes but the employee wishes to have federal income taxes withheld, a W-2 must be filed for that employee. A Form W-3, Transmittal of Wage and Tax Statements, must also be filed if one or more W-2s are required to be filed.

If cash wages are paid of $1,000 or more in any calendar quarter of 2019 or 2020 to household employees for 2020, the taxpayer may also be subject to federal and state unemployment taxes.

In the case of persons performing domestic services in a private home of the employer and person performing agricultural labor, if the employer pays the employee’s liability for FICA taxes or state unemployment taxes without deduction from the employee’s wages, those payments are not wages for FICA purposes. Code Sec. 3121(a)(6).

TAX BLUNDERS

1. Sara Michaels and Tommy Tooks marry on December 31. Sara earned $400,000 for the year, and Tommy earned $100,000. If Sara and Tommy had waited until the beginning of the following year to marry they would have realized a significant tax savings. Each filing as single taxpayers will result in less total tax than filing jointly.

2. Assume Sara earned $95,000 and Tommy earned $5,000 because he attended school most of the year and they marry at the beginning of the next year. There would be a significant tax savings in marrying at the end of the first year and filing jointly over each filing as single taxpayers.

3. Sara and Tommy decide to file as married filing separately. Sara has $12,500 in itemized deductions and Tommy has $10,000 in itemized deductions. Since Sara itemized on her return Tommy is required to itemize. They may be better off to have both take the standard deduction since the total standard deductions would be $24,800 while itemizing only results in a $22,500 total deduction.

SUMMARY

· The standard deduction eliminates low- to moderate-level taxpayers from the tax rolls. The standard deduction is made up of two parts: the basic standard deduction and the additional standard deduction. Both of these parts are adjusted each year for inflation. The standard deduction differs depending upon filing status.

· Taxpayers are allowed a personal exemption for themselves and their spouse, plus an exemption for each qualified dependent. Taxpayers who are dependents are not allowed a personal exemption for themselves.

· Taxpayers must determine their tax liability from among five different filing statuses.

· Special taxation rules are imposed on returns filed by individuals that are dependents of other taxpayers.

· In general, filing requirements are based on a taxpayer’s gross income, filing status, and age.

· Self-employed individuals are required to pay a self-employment tax that is equivalent to the Social Security taxes paid by employees.

· Taxpayers could potentially be subject to a 0.9% Additional Medicare Tax and the Net Investment Income Tax.