Assignment 8 controllership

Understanding and Working with the Federal Tax Law

L E A R N I N G O B J E C T I V E S : After completing Chapter 1, you should be able to:

LO.1 Stress the importance of revenue needs as an objective of Federal tax law.

LO.2 Demonstrate the influence of economic, social, equity, and political considerations on the development of the tax law.

LO.3 Illustrate how the IRS, as the protector of the revenue, has affected tax law.

LO.4 Recognize the role of the courts in interpreting and shaping tax law.

LO.5 Identify tax law sources—statutory, administrative, and judicial.

LO.6 List and assess tax law sources.

LO.7 Demonstrate tax research.

LO.8 Assess the validity and weight of tax law sources.

LO.9 Describe various tax planning procedures.

LO.10 Explain the role of taxation on the CPA examination.

C H A P T E R O U T L I N E

1-1 The Whys of the Tax Law, 1-2 1-1a Revenue Needs, 1-2 1-1b Economic Considerations, 1-2 1-1c Social Considerations, 1-4 1-1d Equity Considerations, 1-5 1-1e Political Considerations, 1-9 1-1f Influence of the Internal Revenue Service, 1-11 1-1g Influence of the Courts, 1-12

1-2 Summary, 1-15

1-3 Reconciling Accounting Concepts, 1-15

1-4 Working with the Tax Law— Tax Sources, 1-15 1-4a Statutory Sources of the Tax Law, 1-16 1-4b Administrative Sources of the Tax Law, 1-20 1-4c Judicial Sources of the Tax Law, 1-23 1-4d Other Sources of the Tax Law, 1-31

1-5 Working with the Tax Law—Locating and Using Tax Sources, 1-31

1-5a Commercial Tax Services, 1-32 1-5b Using Online Tax Services, 1-32 1-5c Noncommercial Online Tax Sources, 1-33

1-6 Working with the Tax Law— Tax Research, 1-35 1-6a Identifying the Problem, 1-36 1-6b Locating the Appropriate Tax Law Sources, 1-38 1-6c Assessing the Validity of Tax Law Sources, 1-38 1-6d Arriving at the Solution or at Alternative Solutions, 1-41 1-6e Communicating Tax Research, 1-41

1-7 Working with the Tax Law— Tax Planning, 1-43 1-7a Nontax Considerations, 1-43 1-7b Components of Tax Planning, 1-43 1-7c Tax Planning—A Practical Application, 1-45 1-7d Follow-Up Procedures, 1-45

1-8 Taxation on the CPA Examination, 1-46

C H A P T E R

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THE BIG PICTURE

IMPORTANCE OF TAX RESEARCH

Dana Pehrson advanced $93,000 to her nephew in 2008 to enable him to attend a private university. Over

the next few years, the nephew repays Dana $16,000 on the loan. However, seven years later Dana comes

to you to determine whether she can claim a bad debt deduction for the $77,000 the nephew has not

repaid. What planning tips might you give to Dana? What mistakes were made?

Read the chapter and formulate your response.

ª STOCKLITE/SHUTTERSTOCK.COM

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T he Federal tax law is a mixture of statutory provisions, administrative pronounce- ments, and court decisions. Anyone who has attempted to work with this body of knowledge is familiar with its complexity. Commenting on his 48-page tax return,

author James Michener said, “It is unimaginable in that I graduated from one of America’s better colleges, yet I am totally incapable of understanding tax returns.” For the person who has to wade through rule upon rule to find the solution to a tax prob- lem, it may be of some consolation to know that the law’s complexity can be explained. There is a reason for the formulation of every rule. Knowing these reasons, therefore, is a considerable step toward understanding the Federal tax law.

1-1 THE WHYS OF THE TAX LAW The major objective of the Federal tax law is the raising of revenue. Despite the importance of the fiscal needs of the government, however, other considerations explain certain por- tions of the law. In particular, economic, social, equity, and political factors play a signifi- cant role. Added to these factors is the marked impact the Internal Revenue Service (IRS) and the courts have had and will continue to have on the evolution of Federal tax law. These matters are treated in the first part of this chapter. Wherever appropriate, the discus- sion is related to subjects covered later in the text.

1-1a Revenue Needs The foundation of any tax system has to be the raising of revenue to absorb the cost of government operations. Ideally, annual outlays should not exceed anticipated revenues. This situation leads to a balanced budget with no deficit. Many states have achieved this objective by passing laws or constitutional amendments precluding deficit spending. The Federal government has no such prohibition. As a result, the national debt has been allowed to increase significantly, reaching more than $17 trillion, or more than $56,000 per citizen, in late 2014. According to the U.S. National Debt Clock, the U.S. total unfunded liabilities for Social Security, Medicare, and prescription drugs is over $118 tril- lion, or about $1.1 million per taxpayer.

When enacting tax legislation, Congress is often guided by the concept of revenue neutrality so that any changes neither increase nor decrease the net revenues raised under the prior rules. Revenue neutrality does not mean that any one taxpayer’s tax liability remains the same. Because this liability depends upon the circumstances involved, one taxpayer’s increased tax liability could be another’s tax saving. Revenue-neutral tax reform does not reduce deficits, but at least it does not aggravate the problem.

1-1b Economic Considerations Using the tax system to attempt to accomplish economic objectives has become increas- ingly popular in recent years. Generally, this process involves amending the Internal Revenue Code1 through tax legislation and emphasizes measures designed to help con- trol the economy or encourage certain activities and businesses.

Control of the Economy Congress has made use of depreciation write-offs as a means of controlling the econ- omy. Theoretically, shorter asset lives and accelerated methods should encourage addi- tional investments in depreciable property acquired for business use. Conversely, longer class lives and the required use of the straight-line method of depreciation dampen the tax incentive for capital outlays.

Another approach that utilizes depreciation as a means of controlling capital invest- ment is the amount of write-off allowed upon the acquisition of assets. This approach is

LO.1

Stress the importance of revenue needs as an objective of Federal tax law.

LO.2

Demonstrate the influence of economic, social, equity, and political considerations on the development of the tax law.

1The Internal Revenue Code is a compilation of Federal tax legislation that appears in Title 26 of the U.S. Code.

1-2 PART 1 Introduction

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followed by the § 179 election to immediately expense assets up to a certain amount. It also was the approach used by Congress in various provisions that permitted up to 50 percent additional first-year depreciation in some prior years.

A change in the tax rate structure has a more immediate impact on the economy. When tax rates are lowered, taxpayers are able to retain additional spendable funds. In the interest of revenue neutrality, however, rate decreases may be accompanied by a reduction or elimination of deductions or credits. Thus, lower rates do not always mean lower taxes.

Encouragement of Certain Activities Without passing judgment on the wisdom of any such choices, it is quite clear that the tax law does encourage certain types of economic activity or segments of the economy. For example, the desire to foster technological progress helps explain the favorable treatment accorded to research and development expenditures. Under the tax law, these expenditures can be deducted in the year incurred or, alternatively, capitalized and amortized over a period of 60 months or more. Given the time value of money, the tax savings from a current deduction usually is preferable to a capitalization of the cost with a write-off over the estimated useful life of the asset created.2

The encouragement of technological progress also can explain why the tax law places the inventor in a special position. Besides the fact that patents can qualify as capital assets, under certain conditions, their disposition automatically carries long-term capital gain treatment.3

Are ecological considerations a desirable objective? If they are, it explains why the tax law permits a 60-month amortization period for costs incurred in the installation of pollution control facilities.

Does stimulating the development and rehabilitation of low-income rental housing benefit the economy? The tax law definitely favors these activities by allowing generous tax credits to taxpayers incurring such costs.

Is saving desirable for the economy? Saving leads to capital formation and thus makes funds available to finance home construction and industrial expansion. The tax law provides incentives to encourage saving by giving private retirement plans preferential treatment. Not only are contributions to Keogh (H.R. 10) plans and certain Individual Retirement Accounts (IRAs) deductible, but income from these contributions accumulates on a tax-free basis. As noted in a following section, the encouragement of private-sector pension plans can be justified under social con- siderations as well.

T A X I N T H E N E W S Stimulating the Economy

During the recent economic downturn, there was considerable discussion about what the government should do. There are two primary ways to stabilize an econ- omy through government policy: fiscal policy and monetary policy. Fiscal policy involves spending and taxation.

There are two forms of fiscal policy: discretionary and automatic. The 2009 stimulus package, which provided vari- ous tax cuts and incentives and increased government spending by statute, while increasing government deficits, is

an example of discretionary fiscal policy. The income tax is an example of an automatic fiscal stabilizer—it is automatic because as incomes decline during a recession, taxes owed also decline. In recent years, changes in the Internal Revenue Code have become less important than government spend- ing programs as a way to stimulate the economy.

Source: Based on Yair Listokin, “Stabilizing the Economy through the Income Tax Code,” Tax Notes, June 29, 2009, pp. 1575–1577.

2If the asset developed has no estimated useful life, no write-off would be available without the two options allowed by the tax law.

3A long-term capital gain has a favorable tax advantage for individuals.

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Encouragement of Certain Industries Because a sound agricultural base is necessary for a well-balanced national economy, farmers are accorded special treatment under the Federal tax system. Among the bene- fits are the election to expense rather than capitalize certain expenditures for soil and water conservation and fertilizers and the election to defer the recognition of gain on the receipt of crop insurance proceeds.

The tax law favors the development of natural resources by permitting the use of per- centage depletion on the extraction and sale of oil and gas and specified mineral deposits and a write-off (rather than a capitalization) of certain exploration costs. The railroad and banking industries also receive special tax treatment. All of these provisions can be explained, in whole or in part, by economic considerations.

A well-balanced economy also should include a vigorous and dynamic manufacturing industry. To encourage this sector, Congress has enacted a tax incentive based on profits from manufacturing. Known as the domestic production activities deduction, the benefit is structured in such a manner as to stimulate the creation of jobs (see Chapter 3).

Encouragement of Small Business In the corporate tax area, several provisions can be explained by the desire to benefit small business. One provision enables a shareholder in a small business corporation to obtain an ordinary deduction for any loss recognized on a stock investment. Normally, this loss would receive the less attractive capital loss treatment. The point of this favorit- ism is to encourage additional equity investments in small business corporations.4

Another provision permits the shareholders of a small business corporation to make a special election that generally will avoid the imposition of the corporate income tax.5

Furthermore, this election enables the corporation to pass through to its shareholders any of its operating losses.6

As Example 1 shows, the tax rates applicable to corporations tend to favor small busi- ness in that size is relative to the amount of taxable income generated in any one year. Because a corporate tax rate of 34 percent applies only to taxable income in excess of $75,000, corporations that stay within this limit are subject to lower average tax rates.

If a corporation has taxable income in excess of $100,000, the benefits of the lower brackets are phased out until all income is taxed at the maximum rate of 34 percent. Once taxable income reaches $10 million, the rate becomes 35 percent.

One of the justifications for the enactment of the tax law governing corporate reorganizations (see Chapter 7) was the economic benefit it would provide for small businesses. By allowing corporations to combine without adverse tax consequences, small corporations would be in a position to compete more effectively with larger concerns.

1-1c Social Considerations Some of the tax laws, especially those related to the Federal income tax of individuals, can be explained by social considerations. Rather than using loans, grants, and other

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For calendar year 2015, Brown Corporation has taxable income of $75,000 and Red Corporation has taxable income of $100,000. Based on this information, the corporate income tax is $13,750 for Brown Corporation and $22,250 for Red Corporation (see Chapter 2). Brown Corporation is sub- ject to an average tax rate of 18.33% ($13,750/$75,000), while Red Corporation is subject to an average rate of 22.25% ($22,250/$100,000).

4Known as Section 1244 stock, this subject is covered in Chapter 4. 5Known as the S corporation election, this subject is discussed extensively in Chapter 12.

6In general, an operating loss can benefit only the corporation incurring the loss through a carryback or carryover to profitable years. Consequently, the shareholders of the corporation usually cannot take advantage of any such loss.

1-4 PART 1 Introduction

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programs to reach desired goals, Congress often uses the Internal Revenue Code to pro- vide incentives and benefits. Here are some notable examples:

• The nontaxability of certain benefits provided to employees through accident and health plans financed by employers. It is socially desirable to encourage such plans because they provide medical benefits in the event of an employee’s illness or injury.

• The nontaxability to the employee of some of the premiums paid by an employer for group term insurance covering the life of the employee. These arrangements can be justified in that they provide funds to help the family unit adjust to the loss of wages caused by the employee’s death.

• The deduction allowed for contributions to qualified charitable organizations. The deduction attempts to shift some of the financial and administrative burden of socially desirable programs from the public (the government) to the private (the citizens) sector.

• Various tax credits, deductions, and exclusions that are designed to encourage tax- payers to obtain additional education (e.g., American Opportunity tax credit, lifetime learning credit, and the Coverdell Education Savings Account).7

• The disallowance of a tax deduction for certain expenditures that are deemed to be contrary to public policy. This disallowance extends to such items as fines, penalties, illegal kickbacks, and bribes to government officials. Public policy con- siderations also have been used to disallow gambling losses in excess of gambling gains and political campaign expenditures in excess of campaign contributions. Social considerations dictate that the tax law should not encourage these activities by permitting a deduction.

Although many other examples could be identified, these examples demonstrate that social considerations do explain a significant part of the Federal tax law.

1-1d Equity Considerations The concept of equity is relative. Reasonable persons can, and often do, disagree about what is fair or unfair. Compare the tax treatment of a corporation with that of a partner- ship. Two businesses may be equal in size, similarly situated, and competitors in the production of goods or services, but they are not comparably treated under the tax law. The corporation is subject to a separate Federal income tax; the partnership is not. Whether the differences in tax treatment can be logically justified in terms of equity is beside the point. The tax law can and does make a distinction between these business forms.

Equity, then, is not what appears fair or unfair to any one taxpayer or group of taxpayers. It is, instead, what the tax law recognizes. Some recognition of equity does exist, however, and explains part of the law. The concept of equity appears in tax provi- sions that alleviate the effect of multiple taxation and postpone the recognition of gain when the taxpayer lacks the ability or wherewithal to pay the tax. Equity also helps miti- gate the effect of the application of the annual accounting period concept and helps taxpayers cope with the eroding result of inflation.

Alleviating the Effect of Multiple Taxation The same income earned by a taxpayer may be subject to taxes imposed by different tax- ing authorities. If, for example, the taxpayer is a resident of New York City, income might generate Federal, New York State, and New York City income taxes. To compensate for this inequity, the Federal tax law allows a taxpayer to claim a deduction for state and local

7These provisions also can be justified under the category of economic con- siderations since a better educated workforce carries a positive economic impact.

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income taxes. The deduction, however, does not neutralize the effect of multiple taxation because the benefit derived depends on the taxpayer’s Federal income tax rate.8

Equity considerations can explain the Federal tax treatment of certain income from foreign sources. Because double taxation results when the same income is subject to both foreign and U.S. income taxes, the tax law permits the taxpayer to choose either a credit or a deduction for the foreign taxes paid.

The imposition of a separate income tax on corporations leads to multiple taxation of the same income.

For corporate shareholders, for whom triple taxation is possible, the law provides a deduction for dividends received from certain domestic corporations. The deduction, usually 70 percent of the dividends, would be allowed to Gray Corporation for the $5,000 it received from IBM Corporation (see the discussion in Chapter 2). For the individual shareholder, the income tax on qualified dividends ranges from 0 percent (for lower tax bracket shareholders) to 20 percent (for shareholders in the 39.6 percent tax bracket). By allowing a preferential lower tax rate, the approach is to mitigate (not eliminate) the effect of multiple taxation (see the discussion in Chapter 5).

In the area of the Federal estate tax, several provisions reflect attempts to mitigate the effect of multiple taxation. Some degree of equity is achieved, for example, by allowing a limited credit against the estate tax for foreign death taxes imposed on the same trans- fer. Other estate tax credits are available and can be explained on the same grounds.11

The Wherewithal to Pay Concept The wherewithal to pay concept recognizes the inequity of taxing a transaction when the taxpayer lacks the means with which to pay the tax. It is particularly suited to situations when the taxpayer’s economic position has not changed significantly as a result of a transaction.

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During the current year, Gray Corporation has net income of $100,000, of which $5,000 was received as dividends from stock it owns in IBM Corporation. Assume that Gray Corporation dis- tributes the after-tax income to its shareholders (all individuals). At a minimum, the distribution received by the shareholders will be subject to two income taxes: the corporate income tax when the income is earned by Gray Corporation and the individual income tax when the balance is dis- tributed to the shareholders as a dividend.9 The $5,000 that Gray receives from IBM Corporation fares even worse. Because it is paid from income earned by IBM, it has been subjected to a third income tax (the corporate income tax imposed on IBM).10

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White Corporation owns a warehouse that it uses in its business. At a time when the warehouse has an adjusted basis of $60,000, it is destroyed by fire. White collects the insurance proceeds of $100,000, and within two years of the end of the year in which the fire occurred, White uses all of the proceeds to purchase a new warehouse.13

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Wherewithal to Pay Concept Illustrations

White Corporation holds unimproved land as an investment. The land has a basis to White of $60,000 and a fair market value of $100,000. The land is exchanged for a building (worth $100,000) that White will use in its business.12

8A tax credit rather than a deduction would eliminate the effects of multiple taxation on the same income.

9Beginning in 2013, an additional 3.8 percent Medicare tax also applies to certain high-income shareholders.

10This result materializes because under the tax law, a corporation is not allowed a deduction for the dividend distributions it makes.

11See Chapter 18.

12The nontaxability of like-kind exchanges applies to the exchange of prop- erty held for investment or used in a trade or business for property to be similarly held or used.

13The nontaxability of gains realized from involuntary conversions applies when the proceeds received by the taxpayer are reinvested within a pre- scribed period of time in property similar or related in service or use to that converted. Involuntary conversions take place as a result of casualty losses, theft losses, or condemnations by a public authority.

1-6 PART 1 Introduction

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In all of the preceding examples, White Corporation, Tom, or Tera had a realized gain of $40,000 [$100,000 (fair market value of the property received) � $60,000 (basis of the property given up)].17 It would be inequitable to force the taxpayer to recognize any of this gain for two reasons. First, without disposing of the property or interest acquired, the taxpayer would be hard-pressed to pay the tax.18 Second, the taxpayer’s economic situation has not changed significantly. To illustrate by referring to Example 5, can it be said that Tom’s position as sole shareholder of Azure Corporation is much different from his prior status as owner of a sole proprietorship?

Several warnings are in order concerning the application of the wherewithal to pay concept. Recognized gain is merely postponed and not necessarily avoided. Because of the basis carryover to the new property or interest acquired in these nontaxable transac- tions, the gain element is still present and might be recognized upon a subsequent tax- able disposition. Referring to Example 5, suppose Tom later sold the stock in Azure Corporation for $100,000. Tom’s basis in the stock is $60,000 (the same basis as in the assets transferred), and the sale results in a recognized gain of $40,000. Also, many of the provisions previously illustrated prevent the recognition of realized losses. Because these provisions are automatic in application (not elective with the taxpayer), they could operate to the detriment of a taxpayer who wants to obtain a deduction for a loss. The notable exception involves involuntary conversions (Example 4). Here nonrecogni- tion treatment is elective with the taxpayer and also will not apply to a realized loss if it is otherwise deductible.

The wherewithal to pay concept has definitely served as a guideline in shaping part of the tax law. Nevertheless, it is not a hard-and-fast principle that is followed in every case. Only when the tax law specifically provides for no tax consequences will this result materialize.

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Rose, Sam, and Tom want to develop unimproved land owned by Tom. The land has a basis to Tom of $60,000 and a fair market value of $100,000. The RST Partnership is formed with the follow- ing investments: land worth $100,000 transferred by Tom, $100,000 cash by Rose, and $100,000 cash by Sam. Each party receives a one-third interest in the RST Partnership.15

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Amber Corporation and Crimson Corporation decide to consolidate to form Aqua Corpora- tion.16 Pursuant to the plan of reorganization, Tera exchanges her stock in Amber Corporation (basis of $60,000 and fair market value of $100,000) for stock in Aqua Corporation worth $100,000.

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Mary Jo exchanges stock in Green Corporation (basis of $60,000 and fair market value of $100,000) for stock in Purple Corporation (fair market value of $100,000). The exchange is not pursuant to a reorganization. Under these circumstances, Mary Jo’s realized gain of $40,000 is recognized for Federal income tax purposes.19

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Wherewithal to Pay Concept Illustrations

Tom, a sole proprietor, decides to incorporate his business. In exchange for the business’s assets (adjusted basis of $60,000 and a fair market value of $100,000), Tom receives all of the stock of Azure Corporation, a newly created corporation.14 The Azure stock is worth $100,000.

14Transfers of property to controlled corporations are discussed in Chapter 4. 15The formation of a partnership is discussed in Chapter 10. 16Corporate reorganizations are discussed in Chapter 7. 17Realized gain can be likened to economic gain. However, the Federal

income tax is imposed only on that portion of realized gain considered to be recognized under the law. Generally, recognized (or taxable) gain can never exceed realized gain.

18If the taxpayer ends up with other property (boot) as part of the transfer, gain may be recognized to this extent. The presence of boot, however, helps solve the wherewithal to pay problem because it provides property (other than the property or interest central to the transaction) with which to pay the tax.

19The exchange of stock does not qualify for nontaxable treatment as a like- kind exchange (refer to Example 3).

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The result reached in Example 8 seems harsh in that the exchange does not place Mary Jo in a position to pay the tax on the $40,000 gain. How can this result be reconciled with that reached in Example 7 when the exchange was nontaxable? In other words, why does the tax law apply the wherewithal to pay concept to the exchange of stock pursuant to a corporate reorganization (Example 7) but not to certain other stock exchanges (Example 8)?

Recall that the wherewithal to pay concept is particularly suited to situations in which the taxpayer’s economic position has not changed significantly as a result of a transaction. In Example 7, Tera’s stock investment in Amber Corporation really continues in the form of the Aqua Corporation stock because Aqua was formed through a consoli- dation of Amber and Crimson Corporations.20 In Example 8, however, the investment has not continued. Here Mary Jo’s ownership in Green Corporation has ceased, and an investment in an entirely different corporation has been substituted.

Mitigating the Effect of the Annual Accounting Period Concept For purposes of effective administration of the tax law, all taxpayers must report to and settle with the Federal government at periodic intervals. Otherwise, taxpayers would remain uncer- tain as to their tax liabilities, and the government would have difficulty judging revenues and budgeting expenditures. The period selected for final settlement of most tax liabilities is one year. At the close of each year, a taxpayer’s position becomes complete for that particular year. Referred to as the annual accounting period concept, the effect is to divide each taxpayer’s life into equal annual intervals for tax purposes.

The finality of the annual accounting period concept can lead to dissimilar tax treatment for taxpayers who are, from a long-range standpoint, in the same economic position.

The same reasoning used to support the deduction of net operating losses can be applied to explain the special treatment that excess capital losses and excess charitable contributions receive. Carryback and carryover procedures help mitigate the effect of limiting a loss or a deduction to the accounting period in which it is realized. With such procedures, a taxpayer may be able to salvage a loss or a deduction that might otherwise be wasted.

As illustrated in Example 10, the installment method of recognizing gain on the sale of property allows a taxpayer to spread tax consequences over the payout period.21

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Rena and Samuel are both sole proprietors and have experienced the following results during the past three years:

Profit (or Loss)

Year Rena Samuel

2013 $50,000 $150,000

2014 60,000 60,000

2015 60,000 (40,000)

Although Rena and Samuel have the same total profit of $170,000 over the period from 2013 to 2015, the finality of the annual accounting period concept places Samuel at a definite disad- vantage for tax purposes. The net operating loss procedure offers Samuel some relief by allowing him to apply some or all of his 2015 loss to the earliest profitable years (in this case, 2013). Thus, Samuel, with a net operating loss carryback, is placed in a position to obtain a refund for some of the taxes he paid on the $150,000 profit reported for 2013.

20This continuation is known as the continuity of interest concept, which forms the foundation for all nontaxable corporate reorganizations. The concept is discussed at length in Chapter 7.

21Under the installment method, each payment received by the seller repre- sents a return of basis (the nontaxable portion) and profit from the sale (the taxable portion).

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The harsh effect of taxing all of the gain in the year of sale is avoided. The installment method also can be explained by the wherewithal to pay concept because recogni- tion of gain is tied to the collection of the installment notes received from the sale of the property. Tax consequences tend to correspond to the seller’s ability to pay the tax.

The annual accounting period concept has been modified to apply to situations in which taxpayers may have difficulty accurately assessing their tax positions by year- end. In many such cases, the law permits taxpayers to treat transactions taking place in the next year as having occurred in the prior year.

Similar exceptions to the annual accounting period concept cover certain charitable contributions by accrual basis corporations (Chapter 2) and the dividend distributions by S corporations (Chapter 12).

Coping with Inflation During periods of inflation, bracket creep has plagued the working person. Because of the progressive nature of the income tax, any wage adjustment to compensate for inflation could place the employee in a higher income tax bracket. The overall impact is an erosion of purchasing power. Congress recognized this problem and began to adjust various income tax components through an indexation procedure. Indexation, which began in 1985, is based on the rise in the consumer price index over the prior year.

1-1e Political Considerations A large segment of the Federal tax law is made up of statutory provisions. Because these statutes are enacted by Congress, is it any surprise that political considerations influence tax law? For purposes of discussion, the effect of political considerations on the tax law is divided into the following topics: special interest legislation, political expediency, and state and local influences.

Special Interest Legislation Certain provisions of the tax law can be explained largely by looking to the political influence some pressure groups have exerted on Congress. For example, is there any other reason why prepaid subscription and dues income is not taxed until earned while prepaid rents are taxed to the landlord in the year received? This exception came about because certain organizations (e.g., the American Automobile Association) convinced

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In 2013, Tim sold unimproved real estate (cost of $40,000) for $100,000. Under the terms of the sale, Tim receives two notes from the purchaser, each for $50,000 (plus interest). One note is pay- able in 2014; the other, in 2015. Without the installment method, Tim would have to recognize and pay a tax on the gain of $60,000 for the year of the sale (2013). This result is harsh because none of the sale proceeds will be received until 2014 and 2015. With the installment method, and presuming the notes are paid when each comes due, Tim recognizes half of the gain ($30,000) in 2014 and the remaining half in 2015.

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Monica, a calendar year taxpayer, is a participant in an H.R. 10 (Keogh) retirement plan (see Appendix C for a definition of a Keogh plan). Under the plan, Monica contributes 20% of her net self-employment income, such amount being deductible for Federal income tax purposes. On April 9, 2015, Monica determines that her net self-employment income for calendar year 2014 was $80,000. Consequently, she contributes $16,000 (20% � $80,000) to the plan. Even though the $16,000 contribution was made in 2015, the law permits Monica to claim it as a deduction for tax year 2014. Requiring Monica to make the contribution by December 31, 2014, to obtain the deduction for that year would force her to arrive at an accurate determination of net self-employment income long before her income tax return must be prepared and filed.

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Congress that special tax treatment was needed to cover income received from multi- year dues and subscriptions.

A recent provision, sponsored by a senator from Georgia, suspended the import duties on ceiling fans. The nation’s largest seller of ceiling fans is Home Depot, which is based in Atlanta, Georgia. Another provision, sponsored by a congressman from Illinois, reduced the excise taxes on fishing tackle boxes. The representative’s district includes Plano Molding, a major manufacturer of tackle boxes. The justification for this change was that it placed tackle boxes on a more level playing field with toolboxes (which are not subject to tax). Allegedly, fishermen had been buying and converting toolboxes to avoid the excise tax.

Special interest legislation is not necessarily to be condemned if it can be justified on economic or social grounds. It is, however, an inevitable product of our political system.

Political Expediency Various tax reform proposals rise and fall in favor depending upon the shifting moods of the American public. Therefore, certain provisions of the tax law can be explained on the basis of the political climate at the time of enactment. Once the general public became aware that certain large and profitable corporations were able to avoid the cor- porate income tax, Congress responded with an alternative minimum tax. Since a por- tion of a corporation’s adjusted current earnings has been made a tax preference item, many large corporations no longer escape taxation (see Chapter 3).

Measures that deter more affluent taxpayers from obtaining so-called preferential tax treatment have always had popular appeal and, consequently, the support of Congress. Provisions such as the alternative minimum tax, the imputed interest rules, and the limi- tation on the deductibility of interest on investment indebtedness can be explained on this basis. In the same vein are the provisions imposing penalty taxes on corporations that unreasonably accumulate earnings or are classified as personal holding companies (see Chapter 3).

State and Local Government Influences Political considerations have played a major role in the exclusion from gross income of interest received on state and local obligations. Somewhat less apparent has been the influence state law has had in shaping our present Federal tax law. Of prime impor- tance in this regard has been the effect of the community property system employed in some states.22 At one time, the tax position of the residents of these states was so ad- vantageous that many common law states actually adopted community property sys- tems.23 The political pressure placed on Congress to correct the disparity in tax treatment was considerable. To a large extent, this was accomplished in the Revenue Act of 1948, which extended many of the community property tax advantages to resi- dents of common law jurisdictions.24 Thus, common law states avoided the trauma of discarding the time-honored legal system familiar to everyone. The impact of commu- nity property law on the Federal estate and gift taxes is further explored in Chapters 18 and 19.

22The states with community property systems are Louisiana, Texas, New Mexico, Arizona, California, Washington, Idaho, Nevada, Wisconsin, and (if elected by the spouses) Alaska. The rest of the states are classified as com- mon law jurisdictions. The difference between common law and community property systems centers around the property rights possessed by married persons. In a common law system, each spouse owns whatever he or she earns. Under a community property system, one-half of the earnings of each spouse is considered owned by the other spouse. Assume, for example, that Harold and Ruth are husband and wife and that their only income is the $80,000 annual salary Harold receives. If they live in Oklahoma (a common law state), the $80,000 salary belongs to Harold. If, however, they live in

Texas (a community property state), the $80,000 salary is divided equally, in terms of ownership, between Harold and Ruth.

23Such states included Michigan, Oklahoma, and Pennsylvania. 24The major advantage extended was the provision allowing married

taxpayers to file joint returns and compute the tax liability as if each spouse had earned one-half of the income. This result is automatic in a community property state because half of the income earned by one spouse belongs to the other spouse. The income-splitting benefits of a joint return are now incorporated as part of the tax rates applicable to married taxpayers.

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1-1f Influence of the Internal Revenue Service The IRS has been influential in many areas beyond its role in issuing administrative pro- nouncements. In its capacity as the protector of the national revenue, the IRS has been instrumental in securing the passage of much legislation designed to curtail the most fla- grant tax avoidance practices (closing tax loopholes). In its capacity as the administrator of the tax laws, the IRS has sought and obtained legislation to make its job easier (administrative feasibility).

The IRS as Protector of the Revenue Innumerable examples can be given of provisions in the tax law that have stemmed from the direct efforts of the IRS to prevent taxpayers from exploiting a loophole. Work- ing within the letter of existing law, ingenious taxpayers and their advisers devise tech- niques that accomplish indirectly what cannot be accomplished directly. As a consequence, legislation is enacted to close the loophole that taxpayers have located and exploited. The following examples can be explained in this fashion and are dis- cussed in more detail in the chapters to follow:

• The use of a fiscal year by personal service corporations, partnerships, S corporations, and trusts to defer income recognition to the owners (see Chapters 2, 10, 12, and 20).

• The use of the cash basis method of accounting by certain large corporations (see Chapter 2).

• The deduction of passive investment losses and expenses against other income (see Chapters 2 and 10).

• The shifting of income to lower-bracket taxpayers through the use of reversionary trusts (see Chapter 20).

In addition, the IRS has secured from Congress legislation of a more general nature that enables it to make adjustments based upon the substance rather than the formal construction of what a taxpayer has done. One provision, for example, authorizes the IRS to establish guidelines on “thinly capitalized” corporations. This question involves when corporate debt will be recognized as debt for tax purposes and when it will be reclassified as equity or stock (see the discussion of thin capitalization in Chapter 4). Another provision permits the IRS to make adjustments to a taxpayer’s method of accounting when the method used by the taxpayer does not clearly reflect income. The IRS has also been granted the authority to allocate income and deductions among businesses owned or controlled by the same interests when the allocation is necessary to prevent the evasion of taxes or to reflect the income of each business clearly.

E X A M P L E

12

Gold Corporation and Silver Corporation are brother-sister corporations (the stock of each is owned by the same shareholders), and both use the calendar year for tax purposes. For the current tax year, each has taxable income as follows: $335,000 for Gold Corporation and $50,000 for Silver Corporation. Not included in Gold Corporation’s taxable income, however, is $10,000 of rent income usually charged Silver Corporation for the use of some property owned by Gold. Because the parties have not clearly reflected the taxable income of each business, the IRS can allocate $10,000 of rent income to Gold Corporation. After the allocation, Gold Cor- poration has taxable income of $345,000 and Silver Corporation has taxable income of $40,000.25

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Illustrate how the IRS, as the protector of the revenue, has affected tax law.

25By shifting $10,000 of income to Gold Corporation (which is in the 34% bracket), the IRS gains $3,400 in taxes. Allowing the $10,000 deduction to Silver Corporation (which is in the 15% bracket) costs the IRS only $1,500.

See Chapter 2 for further discussion of the income tax rates applicable to corporations.

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Also of a general nature is the authority Congress has given the IRS to prevent tax- payers from acquiring corporations to obtain a tax advantage when the principal pur- pose of the acquisition is the evasion or avoidance of the Federal income tax. The provision of the tax law that provides this authority is discussed briefly in Chapter 7.

Administrative Feasibility Some of the tax law is justified on the grounds that it simplifies the task of the IRS in col- lecting the revenue and administering the law. With regard to collecting the revenue, the IRS long ago realized the importance of placing taxpayers on a pay-as-you-go basis. Elaborate withholding procedures apply to wages, while the tax on other types of income may have to be paid at periodic intervals throughout the year. The IRS has been instrumental in convincing the courts that accrual basis taxpayers should pay taxes on prepaid income in the year received and not when earned. This approach may be con- trary to generally accepted accounting principles, but it is consistent with the wherewi- thal to pay concept.

Of considerable aid to the IRS in collecting revenue are the numerous provisions that impose interest and penalties on taxpayers for noncompliance with the tax law. These provisions include penalties for failure to pay a tax or to file a return that is due and the negligence penalty for intentional disregard of rules and regulations. Various penalties for civil and criminal fraud also serve as deterrents to taxpayer noncompli- ance. This aspect of the tax law is discussed in Chapter 17.

One of the keys to the effective administration of our tax system is the audit process conducted by the IRS. To carry out this function, the IRS is aided by provisions that reduce the chance of taxpayer error or manipulation, thus simplifying the audit effort that is necessary. For example, by increasing the individual standard deduction amount, the audit function is simplified because there are fewer returns with itemized deductions needing to be checked.26 The same objective can be used to explain the $14,000 annual gift tax exclusion (see Chapter 18). This provision decreases the number of gift tax returns that must be filed (as well as reduces the taxes paid) and thereby saves audit effort.27

1-1g Influence of the Courts In addition to interpreting statutory provisions and the administrative pronouncements issued by the IRS, the Federal courts have influenced tax law in two other respects.28

First, the courts have formulated certain judicial concepts that serve as guides in the application of various tax provisions. Second, certain key decisions have led to changes in the Internal Revenue Code. Understanding this influence helps explain some of our tax laws.

E X A M P L E

The Big Picture

13

Return to the facts of The Big Picture on p. 1–1. The advance of $93,000 to her nephew might be considered a taxable gift. If so, Dana would have been allowed a $12,000 gift tax exclusion in 2008. Further, if Dana were married, she and her husband would have been allowed a $24,000 gift tax exclusion (this is called “gift splitting”). Finally, Dana also could use her lifetime exemption to eliminate any gift tax, depending on her previous gift history (see Chapter 18).

26The IRS gave the same justification when it proposed to Congress the $100 per event limitation on personal casualty and theft losses. Imposition of the limitation eliminated many casualty and theft loss deductions and, as a consequence, saved the IRS considerable audit time. Also, an additional li- mitation equal to 10% of adjusted gross income applies to the total of non- business losses after reduction by the floor of $100 for each loss.

27Particularly in the case of nominal gifts among family members, taxpayer compliance in reporting and paying a tax on such transfers would be ques- tionable. The absence of the $14,000 gift tax exclusion would create a seri- ous enforcement problem for the IRS.

28A great deal of case law is devoted to ascertaining congressional intent. The courts, in effect, ask: What did Congress have in mind when it enacted a particular tax provision?

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Recognize the role of the courts in interpreting and shaping tax law.

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The 2012 Supreme Court decision on health care (The Patient Protection and Affordable Care Act of 2010) effectively expanded congressional taxing power by ruling that the “individual mandate” contained in this law was a valid exercise of Congress’s power to “lay and collect taxes” (Article I, Section 8, Clause 1). Further, the Court con- cluded that the “individual mandate” was not a “direct tax” and therefore not required to be apportioned among the states according to population. With this decision, Congress now has the opportunity to use its taxing power as an incentive to influence behavior while avoiding the term tax in the related legislation.

Judicial Concepts Relating to Tax Law Although ranking the tax concepts developed by the courts in order of importance is difficult, the concept of substance over form would almost certainly be near the top of any list. Variously described as the “telescoping” or “collapsing” process or the “step transaction approach,” it involves determining the true substance of what occurred. In a transaction involving many steps, any one step may be collapsed (or disregarded) to arrive directly at the result reached.

The substance over form concept plays an important role in transactions involving corporations.

Another leading tax concept developed by the courts deals with the interpretation of statutory tax provisions that operate to benefit taxpayers. The courts have established the rule that these relief provisions are to be narrowly construed against taxpayers if there is any doubt about their application. Suppose, for example, that Beige Corporation wants to be treated as an S corporation (see Chapter 12) but has not satisfied the statutory require- ments for making the required election. Because S corporation status is a relief provision favoring taxpayers, chances are the courts will deny Beige Corporation this treatment.

Important in the area of corporate-shareholder dealings (see the discussion of con- structive dividends in Chapter 5) and in the resolution of valuation problems for estate and gift tax purposes (see Chapters 18 and 19) is the arm’s length concept. Particularly in dealings between related parties, transactions can be tested by questioning whether the taxpayers acted in an “arm’s length” manner. The question to be asked is: Would unrelated parties have handled the transaction in the same way?

The continuity of interest concept originated with the courts but has, in many sit- uations, been incorporated into statutory provisions of the tax law. Primarily con- cerned with business readjustments, the concept permits tax-free treatment only if the taxpayer retains a substantial continuing interest in the property transferred to

E X A M P L E

14

In 2015, Mrs. Greer, a widow, wants to give $28,000 to Jean without incurring any gift tax liability.29

She knows that the law permits her to give up to $14,000 each year per person without any tax consequences (the annual exclusion). With this in mind, the following steps are taken: a gift by Mrs. Greer to Jean of $14,000 (nontaxable because of the $14,000 annual exclusion), a gift by Mrs. Greer to Ben of $14,000 (also nontaxable), and a gift by Ben to Jean of $14,000 (nontaxable because of Ben’s annual exclusion). Considering only the form of what Mrs. Greer and Ben have done, all appears well from a tax standpoint. In substance, however, what has happened? By col- lapsing the steps involving Ben, it is apparent that Mrs. Greer has made a gift of $28,000 to Jean and therefore has not avoided the Federal gift tax.

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15

The sole shareholder of a corporation leases property to the corporation for a monthly rental of $50,000. To test whether the corporation should be allowed a rent deduction for this amount, the IRS and the courts will apply the arm’s length concept. Would the corporation have paid $50,000 a month in rent if the same property had been leased from an unrelated party (rather than from the sole shareholder)?

29The example assumes that Mrs. Greer has exhausted her unified tax credit. See Chapter 18.

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the new business. Due to the continuing interest retained, the transfer should not have tax consequences because the position of the taxpayer has not changed. This concept applies to transfers to controlled corporations (Chapter 4), corporate reorganizations (Chapter 7), and transfers to partnerships (Chapter 10). The continu- ity of interest concept helps explain the results reached in Examples 5 through 7 of this chapter. This concept is further discussed in Chapter 7.

Also developed by the courts, the business purpose concept principally applies to trans- actions involving corporations. Under this concept, as Example 16 indicates, some sound business reason that motivates the transaction must be present for the prescribed tax treat- ment to result. The avoidance of taxation is not considered a sound business purpose.

The business purpose concept is discussed further in Chapter 7.

Judicial Influence on Statutory Provisions Some court decisions have been of such consequence that Congress has incorporated them into statutory tax law. An illustration of this influence appears in Example 17.

The decision reached by the courts in Example 17, known as the tax benefit rule , is now part of the Internal Revenue Code.

Court decisions sometimes create uncertainty about the tax law. Such decisions may reach the right result but do not produce the guidelines necessary to enable taxpayers to comply. In many situations, Congress may be compelled to add certainty to the law by enacting statutory provisions specifying when a particular tax consequence will or will not materialize. The following are examples of this type of judicial “cause” and the statutory “effect”:

• When a stock redemption will be treated as an exchange or as a dividend (see Chapter 6).

• What basis a parent corporation will have in the assets received from a subsidiary that is liquidated shortly after its acquisition (see Chapter 6).

Some of the statutory provisions can be explained by a negative reaction by Con- gress to a particular court decision. One decision, for example, held that the transfer of a liability to a controlled corporation should be treated as boot received by the trans- feror (see Chapter 4). Congress apparently disagreed with this treatment and promptly enacted legislation to change the result.

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16

Beth and Charles are equal shareholders in Brown Corporation. They have recently disagreed about the company’s operations and are at an impasse about the future of Brown Corporation. This shareholder disagreement on corporate policy constitutes a sound business purpose and would justify a division of Brown Corporation that will permit Beth and Charles to go their separate ways. Whether the division of Brown would be nontaxable to the parties depends on their compli- ance with the statutory provisions dealing with corporate reorganizations. The point is, however, that compliance with statutory provisions would not be enough to ensure nontaxability without a business purpose for the transaction.

E X A M P L E

17

In 1983, Brad claimed a capital loss of $100,000 for Tan Corporation stock that had become worth- less during the year. In the absence of any offsetting gains, the capital loss deduction produced no income tax savings for Brad either in 1983 or in future years. In 1986, Brad instituted a lawsuit against the former officers of Tan Corporation for their misconduct that resulted in the corpora- tion’s failure and thereby led to Brad’s $100,000 loss. In settlement of the suit, the officers paid $50,000 to Brad. The IRS argued that the full $50,000 should be taxed as gain to Brad. The Tan stock was written off in 1983 and had a zero basis for tax purposes. The $50,000 recovery that Brad received on the stock was, therefore, all gain. The IRS’s position was logical but not equitable. The court stated that Brad should not be taxed on the recovery of an amount previously deducted unless the deduction produced a tax savings. Because the $100,000 capital loss deduction in 1983 produced no tax benefit, none of the $50,000 received in 1986 resulted in gain.

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1-2 SUMMARY In addition to its revenue-raising objective, the Federal tax law has developed in response to several other factors:

• Economic considerations. Here the emphasis is on tax provisions that help regu- late the economy and encourage certain activities and types of businesses.

• Social considerations. Some tax provisions are designed to encourage or discour- age certain socially desirable or undesirable practices.

• Equity considerations. Of principal concern in this area are tax provisions that al- leviate the effect of multiple taxation, recognize the wherewithal to pay concept, mitigate the effect of the annual accounting period concept, and recognize the eroding effect of inflation.

• Political considerations. Of significance in this regard are tax provisions that rep- resent special interest legislation, reflect political expediency, and illustrate the effect of state law.

• Influence of the IRS. Many tax provisions are intended to aid the IRS in collecting revenue and administering the tax law.

• Influence of the courts. Court decisions have established a body of judicial con- cepts relating to tax law and have, on occasion, led Congress to enact statutory provisions that either clarify or negate their effect.

These factors explain various tax provisions and thereby help in understanding why the tax law developed to its present state. The next step involves learning to work with the tax law.

1-3 RECONCILING ACCOUNTING CONCEPTS The vast majority of an entity’s business transactions receive the same treatment for fi- nancial accounting purposes as they do under Federal and state tax law. But “book-tax differences” exist. When variances between Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS) and tax rules do arise, these are highlighted and discussed in a special feature used throughout the text titled Finan- cial Disclosure Insights.

1-4 WORKING WITH THE TAX LAW— TAX SOURCES

Understanding taxation requires a mastery of the sources of tax law. These sources include not only the legislative provisions in the Internal Revenue Code but also congres- sional Committee Reports, Regulations, Treasury Department pronouncements, and court decisions. Thus, the primary sources of tax information are the pronouncements of the three branches of government: legislative, executive, and judicial.

The law is of little significance, however, until it is applied to a set of facts and cir- cumstances. A tax researcher not only must be able to read and interpret the sources of the law but also must understand the relative weight of authority within the rules of law. Learning to work with the tax law involves three basic steps:

1. Familiarity with the sources of the law. 2. Application of research techniques. 3. Effective use of planning procedures.

The remainder of this chapter introduces the sources of tax law and explains how the law is applied to problems and conditions of individual and business transactions. Statutory, administrative, and judicial sources of the tax law are considered first.

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1-4a Statutory Sources of the Tax Law Statutory sources of law include the Constitution (Article I, Sections 7, 8, and 10), tax treaties (agreements between countries to mitigate the double taxation of taxpayers sub- ject to the tax laws of those countries), and the Internal Revenue Code. The Constitution grants Congress the power to impose and collect taxes and also authorizes the creation of treaties with other countries. The power of Congress to implement and collect taxes is summarized in the Internal Revenue Code, the official title of U.S. tax law, and it is the basis for arriving at solutions to all tax questions.

Origin of the Internal Revenue Code Before 1939, the statutory provisions relating to taxation were contained in the individ- ual revenue acts enacted by Congress. The inconvenience and confusion that resulted from dealing with many separate acts led Congress to codify all of the Federal tax laws. Known as the Internal Revenue Code of 1939, the codification arranged all Federal tax provisions in a logical sequence and placed them in a separate part of the Federal stat- utes. A further rearrangement took place in 1954 and resulted in the Internal Revenue Code of 1954.

Perhaps to emphasize the magnitude of the changes made by the Tax Reform Act (TRA) of 1986, Congress redesignated the Internal Revenue Code of 1954 as the Internal Revenue Code of 1986. This change is somewhat deceiving because the tax law was not recodified in 1986, as it had been in 1954. TRA of 1986 merely amended, deleted, or added provisions to the Internal Revenue Code of 1954. For example, before TRA of 1986, § 336 provided the general rule that no gain or loss would be recognized by a cor- poration when it distributed assets in kind to its shareholders in complete liquidation. After the effective date of TRA of 1986, § 336 provides that gain or loss will be recog- nized upon the same distributions (see Chapter 6).

The following observations will help clarify the significance of the three Codes:

• Neither the 1939, the 1954, nor the 1986 Code changed all of the tax law existing on the date of enactment. Much of the 1939 Code, for example, was incorporated into the 1954 Code. The same can be said for the transition from the 1954 to the 1986 Code. This point is important in assessing judicial and administrative decisions interpreting provisions under prior Codes. For example, a decision interpreting § 61 of the Internal Revenue Code of 1954 will have continuing validity because this pro- vision carried over unchanged to the Internal Revenue Code of 1986.

• Statutory amendments to the tax law are integrated into the existing Code. For example, the tax provisions of the American Taxpayer Relief Act of 2012 became part of the Internal Revenue Code of 1986.

Do not conclude, however, that the codification and recodification process has made the Internal Revenue Code a simplistic body of laws. To a large extent, the complexity of our current Code can be attributed to its growth.

The Legislative Process Federal tax legislation generally originates in the House of Representatives, where it is first considered by the House Ways and Means Committee. Tax bills originate in the Senate when they are attached as riders to other legislative proposals.30 If acceptable to the House Ways and Means Committee, the proposed bill is referred to the entire House of Representatives for approval or disapproval. Approved bills are sent to the Senate, where they are considered by the Senate Finance Committee.

The next step is referral from the Senate Finance Committee to the entire Senate. Assuming no disagreement between the House and the Senate, a bill passed by the

LO.5

Identify tax law sources— statutory, administrative, and judicial.

30The Tax Equity and Fiscal Responsibility Act of 1982 originated in the Sen- ate; its constitutionality was unsuccessfully challenged in the courts. The

Senate version of the Deficit Reduction Act of 1984 was attached as an amendment to the Federal Boat Safety Act.

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Senate is referred to the President for approval or veto. If the bill is approved or if the President’s veto is overridden by a two-thirds vote, the bill becomes law and part of the Internal Revenue Code.

When the Senate version of the bill differs from that passed by the House, the Joint Conference Committee resolves these differences. The Joint Conference Committee includes members of the House Ways and Means Committee and the Senate Finance Committee. Exhibit 1.1 summarizes the typical legislative process for tax bills.

Referrals from the House Ways and Means Committee, the Senate Finance Committee, and the Joint Conference Committee are usually accompanied by Committee Reports. These Committee Reports often explain the provisions of the proposed legislation and are therefore a valuable source in ascertaining the intent of Congress. What Congress has in mind when it considers and enacts tax legislation is, of course, the key to interpreting that legislation. Because Regulations normally are not issued immediately after a statute is enacted, taxpayers often look to Committee Reports to ascertain congressional intent.

The role of the Joint Conference Committee indicates the importance of compromise in the legislative process. As an example of the practical effect of the compromise

E X H I B I T 1.1 Legislative Process for Tax Bills

Joint Conference Committee (if the House and Senate differ)

Consideration by the House and Senate

Consideration by the House of

Representatives

Senate Finance Committee

Approval or Veto by the President

Incorporation into the Code (if approved by the President or if the President’s veto is overridden)

Consideration by the Senate

House Ways and Means

Committee

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process, consider Exhibit 1.2, which shows what happened in the Hiring Incentives to Restore Employment Act of 2010 regarding a new credit.

Some tax provisions are commonly referred to by the number the bill received in the House when first proposed or by the name of the member of Congress sponsoring the legislation. For example, the Self-Employed Individuals Tax Retirement Act of 1962 is popularly known as H.R. 10 (the House of Representatives Bill No. 10) or as the Keogh Act (Representative Keogh being one of the members of Congress sponsoring the bill).

Arrangement of the Code In working with the Code, it helps to understand the format. Note the following partial table of contents:

Subtitle A. Income Taxes Chapter 1. Normal Taxes and Surtaxes

Subchapter A. Determination of Tax Liability Part I. Tax on Individuals

Sections 1–5 Part II. Tax on Corporations

Sections 11–12

* * * In referring to a provision of the Code, the key is usually the Section number. In citing

Section 2(a) (dealing with the status of a surviving spouse), for example, it is unneces- sary to include Subtitle A, Chapter 1, Subchapter A, Part I. Merely mentioning Section 2(a) will suffice because the Section numbers run consecutively and do not begin again with each new Subtitle, Chapter, Subchapter, or Part. Not all Code Section numbers are used, however. Note that Part I ends with Section 5 and Part II starts with Section 11 (at present there are no Sections 6, 7, 8, 9, and 10).31

E X H I B I T 1.2 Example of Compromise in the Joint Conference Committee

House Version $1,000 tax credit to

employers per each new qualified employee hired.

New employees must be retained for 52

consecutive weeks.

Joint Conference Committee Result $1,000 tax credit to employers per

each new qualified employee hired. New employees must be retained for

52 consecutive weeks and must be paid wages in the last 26 weeks

that are equal to at least 80% of the wages paid in the first 26 weeks.

Senate Version Tax credit to employers for each

new qualified employee hired. Credit is the lesser of $1,000 or 6.2% of

the wages paid to the employee. New employees must be retained

for 52 consecutive weeks.

31When the 1954 Code was drafted, Section numbers were intentionally omitted. This omission provided flexibility to incorporate later changes into the Code without disrupting its organization. When Congress does not

leave enough space, subsequent Code Sections are given A, B, C, etc., designations. A good example is the treatment of §§ 280A through 280H.

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Tax practitioners commonly refer to a specific area of income taxation by Subchapter designation. Some of the more common Subchapter designations include Subchapter C (Corporate Distributions and Adjustments), Subchapter K (Partners and Partnerships), and Subchapter S (Tax Treatment of S Corporations and Their Shareholders). Particu- larly in the last situation, it is more convenient to describe the subject of the applicable Code provisions (Sections 1361 through 1379) as S corporation status rather than as the “Tax Treatment of S Corporations and Their Shareholders.”

Citing the Code Code Sections often are broken down into subparts.32 Section 2(a)(1)(A) serves as an example.

Abbreviation for “Section”

Section number

Subsection number33

Paragraph designation

Subparagraph designation

§ 2 (a) (1) (A)

Broken down as to content, § 2(a)(1)(A) becomes:

Definitions and special rules (relating to the income tax imposed on individuals).

Definition of a surviving spouse.

For purposes of § 1 (the determination of the applicable rate schedule), a surviving spouse must meet certain conditions.

One of the conditions necessary to qualify as a surviving spouse is that the taxpayer’s spouse must have died during either of his or her two taxable years immediately preceding the present taxable year.

§ 2

(a)

(1)

(A)

Throughout this text, references to Code Sections are in the form just given. The sym- bols “§” and “§§” are used in place of “Section” and “Sections.” Unless otherwise stated, all Code references are to the Internal Revenue Code of 1986. The format followed in the remainder of the text is summarized as follows:

Complete Reference Text Reference

Section 2(a)(1)(A) of the Internal Revenue Code of 1986

§ 2(a)(1)(A)

Sections 1 and 2 of the Internal Revenue Code of 1986

§§ 1 and 2

Section 2 of the Internal Revenue Code of 1954 § 2 of the Internal Revenue Code of 1954

Section 12(d) of the Internal Revenue Code of 193934 § 12(d) of the Internal Revenue Code of 1939

32Some Code Sections do not have subparts. See, for example, § 482. 33Some Code Sections omit the subsection designation and use, instead, the

paragraph designation as the first subpart. See, for example, §§ 212(1) and 1222(1).

34Section 12(d) of the Internal Revenue Code of 1939 is the predecessor to § 2 of the Internal Revenue Code of 1954. Keep in mind that the 1954 Code superseded the 1939 Code.

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1-4b Administrative Sources of the Tax Law The administrative sources of the Federal tax law can be grouped as follows: Treasury Department Regulations, Revenue Rulings and Procedures, and various other adminis- trative pronouncements (see Exhibit 1.3). All are issued by either the U.S. Treasury Department or the IRS. The role played by the IRS in this process is considered in greater depth in Chapter 17.

Treasury Department Regulations Regulations are issued by the U.S. Treasury Department under authority granted by Congress (§ 7805). Interpretative by nature, they provide taxpayers with considerable guidance on the meaning and application of the Code. Although not issued by Congress, Regulations do carry considerable weight. They are an important factor to consider in complying with the tax law. Anyone taking a position contrary to a finalized Regulation must disclose that fact on Form 8275 or Form 8275–R to avoid costly penalties.

Because Regulations interpret the Code, they are arranged in the same sequence. Regu- lations are, however, prefixed by a number that indicates the type of tax or administrative, procedural, or definitional matter to which they relate. For example, the prefix 1 designates the Regulations under the income tax law. Thus, the Regulations under Code § 2 would be cited as Reg. § 1.2, with subparts added for further identification. The numbering of these subparts often has no correlation with the Code subsections. The prefix 20 designates estate tax Regulations; 25 covers gift tax Regulations; 31 relates to employment taxes; and 301 refers to Regulations dealing with procedure and administration. This list is not all-inclusive.

New Regulations and changes in existing Regulations usually are issued in proposed form before they are finalized. The time interval between the proposal of a Regulation and its finalization permits taxpayers and other interested parties to comment on the propriety of the proposal. Proposed Regulations under Code § 2, for example, would be cited as Prop.Reg. § 1.2.

E X H I B I T 1.3 Administrative Sources

Source Location Authority**

Regulations Federal Register* Force and effect of law.

Temporary Regulations Federal Register* May be cited as a precedent.

Internal Revenue Bulletin

Cumulative Bulletin

Proposed Regulations Federal Register* Preview of final Regulations.

Internal Revenue Bulletin

Cumulative Bulletin

Revenue Rulings Internal Revenue Bulletin Do not have the force and effect of law.Revenue Procedures Cumulative Bulletin

Treasury Decisions

Actions on Decisions

General Counsel Memoranda Tax Analysts’ Tax Notes; RIA’s Internal May not be cited as a precedent.

Technical Advice Memoranda Memoranda of the IRS; Commerce Clearing House’s IRS Position Reporter

Letter Rulings Research Institute of America and Commerce Clearing House tax services

Applicable only to taxpayer addressed. No precedential force.

* Finalized, Temporary, and Proposed Regulations are published in soft-cover form by several publishers. ** Each of these sources may be substantial authority for purposes of the accuracy-related penalty in § 6662. Notice 90–20, 1990–1 C.B. 328.

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Sometimes the Treasury Department issues Temporary Regulations relating to elections and other matters where immediate guidance is critical. These Regulations often are needed for recent legislation that takes effect immediately. Temporary Regulations have the same authoritative value as final Regulations and may be cited as precedent for three years. How- ever, Temporary Regulations must also be issued as Proposed Regulations and automati- cally expire within three years after the date of issuance. Temporary Regulations and the simultaneously issued Proposed Regulations carry more weight than traditional Proposed Regulations. An example of a Temporary Regulation is Temp. Reg. § 1.36B-2T(d), which involves the health insurance premium tax credit.

Proposed, final, and Temporary Regulations are published in the Federal Register (now online) and are reproduced in major tax services. Final Regulations are issued as Treasury Decisions (TDs) and carry the force and effect of law.

Revenue Rulings and Revenue Procedures Revenue Rulings are official pronouncements of the National Office of the IRS. Like Reg- ulations, Revenue Rulings are designed to provide interpretation of the tax law. How- ever, they do not carry the same legal force and effect as Regulations and usually deal with more restricted problems.

A Revenue Ruling often results from a specific taxpayer’s request for a letter ruling (as discussed below). If the IRS believes that a taxpayer’s request for a letter ruling deserves official publication due to its widespread impact, the holding will be converted into a Rev- enue Ruling. In making this conversion, names, identifying facts, and money amounts are changed to disguise the identity of the requesting taxpayer. The IRS then issues what would have been a letter ruling as a Revenue Ruling.

Revenue Procedures are issued in the same manner as Revenue Rulings, but deal with the internal management practices and procedures of the IRS. Familiarity with these pro- cedures increases taxpayer compliance and helps make the administration of the tax laws more efficient. Revenue Procedures often involve mechanical rules, but sometimes substantive positions are embedded in them as well. Revenue Rulings and Revenue Pro- cedures serve an important function in that they provide guidance to both IRS personnel and taxpayers in handling routine tax matters. For example, one recent Revenue Proce- dure provided inflation-adjusted amounts for various Code provisions. Revenue Rulings and Revenue Procedures generally apply retroactively and may be revoked or modified by subsequent rulings or procedures, Regulations, legislation, or court decisions.

Revenue Rulings and Revenue Procedures are published weekly by the U.S. Govern- ment in the Internal Revenue Bulletin (I.R.B.).

The proper form for citing Revenue Rulings follows. Revenue Procedures are cited in the same manner, except that “Rev.Proc.” is substituted for “Rev.Rul.”

Rev.Rul. 2014–4, 2014–7 I.R.B. 523. Explanation: Revenue Ruling Number 4, appearing on page 523 of the 7th weekly

issue of the Internal Revenue Bulletin for 2014.

Revenue Rulings and other tax resources may be found in the Tax Almanac, a free online resource from Intuit at www.taxalmanac.org.35

Other Administrative Pronouncements Treasury Decisions (TDs) are issued by the Treasury Department to promulgate new Reg- ulations, to amend or otherwise change existing Regulations, or to announce the position of the Government on selected court decisions. Like Revenue Rulings and Revenue Pro- cedures, TDs are published in the Internal Revenue Bulletin.

Technical Information Releases (TIRs) are usually issued to announce the publication of various IRS pronouncements (e.g., Revenue Rulings, Revenue Procedures).

35Commercial sources for Revenue Rulings and Procedures are available, usually requiring a subscription fee. Older Revenue Rulings and Proce-

dures often are cited as being published in the Cumulative Bulletin (C.B.) rather than the Internal Revenue Bulletin (I.R.B.).

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Letter rulings are issued for a fee by the National Office of the IRS upon a taxpayer’s request and describe how the IRS will treat a proposed transaction for tax purposes. In general, they apply only to the taxpayer who asks for and obtains the ruling, but post- 1984 rulings may be substantial authority for purposes of avoiding the accuracy-related penalties.36 Although this procedure may sound like the only real way to carry out effec- tive tax planning, the IRS limits the issuance of letter rulings to restricted, preannounced areas of taxation. Thus, a ruling may not be obtained on many of the problems that are particularly troublesome for taxpayers.37 For example, the IRS will not issue a ruling as to whether compensation paid to shareholder-employees is reasonable (see Chapter 5) or whether § 269 applies [the acquisition of a corporation to evade or avoid income tax (see Chapter 7)]. The main reason the IRS will not rule on such matters is that they involve fact- oriented situations.

The IRS must make letter rulings available for public inspection after identifying details are deleted. Published digests of private letter rulings can be found in Private Let- ter Rulings (published by Research Institute of America), Bloomberg BNA Daily Tax Reports, and Tax Analysts’ Tax Notes. In addition, computerized databases of letter rul- ings are available through several private publishers.

The National Office of the IRS releases technical advice memoranda (TAMs) weekly. TAMs resemble letter rulings in that they give the IRS’s determination of an issue. Letter rulings, however, are responses to requests by taxpayers, whereas TAMs are issued by the National Office of the IRS in response to questions raised by taxpayers or IRS field personnel during audits. TAMs deal with completed rather than proposed transactions and are often requested for questions relating to exempt organizations and employee plans. Post-1984 TAMs may be substantial authority for purposes of the accuracy-related penalties. See Chapter 17 for a discussion of these penalties.

Both letter rulings and TAMs are issued with multidigit file numbers. Consider, for example, Ltr.Rul. 201432030, which requests a waiver for the rollover period for an IRA. Broken down by digits, the file number reveals the following information:

2014 32 030

Year 2014 Issued during the 32nd week of 2014 30th ruling issued during the 32nd week

Letter rulings and TAMs issued before 2000 are often cited with only two-digit years (e.g., Ltr.Rul. 9933108).

Like letter rulings, determination letters are issued at the request of taxpayers and provide guidance concerning the application of the tax law. They differ from individual rulings in that the issuing source is the Area Director rather than the National Office of the IRS. Also, determination letters usually involve completed (as opposed to proposed) transactions. Determination letters are not published by the government and are made known only to the party making the request.

The following examples illustrate the distinction between individual rulings and determination letters:

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Difference Between Letter Rulings and Determination Letters

The shareholders of Black Corporation and White Corporation want assurance that the consolidation of the corporations into Gray Corporation will be a nontaxable reorganization (see Chapter 7). The proper approach is to request from the National Office of the IRS an individual ruling concerning the income tax effect of the proposed transaction.

36Notice 90–20, 1990–1 C.B. 328, part V (A). 37Rev.Proc. 2015–3, 2015–1 I.R.B. 129, contains a list of areas in which the IRS will not issue advance rulings. From time to time, subsequent Revenue Procedures are issued that modify or amplify Rev.Proc. 2015–3.

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1-4c Judicial Sources of the Tax Law Five Federal courts have jurisdiction over tax disputes between the IRS and taxpayers: the U.S. Tax Court, the U.S. District Court, the U.S. Court of Federal Claims, the U.S. Court of Appeals, and the U.S. Supreme Court.

The Judicial Process in General After a taxpayer has exhausted some or all of the remedies available within the IRS (no satisfactory settlement has been reached at the agent or conference level dis- cussed in Chapter 17), the dispute can be taken to the Federal courts. The dispute is first considered by a court of original jurisdiction (known as a trial court) with any appeal (either by the taxpayer or the IRS) taken to the appropriate appellate court. In most situations, the taxpayer has a choice of any of four trial courts: a Federal District Court, the U.S. Court of Federal Claims, the Tax Court, or the Small Cases Division of the Tax Court. The trial and appellate court system for Federal tax litigation is illus- trated in Exhibit 1.4.

The broken line between the Tax Court and the Small Cases Division indicates that there is no appeal from the Small Cases Division. Currently, the jurisdiction of the Small Cases Division of the Tax Court is limited to $50,000 or less. The proceedings of the Small Cases Division are informal, and its decisions are not precedents for any other court decision and are not reviewable by any higher court. Proceedings can be more timely and less expensive in the Small Cases Division. Some of these cases can now be found on the U.S. Tax Court Internet site.

E X H I B I T 1.4 Federal Judicial Tax Process

* No appeal from this court.

U.S. Supreme Court

U.S. Court of Appeals

(Regional Circuit)

U.S. Court of Appeals

(Federal Circuit)

U.S. Tax Court

U.S. District Court

U.S. Court of Federal

Claims

Small Cases Division*

Appellate Courts

Trial Courts (Courts of Original

Jurisdiction)

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Difference Between Letter Rulings and Determination Letters

Gilbert operates a barbershop in which he employs eight barbers. To comply with the rules gov- erning income tax and payroll tax withholdings, Gilbert wants to know whether the barbers work- ing for him are employees or independent contractors. The proper procedure is to request a determination letter on the status of the barbers from the Area Director in Holtsville, New York, or Newport, Vermont, depending on the location of the requesting firm.

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American law, following English law, is frequently created by judicial decisions. Under the doctrine of stare decisis, each case (except in the Small Cases Division) has precedential value for future cases with the same controlling set of facts.

Judges are not required to follow judicial precedent beyond their own jurisdiction. For example, the decisions of an appellate court are binding only on the trial courts within its jurisdiction and not on other trial courts. Different appellate courts may reach different opinions about the same issue. Further, the doctrine of precedential authority requires a court to follow prior cases only when the issues and material facts of the current case are essentially the same as those involved in the prior decisions.

Most Federal and state appellate court decisions and some decisions of trial courts are published. Published court decisions are organized by jurisdiction (Federal or state) and level of court (appellate or trial).

Trial Courts The differences between the various trial courts (courts of original jurisdiction) can be summarized as follows:

• Number of courts. There is only one Court of Federal Claims and only one Tax Court, but there are many Federal District Courts. The taxpayer does not select the District Court that will hear the dispute, but must sue in the one that has jurisdiction.

• Jurisdiction of the Court of Federal Claims. The U.S. Court of Federal Claims has jurisdiction over any claim against the United States that is based on the Constitu- tion, any Act of Congress, or any regulation of an executive department. Thus, the Court of Federal Claims hears nontax litigation as well as tax cases. This forum appears to be more favorable for issues having an equitable or pro-business orien- tation (as opposed to purely technical issues) and for those requiring extensive discovery of evidence.

• Number of judges. District Courts have various numbers of judges, but only one judge hears a case. The Court of Federal Claims has 16 judges, and the Tax Court has 19 regular judges. In the case of the Tax Court, the whole court will review a case (the case is sent to court conference) only when more important or novel tax issues are involved. Many cases will be heard and decided by one of the 19 regular judges. If a case is reviewed by the full Tax Court, such an en banc decision has compelling authority.

• Location. The Court of Federal Claims meets most often in Washington, D.C., while a District Court meets at a prescribed seat for the particular district. Because each state has at least one District Court and many of the populous states have more, the inconvenience and expense of traveling for the taxpayer and counsel (present with many suits in the Court of Federal Claims) are largely eliminated. The Tax Court is officially based in Washington, D.C., but the various judges travel to different parts of the country and hear cases at predetermined locations and dates. This procedure eases the distance problem for the taxpayer, but it can mean a delay before the case comes to trial and is decided.

• Jurisdiction of the Tax Court and District Courts. The Tax Court hears only tax cases; the Court of Federal Claims and District Courts hear nontax litigation as well. This difference, as well as the fact that many Tax Court justices have been appointed from IRS or Treasury Department positions, has led some to conclude that the Tax Court has more expertise in tax matters.

• Jury trial. The only court in which a taxpayer can obtain a jury trial is a District Court. Juries can decide only questions of fact and not questions of law, however. There- fore, taxpayers who choose the District Court route often do not request a jury trial. In this event, the judge will decide all issues. Note that a District Court decision applies only in the district in which the court has jurisdiction.

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• Payment of deficiency. Before the Court of Federal Claims or a District Court can have jurisdiction, the taxpayer must pay the tax deficiency assessed by the IRS and then sue for a refund. If the taxpayer wins (assuming no successful appeal by the IRS), the tax paid plus appropriate interest will be recovered. Jurisdiction in the Tax Court, how- ever, is usually obtained without first paying the assessed tax deficiency. In the event the taxpayer loses in the Tax Court (and no appeal is taken or any appeal is unsuccess- ful), the deficiency must be paid with accrued interest.

• Appeals. Appeals from a District Court or a Tax Court decision are to the appropri- ate U.S. Court of Appeals. Appeals from the Court of Federal Claims go to the Court of Appeals for the Federal Circuit.

• Special trial judges hear small tax cases and write summary opinions. The IRS’s deficiency recovery rate is higher here than in regular Tax Court decisions. Begin- ning in 2001, these summary opinions are posted on the U.S. Tax Court’s Internet site; regular decisions have been posted there since 1995.

• Because there are “gray areas” in the tax laws, courts may disagree as to the proper tax treatment of a dispute. With these splits in judicial authority, a taxpayer may have some flexibility to “forum shop”—choose the most favorable route to bring a lawsuit.

Some of the characteristics of the judicial system just described are summarized in Concept Summary 1.1.

Appellate Courts An appeal from a trial court goes to the U.S. Court of Appeals of appropriate jurisdiction. Generally, a three-judge panel hears a Court of Appeals case, but occasionally the full court will decide more controversial conflicts. A jury trial is not available.

Exhibit 1.5 shows the geographic area within the jurisdiction of each Federal Court of Appeals.

If the Government loses at the trial court level (District Court, Tax Court, or Court of Federal Claims), it need not (and frequently does not) appeal. The fact that an appeal is not made, however, does not indicate that the IRS agrees with the result and will not liti- gate similar issues in the future.

The IRS may decide not to appeal for a number of reasons. First, the current litigation load may be heavy. As a consequence, the IRS may decide that available personnel should be assigned to other more important cases. Second, the IRS may determine that this is not a good case to appeal. For example, the taxpayer may be in a sympathetic position or the facts may be particularly strong in his or her favor. In such event, the IRS may wait to test

Concept Summary 1.1 Federal Judicial System

Issue U.S. Tax Court U.S. District Court U.S. Court of Federal Claims

Number of judges per court 19* 1 16

Payment of deficiency before trial

No Yes Yes

Jury trial available No Yes No

Types of disputes Tax cases only Most criminal/civil cases Claims against the United States

Jurisdiction Nationwide Location of taxpayer Nationwide

IRS acquiescence policy Yes Yes Yes

Appeal route U.S. Court of Appeals U.S. Court of Appeals U.S. Court of Appeals for the Federal Circuit

* Normally; there are also 5 special trial judges and 15 senior judges.

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the legal issues involved with a taxpayer who has a much weaker case. Third, if the appeal is from a District Court or the Tax Court, the Court of Appeals of jurisdiction could have some bearing on whether the IRS decides to pursue an appeal. Based on past experience and precedent, the IRS may conclude that the chance for success on a particular issue might be more promising in another Court of Appeals. The IRS will wait for a similar case to arise in a different jurisdiction.

District Courts, the Tax Court, and the Court of Federal Claims must abide by the precedents set by the Court of Appeals of jurisdiction. A particular Court of Appeals need not follow the decisions of another Court of Appeals. All courts, however, must follow the decisions of the U.S. Supreme Court.

The role of appellate courts is limited to a review of the trial record compiled by the trial courts. Thus, the appellate process usually involves a determination of whether the trial court applied the proper law in arriving at its decision. Usually, an appellate court will not question a lower court’s fact-finding determination.

An appeal can have any of a number of possible outcomes. The appellate court may approve (affirm) or disapprove (reverse) the lower court’s finding, and it also may send the case back for further consideration (remand). When many issues are involved, it is not unusual to encounter a mixed result. Thus, the lower court may be affirmed (aff’d) on Issue A and reversed (rev’d) on Issue B, while Issue C is remanded (rem’d) for addi- tional fact finding.

When more than one judge is involved in the decision-making process, disagreement is not uncommon. In addition to the majority view, one or more judges may concur (agree with the result reached but not with some or all of the reasoning) or dissent (disagree with the result). In any one case, the majority view controls. But concurring and dissenting views can have influence on other courts or, at some subsequent date when the composi- tion of the court has changed.

Appealing from the Tax Court The Tax Court is a national court, meaning that it hears and decides cases from all parts of the country. For many years, the Tax Court

E X H I B I T 1.5 The Federal Courts of Appeals

7

1

11

2

3

FEDERAL CIRCUIT

8

D.C. CIRCUIT

6 10 4

99

1

3

5

9

FLORIDA MIDDLE

NEW MEXICO

DELAWARE

MARYLAND

TEXAS WESTERN

OKLAHOMA WESTERN

KANSAS

NEBRASKA

SOUTH DAKOTA

NORTH DAKOTAMONTANA

WYOMING

COLORADO

UTAH

IDAHO

ARIZONA

NEVADA

WASHINGTON EASTERN

OREGON

KENTUCKY WESTERN

MAINE

PENNSYLVANIA MIDDLE

MICHIGAN WESTERN

MASSACHUSETTS

RHODE ISLAND

CONN

VIRGINIA WESTERN

W. VIRGINIA SOUTHERN

OHIO NORTHERNINDIANA

NORTHERN

NORTH CAROLINA EASTERN

TENNESSEE MIDDLE

SOUTH CAROLINA

ALABAMA NORTHERNMISSISSIPPI

NORTHERN

ARKANSAS EASTERN

LOUISIANA WESTERN

MISSOURI WESTERN

IOWA NORTHERN

MINNESOTA

WISCONSIN WESTERN

DISTRICT OF COLUMBIA

NEW JERSEY

GEORGIA SOUTHERN

NEW YORK EASTERN

CALIFORNIA EASTERN

ILLINOIS CENTRAL

HAWAII

NORTHERN MARIANA ISLANDS

GUAM

ALASKA

Washington, D.C.

Washington, D.C.

PUERTO RICO

VIRGIN ISLANDS

CALIFORNIA CENTRAL

CALIFORNIA SOUTHERN

C A

L FI

O R

N AI

N

O

R T

H E

R N

WASHINGTON WESTERN

TEXAS NORTHERN

TEXAS SOUTHERN

TEXAS EASTERN

LOUISIANA EASTERN

LOUISIANA MIDDLE

OKLAHOMA EASTERN

OKLAHOMA NORTHERN

MISSISSIPPI SOUTHERN

ALABAMA SOUTHERN

ALABAMA MIDDLE

GEORGIA NORTHERN

GEORGIA MIDDLE

FLORIDA SOUTHERN

FLORIDA NORTHERN

NORTH CAROLINA

MIDDLE

NORTH CAROLINA EASTERN

TENNESSEE EASTERN

TENNESSEE WESTERN

KENTUCKY EASTERN

W. VIRGINIA NORTHERN

VIRGINIA EASTERN

OHIO SOUTHERN

INDIANA SOUTHERN

MICHIGAN EASTERN

WISCONSIN EASTERN

IOWA SOUTHERN

MISSOURI EASTERN

ILLINOIS SOUTHERN

ILLINOIS NORTHERN

ARKANSAS WESTERN

PENNSYLVANIA WESTERN

PENN EASTERN

NEW YORK NORTHERN

NEW YORK SOUTH

NEW YORK WESTERN

LEGEND Circuit Boundaries State Boundaries District Boundaries

ADMINISTRATIVE OFFICE OF THE UNITED STATES SUPREME COURT

APRIL 1988

MICHIGAN WESTERN

NEW HAMPSHIRE

VERMONT

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followed a policy of deciding cases based on what it thought the result should be, even when its decision might be appealed to a Court of Appeals that had previously decided a similar case differently.

Some years ago this policy was changed. Now the Tax Court will still decide a case as it believes the law should be applied only if the Court of Appeals of appropriate jurisdiction has not yet ruled on the issue or has previously decided a similar case in accordance with the Tax Court’s decision. If the Court of Appeals of appropriate jurisdiction has previously held squarely on point otherwise, the Tax Court will conform even though it disagrees with the holding.38 This policy is known as the Golsen rule.

Appeal to the U.S. Supreme Court Appeal to the U.S. Supreme Court is by Writ of Certiorari . If the Court agrees to hear the case, it will grant the Writ (cert. granted). Most often it will deny jurisdiction (cert. denied). For whatever reason or reasons, the Supreme Court rarely hears tax cases. The Court usually grants certiorari when it must resolve a conflict among the Courts of Appeals (e.g., two or more appellate courts have assumed opposing positions on a particular issue) or when the tax issue is extremely important. The granting of a Writ of Certiorari indicates that at least four of the nine members of the Supreme Court believe that the issue is of sufficient importance to be heard by the full Court.

Judicial Citations Having briefly described the judicial process, it is appropriate to consider the more practical problem of the relationship of case law to tax research. As previously noted, court decisions are an important source of tax law. Therefore, the ability to cite a case and to locate it is a must in working with the tax law. Judicial citations usually follow a standard pattern: case name, volume number, reporter series, page or paragraph num- ber, court (where necessary), and year of the decision (see Concept Summary 1.2).

Judicial Citations—The U.S. Tax Court A good starting point is the U.S. Tax Court, which issues three types of decisions: Regular decisions, Memorandum decisions, and summary opinions. They differ in both substance and form. In terms of substance, Mem- orandum decisions deal with situations necessitating only the application of already established principles of law. Regular decisions involve novel issues not previously resolved by the Tax Court. In actual practice, this distinction is not always preserved. Not infrequently, Memorandum decisions will be encountered that appear to warrant Regular status and vice versa. At any rate, do not conclude that Memorandum decisions possess no value as precedents. Both Memorandum and Regular decisions represent the position of the Tax Court and, as such, can be relied upon. Summary opinions, on the other hand, are issued in small tax cases and may not be used as precedent in any other case.

Regular decisions are published by the U.S. Government in a series called Tax Court of the United States Reports (T.C.). Each volume of these reports covers a six-month period (January 1 through June 30 and July 1 through December 31) and is given a

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Gene lives in Texas and sues in the Tax Court on Issue A. The Fifth Circuit Court of Appeals, the appellate court of appropriate jurisdiction, has already decided, in a case involving similar facts but a different taxpayer, that Issue A should be resolved against the IRS. Although the Tax Court believes that the Fifth Circuit Court of Appeals is wrong, under the Golsen rule, it will render judg- ment for Gene. Shortly thereafter, Beth, a resident of New York, in a comparable case, sues in the Tax Court on Issue A. Assume that the Second Circuit Court of Appeals, the appellate court of appropriate jurisdiction, has never expressed itself on Issue A. Presuming that the Tax Court has not reconsidered its position on Issue A, it will decide against Beth. Thus, it is entirely possible for two taxpayers suing in the same court to end up with opposite results merely because they live in different parts of the country.

38Jack E. Golsen, 54 T.C. 742 (1970); see also John A. Lardas, 99 T.C. 490 (1992).

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succeeding volume number. But there is usually a time lag between the date a decision is rendered and the date it appears in bound form. A temporary citation may be neces- sary to help the researcher locate a recent Regular decision. Consider, for example, the temporary and permanent citations for Uniband, Inc., a decision filed on May 22, 2013.

Temporary Citation

� Uniband, Inc., 140 T.C. ___, No. 13 (2013). Explanation: Page number left blank because not yet known.

Permanent Citation

� Uniband, Inc., 140 T.C. 230 (2013). Explanation: Page number now available.

Both citations tell us that the case ultimately will appear in Volume 140 of the Tax Court of the United States Reports. But until this volume is bound and made available to the general public, the page number must be left blank. Instead, the temporary citation identifies the case as being the 3rd Regular decision issued by the Tax Court since Volume 139 ended. With this information, the decision can be easily located in either of the special Tax Court services published by Commerce Clearing House (CCH) and by Research Institute of America (RIA). Once Volume 140 is released, the permanent cita- tion can be substituted and the number of the case dropped. Starting in 1995, both Regular and Memorandum decisions are issued on the U.S. Tax Court website (www.ustaxcourt.gov).

Concept Summary 1.2 Judicial Sources

Court Location Authority

U.S. Supreme Court S.Ct. Series (West) Highest authority

U.S. Series (U.S. Gov’t.)

L.Ed.2d (Lawyer’s Co-op.)

AFTR (RIA)

USTC (CCH)

U.S. Courts of Appeal Federal 3d (West) Next highest appellate court

AFTR (RIA)

USTC (CCH)

Tax Court (Regular decisions) U.S. Gov’t. Printing Office Highest trial court*

RIA/CCH separate services

Tax Court (Memorandum decisions) RIA T.C.Memo. (RIA) Less authority than Regular T.C. decision

TCM (CCH)

U.S. Court of Federal Claims** Federal Claims Reporter (West) Similar authority as Tax Court

AFTR (RIA)

USTC (CCH)

U.S. District Courts F.Supp.2d Series (West) Lowest trial court

AFTR (RIA)

USTC (CCH)

Small Cases Division of Tax Court U.S. Tax Court website*** No precedent value

* Theoretically, the Tax Court, Court of Federal Claims, and District Courts are on the same level of authority. But some people believe that because the Tax Court hears and decides tax cases from all parts of the country (i.e., it is a national court), its decisions may be more authoritative than a Court of Federal Claims or District Court decision.

** Before October 29, 1992, the U.S. Claims Court. *** Starting in 2001.

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Before 1943, the Tax Court was called the Board of Tax Appeals and its decisions were published as the United States Board of Tax Appeals Reports (B.T.A.). These 47 volumes cover the period from 1924 to 1942. For example, the citation Karl Pauli, 11 B.T.A. 784 (1928) refers to the 11th volume of the Board of Tax Appeals Reports, page 784, issued in 1928.

Memorandum decisions are published by CCH and by RIA. Consider for example, the three different ways the Nick R. Hughes case can be cited:

Nick R. Hughes, T.C.Memo. 2009–94. Explanation: The 94th Memorandum decision issued by the Tax Court in 2009.

Nick R. Hughes, 97 TCM 1488. Explanation: Page 1488 of Vol. 97 of the CCH Tax Court Memorandum Decisions.

Nick R. Hughes, 2009 RIA T.C. Memo. {2009,094. Explanation: Paragraph 2009,094 of the RIA T.C. Memorandum Decisions.

Note that the third citation contains the same information as the first. Thus,{2009,094 indi- cates the following information about the case: year 2009, 94th T.C.Memo. decision. Before the Prentice Hall Service division was incorporated into the Research Institute of America, “PH” was used in the third citation instead of “RIA.”39

U.S. Tax Court Summary Opinions relate to decisions of the Tax Court’s Small Cases Division and may not be treated as precedent. These opinions are published commer- cially, and some are also available on the U.S. Tax Court website. For example, John Erwin Smith, filed on February 19, 2014, is cited as follows:

John Erwin Smith, T.C. Summary 2014–13.

Judicial Citations—The U.S. District Courts, Claims Court, and Courts of Appeals District Court, Claims Court (now Court of Federal Claims), Court of Appeals, and Supreme Court decisions dealing with Federal tax matters are reported in both the CCH U.S. Tax Cases (USTC) and the RIA American Federal Tax Reports (AFTR) series.

Federal District Court decisions, dealing with both tax and nontax issues, are also published by West in its Federal Supplement (F.Supp.) series. The following examples illustrate how a District Court case can be cited in three different forms:

Turner v. U.S., 2004–1 USTC {60,478 (D.Ct. Tex., 2004). Explanation: Reported in the first volume of the U.S. Tax Cases published by

Commerce Clearing House for calendar year 2004 (2004–1) and located at paragraph 60,478 ({60,478).

Turner v. U.S., 93 AFTR 2d 2004–686 (D.Ct. Tex., 2004). Explanation: Reported in the 93rd volume of the second series of the American

Federal Tax Reports (AFTR 2d) published by RIA and beginning on page 686.

Turner v. U.S., 306 F.Supp.2d 668 (D.Ct. Tex., 2004). Explanation: Reported in the 306th volume of the second series of the Federal

Supplement (F.Supp.2d) published by West and beginning on page 668.

In all of the preceding citations, note that the name of the case is the same (Turner being the taxpayer), as is the reference to the Federal District Court of Texas (D.Ct. Tex.) and the year the decision was rendered (2004).40

39In this text, the Research Institute of America (RIA) citation for Memoran- dum decisions of the U.S. Tax Court is omitted. Thus, Nick R. Hughes will be cited as 97 TCM 1488, T.C.Memo. 2009–94.

40In the text, the case will be cited in the following form: Turner v. U.S., 2004–1 USTC{60,478, 93 AFTR 2d 2004–686, 306 F.Supp.2d 668 (D.Ct.Tex., 2004).

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Beginning in October 1982, decisions of the Claims Court are reported by West in a series designated Federal Claims Reporter. Thus, the Claims Court decision in Recchie v. U.S. appears as follows:

Recchie v. U.S.

83–1 USTC ¶9312 (CCH citation) 51 AFTR 2d 83–1010 (RIA citation) 1 Cl.Ct. 726 (West citation)

(Cl.Ct., 1983)

Beginning on October 30, 1992, the Claims Court underwent a further name change. The new designation, U.S. Court of Federal Claims, began with Volume 27 of the former Cl.Ct. (West citation), now abbreviated as Fed.Cl.

(Fed.Cl., 1994)Apollo Computer, Inc. v. U.S.

95–1 USTC ¶50,015 (CCH citation) 74 AFTR 2d 94–7172 (RIA citation) 32 Fed.Cl. 334 (West citation)

Decisions of the Courts of Appeals are published in a West reporter designated as the Federal Third (F.3d) series, which began in October 1993, at the conclusion of the Federal Second (F.2d) series. Illustrations of the different forms follow:

(CA–2, 2003)Estate of Gribaukas v. Comm.

2003–2 USTC ¶60,466 (CCH citation) 92 AFTR 2d 2003–5914 (RIA citation) 342 F.3d 85 (West citation)

Note that Estate of Gribaukas v. Comm. is a decision rendered by the Second Circuit Court of Appeals in 2003 (CA–2, 2003).

If the IRS loses in a decision, it may indicate whether it agrees or disagrees with the results reached by the court by publishing an acquiescence (“A” or “Acq.”) or nonacquiescence (“NA” or “Nonacq.”), respectively. The acquiescence or nonacquies- cence is published in the Internal Revenue Bulletin and the Cumulative Bulletin as an Action on Decision. The IRS can retroactively revoke an acquiescence or nonacquies- cence. Originally, acquiescences and nonacquiescences were published only for Regu- lar U.S. Tax Court decisions, but since 1991, the IRS has expanded its acquiescence program to include other civil tax cases where guidance is helpful.

Judicial Citations—The U.S. Supreme Court Like all other Federal tax cases (except those rendered by the U.S. Tax Court), Supreme Court decisions are published by CCH in the USTCs and by RIA in the AFTRs. The U.S. Government Printing Office also publishes these decisions in the United States Supreme Court Reports (U.S.) as does West in its Supreme Court Reporter (S.Ct.) and the Lawyer’s Co-operative Publishing Company in its United States Reports, Lawyer’s Edition (L.Ed.). The following illustrates the different ways the same decision can be cited:

U.S. v. The Donruss Co.

69–1 USTC ¶9167 (CCH citation) 23 AFTR 2d 69–418 (RIA citation) 89 S.Ct. 501 (West citation) 393 U.S. 297 (U.S. Government Printing Office citation) 21 L.Ed.2d 495 (Lawyer's Co-operative Publishing Co. citation)

(USSC, 1969)

The parenthetical reference (USSC, 1969) identifies the decision as having been rendered by the U.S. Supreme Court in 1969. The citations given in this text for Supreme Court deci- sions will be limited to the CCH (USTC), the RIA (AFTR), and the West (S.Ct.) versions.

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1-4d Other Sources of the Tax Law Other sources of the tax law include tax treaties and tax periodicals.

Tax Treaties The United States signs certain tax treaties (sometimes called tax conventions) with for- eign countries to render mutual assistance in tax enforcement and to avoid double taxa- tion. Tax legislation enacted in 1988 provided that neither a tax law nor a tax treaty takes general precedence. Thus, when there is a direct conflict between a treaty and the Code, the most recent item takes precedence. More than 34 sections of the Code con- tain direct references to treaties [e.g., § 245(a)(10)].

Tax Periodicals The use of tax periodicals can often shorten the research time needed to resolve a tax problem. If the article is relevant to the issue at hand, it may provide the references needed to locate the primary sources of the tax that apply (e.g., citations to judicial deci- sions, Regulations, and other IRS pronouncements). Thus, the researcher obtains a “running start” in arriving at a solution to the problem.

Among the many indexes available for locating tax articles are Federal Tax Articles (published by CCH) and Index to Federal Tax Articles (published by Warren, Gorham, and Lamont). These indexes are updated periodically but are available only in print form.

Following are some of the more useful tax periodicals with their online addresses (usually preceded by http://):

Journal of Taxation Journal of International Taxation Practical Tax Strategies Estate Planning Corporate Taxation Business Entities Taxation of Exempts Real Estate Taxation ria.thomsonreuters.com/journals

The Tax Executive www.tei.org

The Tax Adviser www.aicpa.org/pubs/taxadv

Journal of the American Taxation Association aaajournals.org/loi/atax

The ATA Journal of Legal Tax Research aaajournals.org/loi/jltr

Oil, Gas & Energy Quarterly www.bus.lsu.edu/accounting/ faculty/lcrumbley/oilgas.html

Trusts and Estates wealthmanagement.com/te-home

Journal of Passthrough Entities TAXES—The Tax Magazine tax.cchgroup.com/books

Tax Notes www.taxanalysts.com

Tax Law Review www.law.nyu.edu/tax/ taxlawreview/index.htm

1-5 WORKING WITH THE TAX LAW—LOCATING AND USING TAX SOURCES

Tax law consists of a body of legislative (e.g., Code Sections and tax treaties), adminis- trative (e.g., Regulations and Rulings), and judicial (e.g., court cases) pronouncements. Working with the tax law, moreover, requires being able to locate and effectively use these sources. A key consideration is the time required to carry out this search and find activity.

LO.6

List and assess tax law sources.

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Unless the problem is simple (e.g., the Code Section is known and there is a Regula- tion on point), the research process will begin with a tax service.

1-5a Commercial Tax Services Due to various changes, categorizing tax services has become an almost impossible task. The old classification of annotated (i.e., organized by Internal Revenue Code) or topical (i.e., organized by major topics) is no longer appropriate for many services as their format has been modified. Often the change is due to the acquisition of a compet- ing service. For example, the United States Tax Reporter (annotated) now has a version containing the Federal Tax Coordinator 2d (topical).

In addition, services can no longer be distinguished based on whether they are avail- able in hard copy or online versions. Tax Management Portfolios, for example, was previously solely a print publication. Now, like most other services, it is also accessible online.

A partial list of the available commercial services includes the following:

• Standard Federal Tax Reporter, Commerce Clearing House.

• CCH IntelliConnect, Commerce Clearing House. The online version of the Standard Federal Tax Reporter (along with other CCH products).

• United States Tax Reporter, Research Institute of America.

• Thomson Reuters Checkpoint, Research Institute of America. The online version of RIA’s United States Tax Reporter and Federal Tax Coordinator 2d.

• ATX/Kleinrock Tax Expert, CCH/Wolters Kluwer Business Services.

• Tax Management Portfolios, Bloomberg BNA.

• Mertens Law of Federal Income Taxation, West Group.

• Westlaw services—compilations include access to Tax Management Portfolios, Federal Tax Coordinator 2d, and Mertens.

• Tax Center, LexisNexis compilation of primary sources and various materials taken from CCH, Matthew Bender, Kleinrock, and Bloomberg BNA.

• Federal Research Library, Tax Analysts (a nonprofit organization) databases deal- ing with explanations and commentaries on primary source materials.

1-5b Using Online Tax Services Instructions on how to use a tax service are not particularly worthwhile unless a specific service is involved. Even then, instructions need to be followed by hands-on experi- ence. Following certain procedures, however, can simplify the process of using an online version of a tax service. Because a practitioner’s time is valuable and various research services base usage charges on time spent, time is of the essence.

Given this emphasis on time, every shortcut helps. Some suggestions (most of which are familiar to any user of the Internet) follow:41

• Take care in choosing keywords for the search. Words with a broad usage, such as income, are worthless when standing alone. If the researcher is interested in qualified dividend income, even dividend income is too broad as it will call up a variety of subjects such as stock dividends, constructive dividends, and liquidating dividends. By using qualified dividend income at the outset, the search is consid- erably narrowed. In Thomson Reuters Checkpoint, for example, these two modifi- cations narrowed the search from 10,000 items to 3,824 and finally to 884. From that point, further contraction will be needed.

41For a more complete discussion of the use of Thomson Reuters Checkpoint and CCH IntelliConnect, as well as Internet research in taxation in general,

see Sawyers, Raabe, Whittenburg, and Gill, Federal Tax Research, 10th ed. (Cengage Learning, 2015), Chapters 6 and 7.

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• Take advantage of connectors to place parameters on the search and further restrict the output. Although each service has its own set of connectors, many are common as to usage. Thus, enclosing words in quotation marks (e.g., “personal service corporation”) means “exact phrase” in both Thomson Reuters Checkpoint and CCH IntelliConnect.

• Be selective in choosing a database. For example, if the research project will not involve case law, there is no point in including judicial decisions in the search database. Doing so just adds to the output and will necessitate further screening through a search modification.

• Although the keyword approach is most frequently used, consider using the table of contents or index or searching by citation. The first two of these methods are the usual approach with print versions of a tax service. Citations may be used to search for statutory (e.g., Code Section), administrative (e.g., Rev.Rul.), or judicial (e.g., Tax Court) sources depending on the service. Using just a Code Section number or the taxpayer’s last name, however, can require a significant amount of screening to narrow the information.

1-5c Noncommercial Online Tax Sources The Internet provides a wealth of tax information in several popular forms, sometimes at no direct cost to the researcher. Using so-called browser software that often is distributed

F I N A N C I A L D I S C L O S U R E I N S I G H T S Where Does GAAP Come From?

As this chapter has explained, the tax law has many sources, including Congress and the legislators of other countries, the courts, and the IRS. Similarly, accounting principles also have many sources. In reconciling the tax and financial accounting reporting of a transaction, the tax professional may need to know the hierarchy of authority of accounting principles so that the proper level of importance can be assigned to a specific GAAP document. The diagram shown below presents the sources of GAAP, listed in general order of authority, from highest to lowest.

Professional research is conducted to find and analyze the sources of accounting reporting standards in much the same way tax professionals conduct research into open tax questions. In fact, many of the publishers that provide tax research materials also can be used to find GAAP and IFRS documents. These include the Research Institute of America (RIA) and Commerce Clearing House (CCH). The Financial Accounting Standards Board (FASB) also makes its standards and interpretations available by subscription.

• Financial Accounting Standards and Interpretations of the FASB.

• Pronouncements of bodies that preceded the FASB, such as the Accounting Principles Board (APB).

• FASB Technical Bulletins.

• Audit and Accounting Guides, prepared by the American Institute of CPAs (AICPA) and cleared by the FASB.

• Practice Bulletins, prepared by the AICPA and cleared by the FASB.

• Interpretation Guides of the FASB Staff.

• Accounting Interpretations of the AICPA.

• IASB Accounting Standards

• FASB Concepts Standards.

• Widely accepted accounting practices, professional journals, accounting textbooks, and treatises.

Highest Authority

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with new computer systems and their communication devices, the tax professional can access information provided around the world that can aid the research process.

• Home pages (sites) on the Web are provided by accounting and consulting firms, publishers, tax academics and libraries, and governmental bodies as a means of making information widely available or of soliciting subscriptions or consulting engagements. The best sites offer links to other sites and direct contact to the site providers. One of the best sites available to the tax practitioner is the Internal Rev- enue Service’s home page, illustrated in Exhibit 1.6. This site offers downloadable forms and instructions, “plain English” versions of Regulations, and news update items. Exhibit 1.7 lists some of the websites that may be most useful to tax researchers and the Internet addresses as of press date. Particularly useful is the directory at http://taxsites.com, which provides links to accounting and tax sources (includes international as well as payroll).

• Blogs and RSS sites provide a means by which information related to the tax law can be exchanged among taxpayers, tax professionals, and others who sub- scribe to the group’s services. Individuals can read the exchanges among other people and offer replies and suggestions to inquiries as desired. Discussions address the interpretation and application of existing law, analysis of proposals and new pronouncements, and reviews of tax software.

E X H I B I T 1.6 The IRS’s Home Page

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While tax information on the Internet is plentiful, public domain information never should be relied upon without referring to other more reliable sources. Always remem- ber that anyone can set up a website and that quality control can be difficult for the tax professional to ascertain.

1-6 WORKING WITH THE TAX LAW— TAX RESEARCH

Tax research is the method used to determine the best available solution to a situa- tion that possesses tax consequences. In other words, it is the process of finding a competent and professional conclusion to a tax problem. The problem may originate from either completed or proposed transactions. In the case of a completed transac- tion, the objective of the research is to determine the tax result of what has already taken place. For example, is the expenditure incurred by the taxpayer deductible or not deductible for tax purposes? When dealing with proposed transactions, the tax research process is concerned with the determination of possible alternative tax con- sequences. To the extent that tax research leads to a choice of alternatives or other- wise influences the future actions of the taxpayer, it becomes the key to effective tax planning.

E X H I B I T 1.7 Tax-Related Websites

Website Web Address Description

Accounting firms and professional organizations

For instance, the AICPA’s page is at aicpa.org, Ernst & Young is at ey.com, and KPMG is at kpmg.com

Tax planning newsletters, descriptions of services offered and career opportunities, and exchange of data with clients and subscribers

Cengage Learning cengagebrain.com Informational updates, newsletters, support materials for students and adopters, and continuing education

Commercial tax publishers For instance, tax.com, cchgroup.com, tax.thomsonreuters.com, and bna.com

Information about products and services available for subscription and newsletter excerpts

Court opinions The site at law.justia.com covers state, Federal, and Supreme Court decisions but not Tax Court

A synopsis of result reached by the court

Federal Register federalregister.gov Releases from the IRS (e.g., Regulations)

Internal Revenue Service irs.gov News releases, downloadable forms and instructions, tables, Circular 230, and e-mail

Tax Almanac taxalmanac.org Smorgasbord of tax research resources

Tax Analysts taxanalysts.com Policy-oriented readings on the tax law and proposals to change it and moderated bulletins on various tax subjects

Tax Foundation taxfoundation.org Nonprofit educational organization that promotes sound tax policy and measures tax burdens

Tax laws online Regulations are at law.cornell.edu/cfr and the Code is at uscode.house.gov

Tax Sites Directory taxsites.com References and links to tax sites on the Internet, including state and Federal tax sites, academic and professional pages, tax forms, and software

U.S. Tax Court decisions ustaxcourt.gov Recent U.S. Tax Court decisions

Caution: Web addresses change frequently.

LO.7

Demonstrate tax research.

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Tax research involves the following procedures:

• Identifying and refining the problem.

• Locating the appropriate tax law sources.

• Assessing the validity of the tax law sources.

• Arriving at the solution or at alternative solutions while giving due consideration to nontax factors.

• Effectively communicating the solution to the taxpayer or the taxpayer’s representative.

• Following up on the solution (where appropriate) in light of new developments.

This process is depicted schematically in Exhibit 1.8. The broken lines indicate steps of particular interest when tax research is directed toward proposed rather than com- pleted transactions.

1-6a Identifying the Problem Problem identification starts with a compilation of the relevant facts involved. In this regard, all of the facts that might have a bearing on the problem must be gathered as any omission could modify the solution reached. To illustrate, refer to the facts of The Big Picture on p. 1-1. Is Dana entitled to a bad debt deduction?

Refining the Problem Before a bad debt deduction can arise, it must be established that a debt really existed. In a related-party setting (e.g., aunt and nephew), the IRS may contend that the original advance was not a loan but was, in reality, a gift. Of key significance in this regard would be whether the lender (the aunt) had an honest and real expectation of payment

E X H I B I T 1.8 Tax Research Process

Communication New

Developments

Problem Refinement and

Discovery of New Problem

Areas

Legislative Sources

Administrative Sources

Judicial Sources

Unofficial Sources

Nontax Considerations

Preliminary Problem

Identification

Tax Research

Solution

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by the borrower (the nephew).42 Indicative of this repayment expectation is whether the parties preserved the formalities of a loan, including the following:

• The borrower issued a written instrument evidencing the obligation.

• The loan arrangement provided for interest.

• The note specified a set due date.

• Collateral was available to the lender in the event of default by the borrower.43

The presence of some or all of these formalities does not, however, guarantee that a bona fide loan will be found. By the same token, the absence of some or all of the for- malities does not make the advance a gift. Applying the formalities criteria to The Big Picture on p. 1-1 is not possible because key facts (e.g., the presence or absence of a written note) are not given. Nevertheless, several inferences might be made that lead to a loan interpretation:

• It appears that the nephew has repaid $16,000 of the $93,000 that he borrowed. If the parties intended a gift of the full amount of the loan, why was partial repay- ment made?

• Although one would not expect a nephew on his way to college to have assets to serve as collateral for a loan, the fact that he was obtaining additional education could reinforce any expectation of repayment. In most situations, a person with a college education will possess a higher earning potential than one without such education. This education would improve the nephew’s financial ability to repay the loan.

Further Refinement of the Problem It may be impossible to determine with any degree of certainty whether the advance constitutes a loan or a gift. In either event, however, the tax consequences of each pos- sibility must be ascertained.

If the advance is determined to be a gift, it is subject to the Federal gift tax.44 Whether a gift tax results depends upon how much of the unified tax credit the aunt has available to absorb the gift tax on $81,000 [$93,000 (total gift)�$12,000 (annual exclusion in 2008)].45 Whether the transfer results in a gift tax or not, it must be reported on Form 709 (United States Gift Tax Return) because the amount of the gift exceeds the annual exclusion.

Even if it is assumed that Dana made a gift to her nephew in 2008, does not the inter- vention of seven years preclude the IRS from assessing any gift tax that might be due as a result of the transfer?46 Further research indicates that the statute of limitations on assessments does not begin to run when a tax return is not filed.47

To complete The Big Picture on p. 1-1, what are the tax consequences if the advance is treated as a loan? Aside from the bad debt deduction aspects (covered later in the chapter), the tax law provides more immediate tax ramifications:48

• If interest is not provided for, it is imputed with the following effect:

a. The lender (the aunt) must recognize interest income as to the imputed value. b. Because the lender has not received the interest, she is deemed to have made a

gift of the interest to the borrower.

42William F. Mercil, 24 T.C. 1150 (1955), and Evans Clark, 18 T.C. 780 (1952), aff’d 53–2 USTC {9452, 44 AFTR 70, 205 F.2d 353 (CA–2, 1953).

43Arthur T. Davidson, 37 TCM 725, T.C.Memo. 1978–167. 44The transfer does not come within the unlimited gift tax exclusion of

§ 2503(e)(2)(A) because the aunt did not pay the amount directly to an educational institution. Besides, the exclusion covers only tuition payments and not other costs attendant on going to college (e.g., room and board).

45The tax, in turn, depends upon the amount of taxable gifts the aunt has made in the past. For a discussion of the mechanics of the Federal gift tax, see Chapter 18.

46Throughout the discussion of The Big Picture on p. 1-1, the assumption has been made that if a gift occurred, it took place in 2008. That assump- tion need not be the case. Depending upon the aunt’s intent, she could have decided to make a gift of the unpaid balance anytime after the loan was made (e.g., 2009 or 2010).

47See § 6501(c)(3) and the discussion of the statute of limitations in Chapter 17. 48§ 7872.

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c. The borrower (nephew) may be entitled to deduct (as an itemized expense) in some tax years a portion of the amount of interest deemed paid to the lender (aunt).

• If interest is provided for but the rate is lower than market (as determined by the yield on certain U.S. government securities), the differential is treated as noted above.

• For gift loans of $100,000 or less, the imputed element cannot exceed the net investment income of the borrower.

1-6b Locating the Appropriate Tax Law Sources Once the problem is clearly defined, what is the next step? Although the next step is a matter of individual judgment, most tax research begins with the index volume of a hard copy tax service or a keyword search on an online tax service (see the earlier discussion). If the problem is not complex, the researcher may bypass the tax service and turn directly to the Internal Revenue Code and the Treasury Regulations. For the beginner, this procedure saves time and will solve many of the more basic problems. If the researcher does not have a personal copy of the Code or Regulations, resorting to the appropriate volume(s) of a tax service may be necessary. Several of the major tax services publish paperback editions of the Code and Treasury Regulations that can be purchased at modest prices. These editions are usually revised twice each year.

1-6c Assessing the Validity of Tax Law Sources After a source has been located, the next step is to assess the source in light of the prob- lem at hand. Proper assessment involves careful interpretation of the tax law and con- sideration of the law’s relevance and validity.

Interpreting the Internal Revenue Code The language of the Code often is extremely difficult to comprehend. For example, a former subsection [§ 341(e)] relating to collapsible corporations contained one sentence of more than 450 words (twice as many as in the Gettysburg Address). Within this same subsection was another sentence of 300 words.

The Code must be read carefully for restrictive language such as “at least 80 percent” and “more than 80 percent” or “less than 50 percent” and “exceeds 50 percent.” It also makes a great deal of difference, for example, whether two or more clauses are con- nected by or or by and.

If an answer is not in the Code, it may be necessary to resort to the Regulations and judicial decisions. In 1969, Congress directed the Treasury Department to promulgate Regulations under § 385 to distinguish corporate debt from corporate equity. As of yet, there are no Regulations under § 385. The researcher, therefore, must resort to past judi- cial decisions for a definition of debt.

Sometimes the Code directs the researcher elsewhere for the answer. For example, § 162(c) refers to the Foreign Corrupt Practices Act for purposes of determining when payments to foreign officials are deductible.

Cross-referencing between Code Sections is often poor or nonexistent. Code Sections are enacted at different times by Congresses that are operating under stringent deadlines. Conse- quently, a certain lack of integration within the Code is frequently apparent.

Definitions vary from one Code Section to another. For example, § 267 disallows losses between related parties and includes brothers and sisters in the definition of related parties. Not so with § 318, which deals with the definition of related parties as to certain stock redemptions.

LO.8

Assess the validity and weight of tax law sources.

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Assessing the Validity of a Treasury Regulation Treasury Regulations are often said to have the force and effect of law. This statement is certainly true for most Regulations, but some judicial decisions have held a Regulation or a portion thereof invalid. Usually, this is done on the grounds that the Regulation is contrary to the intent of Congress.

Keep the following observations in mind when assessing the validity of a Regulation:

• IRS agents must give the Code and any related Regulations equal weight when dealing with taxpayers and their representatives.

• In a challenge, the burden of proof is on the taxpayer to show that the Regulation is wrong. However, a court may invalidate a Regulation that varies from the lan- guage of the statute and has no support in the Committee Reports.

• If the taxpayer loses the challenge, the negligence penalty may be imposed. This ac- curacy-related provision deals with the “intentional disregard of rules and regu- lations” on the part of the taxpayer and is explained further in Chapter 17.

• Some Regulations merely reprint or rephrase what Congress has stated in its Com- mittee Reports issued in connection with the enactment of tax legislation. Such Regulations are “hard and solid” and almost impossible to overturn because they clearly reflect the intent of Congress.

• In some Code Sections, Congress has given to the “[Treasury] Secretary or his del- egate” the authority to prescribe Regulations to carry out the details of administra- tion or to otherwise complete the operating rules. Under such circumstances, Congress effectively is delegating its legislative powers to the Treasury Depart- ment. Regulations issued pursuant to this type of authority truly possess the force and effect of law and are often called “legislative” Regulations. They are to be dis- tinguished from “interpretative” Regulations, which are issued to explain the meaning of a particular Code Section. Examples of legislative Regulations are those dealing with consolidated returns issued under §§ 1501 through 1505. As a further example, note the authority granted to the Treasury Department by § 385 to issue Regulations setting forth guidelines on when corporate debt can be reclas- sified as equity (see Chapter 4).

• Courts tend to apply a legislative reenactment doctrine. A particular interpretive Regulation is assumed to have achieved congressional approval if the Regulation was finalized many years earlier and Congress has not amended the Code Section pertaining to the Regulation.

T A X I N T H E N E W S Baseball and Tax Research

An analogy based on the philosophy of Sandy Koufax, a great pitcher for the Los Angeles Dodgers in the late 1950s and 1960s, is appropriate for a tax researcher. Koufax is one of only 23 baseball players to pitch a perfect game. He said that whenever he started a game, he tried to pitch a perfect game. If he was not successful, he tried for a no-hitter and then a shutout (no runs). And, if he failed at all of these, he tried to win the game.

In researching a tax problem, the researcher first tries to find an Internal Revenue Code section, a tax treaty, or a leg- islative committee report that is on point and can support a

taxpayer’s position. If unable to find specific support with legislative sources, the researcher then turns to other pri- mary sources, including Regulations, Revenue Rulings or Procedures, and court decisions (looking for a decision in the highest-level court possible). If no primary authority can be found, the researcher then looks for support in second- ary authorities, such as Bluebook passages, legal periodicals, treatises, textbooks, letter rulings or other guidance from the IRS (general counsel memorandums or technical advice memorandums), or comments from a tax service to support the taxpayer’s position.

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Assessing the Validity of Other Administrative Sources of the Tax Law Revenue Rulings issued by the IRS carry less weight than Treasury Department Regula- tions. Rulings are important, however, in that they reflect the position of the IRS on tax matters. In any dispute with the IRS on the interpretation of tax law, taxpayers should expect agents to follow the results reached in any applicable rulings.

Actions on Decisions further tell the taxpayer the IRS’s reaction to certain court decisions. Recall that the IRS follows a practice of either acquiescing (agreeing) or nonacquiescing (not agreeing) with court decisions where guidance may be helpful. This practice does not mean that a particular decision has no value if the IRS has nonacquiesced in the result. It does, however, indicate that the IRS will continue to litigate the issue involved.

The validity of individual letter rulings issued by the IRS is discussed in Chapter 17.

Assessing the Validity of Judicial Sources of the Tax Law The judicial process as it relates to the formulation of tax law has been described. How much reliance can be placed on a particular decision depends upon the following variables:

• The level of the court. A decision rendered by a trial court carries less weight than one issued by an appellate court. Under the Code currently, decisions by the U.S. Supreme Court represent the last word on any tax issue.

• The legal residence of the taxpayer. A decision of the appellate court in the tax- payer’s circuit carries more weight than one rendered by an appellate court in a different circuit. If, for example, a taxpayer lives in Texas, a decision of the Fifth Circuit Court of Appeals (which would hear an appeal from a Texas trial court) means more than one rendered by the Second Circuit Court of Appeals.

• Whether the decision represents the weight of authority on the issue. In other words, is it supported by the results reached by other courts?

• The outcome or status of the decision on appeal. That is, if the decision was appealed, what was the result?

In connection with the last two variables, the use of a manual citator or a computer search is invaluable to tax research. A citator provides the history of a case, including the authority relied on (e.g., other judicial decisions) in reaching the result. Reviewing the references listed in the citator discloses whether the decision was appealed and, if so, with what result (e.g., affirmed, reversed, or remanded). It also reveals other cases with the same or similar issues and explains how they were decided. Thus, a citator reflects on the validity of a case and may lead to other relevant judicial material.49

E T H I C S & E Q U I T Y Choosing Cases for Appeal

The U.S. Government loses a tax case against a prominent citizen in the U.S. District Court of Iowa. The taxpayer, a minister, had set up three separate trusts for each of his three children (i.e., a total of nine trusts). The Government argued that these trusts should be consolidated and treated as three trusts (one for each child) to stop the taxpayer from mitigating the progressive individual tax rate structure.

The IRS has decided to appeal a case in this multiple trust area. As one of the attorneys for the Government, you must choose between the Iowa case and a similar multiple trust case decided by the U.S. District Court of Virginia, also

in favor of the taxpayer. In this case, the taxpayer is a CPA who established four separate trusts for her two children (i.e., a total of eight trusts).

Factors you are considering are the potential sympathy associated with the minister’s profession (and a lack thereof associated with the CPA), the facts indicating that the attempt at tax avoidance is more egregious in the Iowa case, and a colleague’s opinion that the Virginia case is winnable. Which case will you select? Comment on the fairness of the Government’s ability and willingness to select a case to appeal in this fashion.

49The major manual citators are published by Commerce Clearing House; RIA; and Shepard’s Citations, Inc. The CCH and RIA versions are available

online through the CCH IntelliConnect service and Thomson Reuters Checkpoint, respectively. Shepard’s Internet version is part of LexisNexis.

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Assessing the Validity of Other Sources Primary sources of tax law include the Constitution, legislative history materials, statutes, treaties, Treasury Regulations, IRS pronouncements, and judicial decisions. The IRS regards only primary sources as substantial authority. However, reference to secondary materials such as legal periodicals, treatises, legal opinions, general counsel memoranda, technical advice memoranda, and written determinations can be useful. In general, sec- ondary sources are not authority.

Although the statement that the IRS regards only primary sources as substantial authority is generally true, there is one exception. For purposes of the accuracy-related penalty in § 6662, the IRS has expanded the list of substantial authority to include a number of secondary materials (e.g., letter rulings, general counsel and technical advice memoranda, and a Bluebook).50 A “Bluebook” is the general explanation of tax legisla- tion prepared by the Joint Committee on Taxation of the U.S. Congress.

As under former § 6661, “authority” does not include conclusions reached in treatises, legal periodicals, and opinions rendered by tax professionals.

1-6d Arriving at the Solution or at Alternative Solutions Returning to The Big Picture on p. 1-1, assume that the parties decide that the loan approach can be justified from the factual situation involved. Does this assumption lead to a bad debt deduction for the aunt? Before this question can be resolved, the loan needs to be classified as either a business or nonbusiness debt. One of the reasons the classification is important is that a nonbusiness bad debt cannot be deducted until it becomes entirely worthless. Unlike a business debt, no deduction for partial worthless- ness is allowed.51

It is very likely that the loan the aunt made in 2008 falls into the nonbusiness cate- gory. Unless exceptional circumstances exist (e.g., the lender was in the trade or busi- ness of lending money), loans in a related-party setting are treated as nonbusiness. The probability is high that the aunt would be relegated to nonbusiness bad debt status.

The aunt has the burden of proving that the remaining unpaid balance of $77,000 is entirely worthless.52 In this connection, what collection effort, if any, has the aunt made? But would any such collection effort be fruitless? Perhaps the nephew is insolvent, ill, or unemployed or has departed for parts unknown.

Even if the debt is entirely worthless, one further issue remains to be resolved. In what year did the worthlessness occur? It could be, for example, that worthlessness took place in a year before it was claimed.53

A clear-cut answer may not be possible as to a bad debt deduction for the aunt in 2015 (seven years after the advance was made). This uncertainty does not detract from the value of the research. Often a guarded judgment is the best possible solution to a tax problem.

1-6e Communicating Tax Research Once the problem has been researched adequately, a memo, letter, or spoken presenta- tion setting forth the result may be required. The form such a communication takes could depend on a number of considerations. For example, is any particular procedure or format for communicating tax research recommended by either an employer or an instructor? Are the research results to be given directly to the client, or will they first pass to the preparer’s employer? If an oral presentation is required, who will be the audi- ence? How long should you talk?54 Whatever form it takes, a good tax research commu- nication should contain the following elements:

• A clear statement of the issue.

• In more complex situations, a short review of the factual pattern that raises the issue.

50Notice 90–20, 1990–1 C.B. 328, part V (A). 51See § 166 and the discussion of investor losses in Chapter 4. 52Compare John K. Sexton, 48 TCM 512, T.C.Memo. 1984–360, with Stewart

T. Oatman, 45 TCM 214, T.C.Memo. 1982–684.

53Ruth Wertheim Smith, 34 TCM 1474, T.C.Memo. 1975–339. 54For more on crafting oral presentations, see W. A. Raabe and G. E. Whit-

tenburg, “Talking Tax: How to Make a Tax Presentation,” Tax Adviser, March 1997, pp. 179–182.

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• A review of the pertinent tax law sources (e.g., Code, Regulations, rulings, and judicial authority).

• Any assumptions made in arriving at the solution.

• The solution recommended and the logic or reasoning in its support.

• The references consulted in the research process.

Exhibits 1.9, 1.10, and 1.11 present a sample client letter and memoranda for the tax files based on the facts of The Big Picture.

E X H I B I T 1.9 Client Letter

Hoffman, Raabe, Maloney, & Young, CPAs 5191 Natorp Boulevard

Mason, OH 45040

August 25, 2015

Dana Pehrson 111 Avenue G Lakeway, OH 45232

Dear Ms. Pehrson:

This letter is in response to your question with respect to your $93,000 advance to your nephew in 2008. In order to advise you correctly, I need the following additional information:

1. Is there a written instrument evidencing this obligation, and is an interest rate specified?

2. When and how much has your nephew paid on the loan? 3. What factors exist to indicate whether the remaining debt will be repaid (for example,

does he live within his means)? 4. Does he have a job? 5. Does he owe money to other people? 6. What is his credit rating? 7. How much credit card debt does he have? 8. What collection efforts, if any, have you made to collect the remaining $77,000?

Any other information or material you can provide would be greatly appreciated.

Sincerely,

James Hicks, CPA Partner

E X H I B I T 1.10 Tax File Memorandum

August 18, 2015

TAX FILE MEMORANDUM

FROM: James Hicks

SUBJECT: Dana Pehrson Engagement Issues

Today I talked to Dana Pehrson with regard to her letter of August 14, 2015.

Dana Pehrson advanced $93,000 to her nephew in 2008 to enable him to attend a private college. Seven years later she claims a bad debt deduction for $77,000 that the nephew has not repaid.

ISSUE: Is Dana entitled to a bad debt deduction?

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1-7 WORKING WITH THE TAX LAW— TAX PLANNING

Tax research and tax planning are inseparable. The main purpose of effective tax plan- ning is to reduce the taxpayer’s total tax bill. This reduction does not mean that the course of action selected must produce the lowest possible tax under the circumstances. The minimization of tax payments must be considered in the context of the legitimate business goals of the taxpayer.

1-7a Nontax Considerations There is a danger that tax motivations may take on a significance that does not conform to the true values involved. In other words, tax considerations can operate to impair the exercise of sound business judgment. Thus, the tax planning process can lead to ends that are socially and economically objectionable. Unfortunately, a tendency exists for planning to move toward the opposing extremes of either not enough or too much em- phasis on tax considerations. The goal should be a balance that recognizes the signifi- cance of taxes, but not beyond the point at which planning detracts from the exercise of good business judgment.

The remark is often made that a good rule to follow is to refrain from pursuing any course of action that would not be followed were it not for certain tax considerations. This statement is not entirely correct, but it does illustrate the desirability of preventing business logic from being “sacrificed at the altar of tax planning.”

1-7b Components of Tax Planning Popular perception of tax planning often is restricted to the adage “defer income and accelerate deductions.” Although this timing approach does hold true and is important, meaningful tax planning involves considerably more.

Preferable to deferring income is complete avoidance. Consider, for example, the corporate employee who chooses nontaxable fringe benefits over a fully taxable future pay increase.55 Complete avoidance of gain recognition also occurs when the owner of appreciated property transfers it by death. If this “step-up” in basis to fair market value occurs, the built-in appreciation forever escapes the income tax.56

If the recognition of income cannot be avoided, its deferral will postpone income tax consequences. A tax paid in the future costs less than a tax paid today because of the time value of money. Deferral of income can take many forms. Besides like-kind

E X H I B I T 1.11 Tax File Memorandum

August 26, 2015

TAX FILE MEMORANDUM

FROM: James Hicks

SUBJECT: Dana Pehrson

Tentative Conclusions

The initial advance could have been a gift rather than a loan and possibly subject to the gift tax. In any case, if the advance was a gift, it should have been reported on Form 709. Further, the statute of limitations does not begin to run when a tax return is not filed.

If the advance is treated as a loan, the probability is high that the aunt would receive nonbusiness bad debt status. This classification means that Ms. Pehrson has the burden of proving that the $77,000 unpaid balance is entirely worthless.

LO.9

Describe various tax planning procedures.

55See Example 9 in Chapter 13. 56See Example 19 in Chapter 19.

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exchanges and involuntary conversions, most retirement plans put off income tax con- sequences until the payout period. Deferral of gain recognition also can occur when appreciated property is transferred to a newly formed corporation or partnership.57

A corollary to the deferral of income is the acceleration of deductions. For example, an accrual basis, calendar year corporation wants an additional charitable deduction for 2015 but has a cash-flow problem. If the corporation authorizes the contribution in 2015 and pays it on or before March 15, 2016, the deduction can be claimed for 2015.58 Taxes can be saved by shifting income to lower-bracket taxpayers. Gifts of appreciated prop- erty to lower-bracket family members can reduce the applicable capital gain rate on a later sale by up to 20 percentage points (from 20 percent to 0 percent).59

If income cannot be avoided, deferred, or shifted, the nature of the gain can be con- verted. By changing the classification of property, income taxes can be reduced. Thus, the taxpayer who transfers appreciated inventory to a controlled corporation has con- verted ordinary income property to a capital asset. When the stock is later sold, prefer- ential capital gain rates apply.

The conversion approach also can work in tax planning for losses. Properly struc- tured, a loan to a corporation that becomes worthless can be an ordinary loss rather than the less desirable capital loss. Likewise, planning with § 1244 permits an investor in qualified small business stock to convert what would be a capital loss into an ordinary loss.60

Effective tax planning requires that careful consideration be given to the choice of entity used for conducting a business. The corporate form results in double taxation but permits shareholder-employees to be covered by fringe benefit programs. Partner- ships and S corporations allow a pass-through of losses and other tax attributes, but transferring ownership interests as gifts to family members may be difficult.61

Although the substance of a transaction rather than its form generally controls, this rule is not always the case with tax planning. Preserving formalities, particularly clear documentation, often is crucial to the result. Is an advance to a corporation a loan or a contribution to capital? The answer may well depend on the existence of a note. Along with preserving formalities, the taxpayer should keep records that support a transaction. Returning to the issue of loan versus contribution to capital, how is the advance listed on the books of the borrower? What do the corporate minutes say about the advance?

T A X I N T H E N E W S Tax Avoidance and Tax Evasion

There is a fine line between legal tax planning and illegal tax planning— tax avoidance versus tax evasion . Although both aim to eliminate or reduce taxes, tax evasion implies the use of subterfuge and fraud as a means to this end. Through tax evasion, taxpayers shortchanged the govern- ment by a staggering $475 billion annually. This gross tax gap is the annual difference between Federal taxes owed and those timely paid.

Tax avoidance, however, is merely tax minimization through legal techniques. In this sense, tax avoidance becomes the proper objective of all tax planning. Perhaps because common goals are involved, popular usage has blurred the distinction between tax avoidance and tax eva- sion. Consequently, the association of the two concepts has

kept some taxpayers from properly taking advantage of planning possibilities. The now-classic words of Judge Learned Hand in Commissioner v. Newman* reflect the true values a taxpayer should have:

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.

*47-1 USTC {9175, 35 AFTR 857, 159 F.2d 848 (CA-2, 1947).

57See Example 1 in Chapter 4 and Example 4 in Chapter 10. 58See Example 15 in Chapter 2. 59See Example 31 in Chapter 19. Beginning in 2013, a 3.8% Medicare tax

might also be avoided.

60See Examples 32 and 33 in Chapter 4. 61See Examples 45 and 46 in Chapter 11 and Example 43 in Chapter 12.

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Finally, effective tax planning requires consistency on the part of taxpayers. A share- holder who treats a corporate distribution as a return of capital cannot later avoid a stock basis adjustment by contending that the distribution was really a dividend.

In summary, the key components of tax planning include the following:

• Avoid the recognition of income (usually by resorting to a nontaxable source or nontaxable event).

• Defer the recognition of income (or accelerate deductions).

• Convert the classification of income (or deductions) to a more advantageous form (e.g., ordinary income into capital gain).

• Choose the business entity with the desired tax attributes.

• Preserve formalities by generating and maintaining supporting documentation.

• Act in a manner consistent with the intended objective.

1-7c Tax Planning—A Practical Application Returning to the facts in The Big Picture on p. 1-1, what should be done to help protect the aunt’s bad debt deduction?

• All formalities of a loan should be present (e.g., written instrument and definite and realistic due date).

• Upon default, the lender (aunt) should make a reasonable effort to collect from the borrower (nephew). If not, the aunt should be in a position to explain why any such effort would be to no avail.

• If interest is provided for, it should be paid.

• Any interest paid (or imputed under § 7872) should be recognized as income by the aunt.

• Because of the annual exclusion of $12,000 in 2008 (it is currently $14,000), it appears doubtful that actual (or imputed) interest would necessitate the filing of a Federal gift tax return by the aunt. But should one be due, it should be filed.

• If § 7872 applies (not enough or no interest is provided for), the nephew should keep track of his net investment income. This record keeping is important because the income the aunt must recognize may be limited by this amount.

In terms of the components of tax planning (see prior discussion beginning on p. 1-43), what do these suggestions entail? Note the emphasis on the formalities—written instrument and definite and realistic due date. Also, much is done to provide the needed documenta- tion—gift tax returns, if necessary, are filed, and the nephew keeps track of his investment income. Most important, however, is that the aunt will have been consistent in her actions—recognizing actual (or imputed) interest income and making a reasonable effort to collect on the loan.

Throughout this text, each chapter concludes with observations on Tax Planning. Such observations are not all-inclusive but are intended to illustrate some of the ways in which the material in the chapter can be effectively used to minimize taxes.

1-7d Follow-Up Procedures Tax planning usually involves a proposed (as opposed to a completed) transaction and is based upon the continuing validity of the advice resulting from tax research. A change in the tax law (legislative, administrative, or judicial) could alter the original conclusion. Additional research may be necessary to test the solution in light of current develop- ments.

Under what circumstances does a tax practitioner have an obligation to inform a client as to changes in the tax law? The legal and ethical aspects of this question are discussed in Chapter 17.

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1-8 TAXATION ON THE CPA EXAMINATION The CPA examination has changed from a paper-and-pencil exam to a computer-based exam with increased emphasis on information technology and general business knowledge. The 14-hour exam has four sections, and taxation is included in the 3-hour Regulation section.

In January 2011, the CPA examination was reorganized, with all written communica- tion tasks now concentrated in the Business Environment & Concepts section. Shorter simulations have replaced the longer simulations.

Each exam section includes multiple-choice questions, and the Regulation section and two other sections also have short task-based simulation (TBS) questions. The Reg- ulation section is 60 percent Taxation and 40 percent Law & Professional Responsibil- ities (all areas other than Business Structure). The Regulation section has the following format:

• Three multiple-choice question (MCQ) testlets consisting of 72 questions.

• One testlet (i.e., a group of questions prepared to appear together) containing six short, task-based simulations with the research question in a new format.

A candidate may review and change answers within each testlet but cannot go back after exiting a testlet. Candidates take different but equivalent exams.

Simulations are small case studies designed to test a candidate’s tax knowledge and skills using real-life work-related situations. Simulations include a four-function pop-up calculator, a blank spreadsheet with some elementary functionality, and authoritative lit- erature appropriate to the subject matter. The taxation database includes authoritative excerpts (e.g., Internal Revenue Code and Regulations, IRS publications, and Federal tax forms) that are necessary to complete the tax case study simulations. Examples of the simulations follow.

Candidates can learn more about the CPA examination at www.cpa-exam.org. This online tutorial site’s topics include the following:

• Common tools.

• Navigation.

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A tax form completion simulation requires the candidate to fill out a portion of a tax form. For example, Blue Company is a limited liability company (LLC) for tax purposes. Complete the income section of the IRS Form 1065 for Blue Company using the values found and calculated on previous tabs along with the following data:

Ordinary income from other partnerships $ 5,200

Net gain (loss) from Form 4797 2,400

Management fee income 12,000

The candidate is provided with page 1 of Form 1065 on which to record the appropriate amounts. Any field that requires an entry is a shaded rectangular cell. Some white rectangular cells automatically calculate based on the entries in the shaded cell.

LO.10

Explain the role of taxation on the CPA examination.

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CPA Exam Simulation Examples

The tax citation type simulation requires the candidate to research the Internal Revenue Code and enter a Code Section and subsection. For example, Amber Company is considering using the sim- plified dollar-value method of pricing its inventory for purposes of the LIFO method that is avail- able to certain small businesses. What Code Section is the relevant authority in the Internal Revenue Code to which you should turn to determine whether the taxpayer is eligible to use this method? To be successful, the candidate needs to find § 474.

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• Forms completion.

• Numeric entry.

• Research questions.

• Authoritative literature search.

• Written communication.

The common tools are a calculator, a spreadsheet, reminder flags, and an examination clock. A 30- to 60-minute sample examination will familiarize a candidate with the type of questions on the exam.

Key Terms

Acquiescence, 1-30

Arm’s length, 1-13

Business purpose, 1-14

Certiorari, 1-27

Continuity of interest, 1-13

Determination letters, 1-22

Generally Accepted Accounting Principles (GAAP), 1-15

Indexation, 1-9

International Financial Reporting Stand- ards (IFRS), 1-15

Letter rulings, 1-22

Nonacquiescence, 1-30

Proposed Regulations, 1-20

Revenue neutrality, 1-2

Revenue Procedures, 1-21

Revenue Rulings, 1-21

Substance over form, 1-13

Tax avoidance, 1-44

Tax benefit rule, 1-14

Tax evasion, 1-44

Temporary Regulations, 1-21

Wherewithal to pay, 1-6

Discussion Questions

1. LO.1 What is meant by revenue neutrality?

2. LO.2 Have nonrevenue factors had any impact upon the development of our taxation system? If so, how?

3. LO.2 How does the tax law encourage technological progress?

4. LO.2 Why is personal saving desirable for the U.S. economy?

5. LO.2 Explain how the following tax provisions encourage small businesses: a. The nature of a shareholder’s loss on a stock investment.

b. The tax rate applicable to corporations.

c. Nontaxable corporate divisive reorganizations.

6. LO.2 The concept of equity is relative. Explain.

7. LO.2 What purpose is served by allowing a deduction for contributions to qualified charitable organizations?

8. LO.2 What purpose is served by the various deductions and credits allowed for education expenses?

9. LO.2 Would the deductibility of political campaign expenditures be contrary to public policy? Explain.

10. LO.2 In the past, Congress has considered proposals that would allow a taxpayer to claim a tax credit for tuition paid to send a dependent to a private school.

Is there any justification for such a proposal? Explain.

11. LO.2 Other than raising revenue, what considerations explain various provisions in our tax laws?

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12. LO.2 A provision of the Code allows a taxpayer a deduction for Federal income tax purposes for state and local income taxes paid. Does this provision eliminate

the effect of multiple taxation of the same income? Why or why not? In this connec- tion, consider the following:

a. Taxpayer, an individual, has itemized deductions that are less than the standard deduction.

b. Taxpayer is in the 10% tax bracket for Federal income tax purposes. The 33% tax bracket.

13. LO.2 Heather and her partners operate a profitable partnership. Because the busi- ness is expanding, the partners would like to transfer it to a newly created

corporation. Heather is concerned, however, over the possible tax consequences that would result from incorporating. Please comment.

14. LO.2 Assume the same facts as in Question 13. Heather is also worried that once the partnership incorporates, the business will be subject to the Federal

corporate income tax. What suggestions do you have?

15. LO.2 Give some examples of the wherewithal to pay concept.

16. LO.2 Can recognized gain exceed the realized gain? Explain.

17. LO.2 In a like-kind exchange, recognized gain is postponed and not avoided. Explain.

18. LO.2 Under the annual accounting period concept, what time period is normally selected for final settlement of most tax liabilities?

19. LO.2 How does the installment method overcome the harsh treatment of the annual accounting treatment concept?

20. LO.2 Why is there a grace period for contributions to a Keogh retirement plan?

21. LO.2 Contrast the tax treatment between a community property state and a common law state.

22. LO.2 List some tax provisions used to deter affluent taxpayers from obtaining preferential tax treatment.

23. LO.4 Explain the continuity of interest concept.

24. LO.3 White Corporation lends $425,000 to Blue Corporation with no provision for interest. White Corporation and Blue Corporation are owned by the same share-

holders. How might the IRS restructure this transaction with adverse tax consequences?

25. LO.5 Federal tax legislation generally originates in the Senate Finance Committee. Comment on the validity of this statement.

26. LO.5 If a tax bill is vetoed by the President, the provisions cannot become law. Evaluate this statement.

27. LO.5 Determine the subparts of § 1563(a)(1)(A).

28. LO.5 Is § 212(1) a proper Code Section citation? Why or why not?

29. LO.5 Why are certain Code Section numbers missing from the Internal Revenue Code (e.g., §§ 6, 7, 8, 9, 10)?

30. LO.6 Where can a researcher find newly issued Proposed, final, and Temporary Regulations?

31. LO.6 Interpret each of the following citations: a. Temp.Reg. § 1.428–7T(b)(4).

b. Rev.Rul. 60–11, 1960–1 C.B. 174.

c. TAM 8837003.

Issue ID

Issue ID

Issue ID

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32. LO.5 Jennifer Olde calls you requesting an explanation of the fact-finding determi- nation of a Federal Court of Appeals. Prepare a letter to be sent to Jennifer

answering this query. Her address is 3246 Highland Drive, Clifton, VA 20124.

33. LO.5 Will Thomas calls you with respect to a tax issue. He has found a tax case in the U.S. District Court of South Carolina that is in favor of his position. The

IRS lost and did not appeal the case. Over the phone, you explain to Will the signifi- cance of the failure to appeal. Prepare a tax file memorandum outlining your remarks to Will.

34. LO.5, 8 In assessing the validity of a court decision, discuss the significance of the following:

a. The decision was rendered by the U.S. District Court of Utah. Taxpayer lives in Utah.

b. The decision was rendered by the U.S. Court of Federal Claims. Taxpayer lives in Utah.

c. The decision was rendered by the Second Circuit Court of Appeals. Taxpayer lives in California.

d. The decision was rendered by the U.S. Supreme Court.

e. The decision was rendered by the U.S. Tax Court. The IRS has acquiesced in the result.

f. Same as (e), except that the IRS has issued a nonacquiescence as to the result.

35. LO.6 Mack Rogers needs to learn quickly about Section 1244 stock. How should Mack approach his research?

36. LO.7 Where does most tax research begin when someone is searching for an answer about a tax dispute?

37. LO.8 Determine whether the following items are primary sources or secondary sources for the purpose of substantial authority.

a. Revenue Procedure.

b. Article written by a judge in Journal of Taxation.

c. U.S. District Court decision.

d. The “Bluebook.”

e. A general counsel memorandum.

38. LO.9 What are the key components of effective tax planning?

39. LO.10 Discuss simulations that are part of the CPA examination.

Problems

40. LO.2 Bart exchanges some real estate (basis of $800,000 and fair market value of $1 million) for other real estate owned by Roland (basis of $1.2 million and

fair market value of $900,000) and $100,000 in cash. The real estate involved is unimproved and is held by Bart and Roland, before and after the exchange, as investment property.

a. What is Bart’s realized gain on the exchange? Recognized gain?

b. What is Roland’s realized loss? Recognized loss?

c. Support your results in (a) and (b) under the wherewithal to pay concept as applied to like-kind exchanges (§ 1031).

41. LO.2, 3 Using the legend provided, classify the overall objective of the particular tax provision.

Communications

Communications

Decision Making

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Legend

CE ¼ Control of the economy W ¼ Wherewithal to pay concept EA ¼ Encouragement of certain activities AF ¼ Administrative feasibility EI ¼ Encouragement of certain industries ESB ¼ Encouragement of small business SC ¼ Social considerations

a. Like-kind exchange treatment.

b. An increase in the individual tax rate.

c. The S corporation election.

d. Adoption expense credit.

e. Percentage depletion.

f. Unified estate tax credit.

g. Charitable contribution deduction.

42. LO.2 Determine whether the following states are community property or common law states:

a. Louisiana.

b. Virginia.

c. Arizona.

d. Rhode Island.

e. Alaska.

f. California.

43. LO.4 Benny sells property (basis of $70,000) to Jet Corporation for $100,000. Based on the following conditions, how could the IRS challenge this transaction?

a. Benny is the sole shareholder of Jet Corporation.

b. Benny is the son of the sole shareholder of Jet Corporation.

c. Benny is neither a shareholder in Jet Corporation nor related to any of Jet’s share- holders.

44. LO.5 Answer the following questions: a. What are letter rulings?

b. What are technical advice memoranda (TAMs)?

45. LO.5 Explain what is meant by the following citations: a. Rev.Proc. 2001–10, 2001–1 C.B. 272.

b. Rev.Rul. 2011–14, 2011–27 I.R.B. 31.

c. Ltr.Rul. 201125030.

46. LO.6 Using the legend provided, classify each of the following citations as to the location. A citation may have more than one answer.

Legend

IRC ¼ Internal Revenue Code FR ¼ Federal Register IRB ¼ Internal Revenue Bulletin NA ¼ Not applicable CB ¼ Cumulative Bulletin

a. § 61(a)(13).

b. Prop.Reg. § 1.368–2(b)(1).

c. Rev.Proc. 77–37, 1977–2 C.B. 568.

d. Temp.Reg. § 1.163–9T(b)(2)(I)(A).

e. Rev.Rul. 64–56, 1964–1 C.B. 133.

f. Jack E. Golsen, 54 T.C. 742 (1970).

g. Ltr.Rul. 9802018.

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47. LO.5 To which U.S. Court of Appeals would a person living in each of the follow- ing states appeal from the U.S. Tax Court?

a. Texas.

b. Colorado.

c. Georgia.

d. Montana.

e. New York.

48. LO.5 Using the legend provided, classify each of the following citations as to the court:

Legend

T ¼ U.S. Tax Court D ¼ U.S. District Court C ¼ U.S. Court of Federal Claims A ¼ U.S. Court of Appeals U ¼ U.S. Supreme Court N ¼ None of the above

a. 388 F.2d 420 (CA–7, 1968).

b. 79 T.C. 7 (1982).

c. 54 S.Ct. 8 (USSC, 1933).

d. 3 B.T.A. 1042 (1926).

e. T.C.Memo 1954–141.

f. 597 F.2d 760 (Ct.Cl., 1979).

g. Ltr.Rul. 9414051.

h. 465 F.Supp. 341 (D.Ct. Okla., 1978).

49. LO.6 Locate the following tax services in your library, and indicate the name of the publisher:

a. United States Tax Reporter.

b. Standard Federal Tax Reporter.

c. Federal Tax Coordinator 2d.

d. Mertens Law of Federal Income Taxation.

e. Tax Management Portfolios.

f. CCH’s Tax Research Consultant.

50. LO.5, 8 Using the legend provided, classify each of the following tax sources:

Legend

P ¼ Primary tax source B ¼ Both S ¼ Secondary tax source N ¼ Neither

a. Sixteenth Amendment to the Constitution.

b. Tax treaty between the United States and China.

c. Temporary Regulations.

d. Revenue Procedure.

e. General counsel memorandum (1988).

f. Tax Court Memorandum decision.

g. Harvard Law Review article.

h. Legislative Regulations.

i. Letter ruling (before 1991).

j. Fifth Circuit Court of Appeals decision.

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k. Small Cases Division of U.S. Tax Court decision.

l. Senate Finance Committee Report.

m. Technical advice memorandum (1993).

n. Proposed Regulations.

51. LO.5 Interpret each of the following citations: a. 54 T.C. 1514 (1970).

b. 408 F.2d 1117 (CA–2, 1969).

c. 69–1 USTC { 9319 (CA–2, 1969). d. 23 AFTR 2d 69–1090 (CA–2, 1969).

e. 293 F.Supp. 1129 (D.Ct. Miss., 1967).

f. 67–1 USTC { 9253 (D.Ct. Miss., 1967). g. 19 AFTR 2d 647 (D.Ct. Miss., 1967).

h. 56 S.Ct. 289 (USSC, 1935).

i. 36–1 USTC { 9020 (USSC, 1935). j. 16 AFTR 1274 (USSC, 1935).

k. 422 F.2d 1336 (Ct.Cl., 1970).

Research Problems

Student Edition

Note: Solutions to Research Problems can be prepared by using the Checkpoint�

Student Edition online research product, which is available to accompany this text. It is also possible to prepare solutions to the Research Problems by using tax research materials found in a standard tax library.

Research Problem 1. Locate the following cited items and give a brief description of the topic or opinion in the item:

a. § 6694(a).

b. § 1.6694-1(b).

c. Rev. Rul. 86-55, 1986-1 C.B. 373.

d. PLR 8022027.

Research Problem 2. Determine the disposition of the following decisions at the appellate level:

a. Gary A. Sargent, 93 T.C. 572 (1989).

b. Charles Johnson, 78 T.C. 882 (1982).

c. Smith & Wiggins Gin, Inc., 37 T.C. 861 (1962).

d. George W. Wiebusch, 59 T.C. 777 (1973).

e. Zanesville Inv. Co., 38 T.C. 406 (1962).

Research Problem 3. The TV show TMZ spoke with Larry Edema from Michigan, who was selected to be in the audience for Oprah’s big giveaway: a free trip to Australia. Supposedly, Winfrey had a certified public accountant on hand to address the tax issue right after the taping. Edema said that the CPA assured the group that all taxes associated with the trip would be “handled by the Oprah show”; so the trip would truly be 100% free. The CPA also explained that Oprah would cover all sightseeing costs and travel-related expenses, including passport costs for people who could not afford them. It was a big change from Oprah’s 2004 controversy when she famously gave away brand-new cars but saddled audience members with as much as $7,000 in income taxes.

Discuss any tax aspects or problems with this statement.

1-52 PART 1 Introduction

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Research Problem 4. Go to each of the following Internet locations: a. Several primary sources of the tax law, including the U.S. Supreme Court, a Court of

Appeals, the Internal Revenue Service, the U.S. Tax Court, and final Regulations.

b. Sources of proposed Federal tax legislation.

c. A collection of tax rules for your state.

Research Problem 5. Using the Internet, obtain definitions of these terms: a. Rule 155.

b. En banc.

c. Pro se.

d. Dicta.

e. Parallel cite.

f. Sunset provisions.

g. Work product.

CHAPTER 1 Understanding and Working with the Federal Tax Law 1-53

For the latest in changes to tax legislation, visit www.cengagebrain.com.

Use the tax resources of the Internet to address the following questions. Do not restrict your search to the Web, but include a review of newsgroups and general reference materials, practitioner sites and resources, primary sources of the tax law, chat rooms and discussion groups, and other opportunities.

Internet Activity

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