Why Study Taxes

1. Taxes are a fact of life; businesses and individuals face a wide variety of taxes at the federal, state and local, and international levels. Money not spent on taxes will be available for more productive business needs.
2. Goal of this course and text – to give students an overview of:
   • how the federal income tax law came about and how and why it is continually revised;
   • the various types of taxes that affect businesses and individuals;
   • why various types of taxes exist;
   • policies underlying the federal income tax law;
   • common tax terminology;
   • the elements of taxable income;
   • the basic tax rules for property transactions;
   • how and why tax rules differ from generally accepted accounting principles (GAAP);
   • the basics of the federal income tax rules governing different types of business entities (such as corporations, partnerships and sole proprietorships);
   • tax planning considerations;
   • how to research the federal income tax laws; and
   • types of tax advisers and their role assisting businesses and individuals with tax matters and the ethical considerations they might deal with.

How Knowledge of the Tax Law Can Benefit Businesses

1. By understanding how taxes affect timing of deductions, and thus cash flow (Situations 1 and 5).
2. By knowing when tax credits may be available (Situation 1).
3. By understanding how to factor taxes into rates of return on investments.
4. By understanding how taxes affect decisions on how to acquire use of property (Situation 2).
5. By knowing about favorable provisions in the tax law (Situations 3 and 4).
6. By being aware of potential traps in the tax law, including penalties.
7. Being aware of filing obligations.

Objective 2:
To be aware of certain common misconceptions about the tax law and tax system and realize why they are wrong

Common Misconceptions About The Tax Law

1. The misconceptions to be clarified:
   1. Tax laws do more than raise money for the government
   2. The federal income tax is not unconstitutional
   3. It's not necessarily good to get a tax refund
   4. Income taxes are only part of the tax picture
   5. Taxes cannot be learned by studying the tax forms
   6. Tax advisers don't just fill out tax forms
2. The need for common sense in learning and reading about the tax law.
   • Politics and complexity can get in the way of understanding the tax law and tax concepts.

Objective 3:
To know and be able to implement study techniques that will help you gain a lasting understanding of the federal tax law and its basic principles

Study Techniques

1. Do not try to learn the tax rules and concepts solely by memorizing them.
2. Compare tax rules and concepts to GAAP and financial reporting rules.
3. While you are reading business periodicals during this course, consider what tax provisions and issues might be involved in the business transactions discussed in the articles.
4. Make good use of the boxed questions that are dispersed throughout each chapter of this textbook.

Types of Tax Advisers

1. Certified Public Accountants
2. CPAs (AICPA's Personal Financial Specialist) and others (Certified Financial Planners) who may be certified in the area of personal financial planning. They provide services in the areas of
   • evaluation of personal financial data;
   • income tax planning;
   • risk management planning (insurance needs);
   • investment planning;
   • retirement planning; and
   • estate planning.
3. Enrolled Agents
   • "Enrolled as an agent" under specific rules established by the U.S. Treasury Department (Circular 230) which allows them to practice before the IRS.
   • Must pass a two–day tax examination administered by the IRS, pass the background investigation performed by the IRS, and pay the required fee. Individuals who have worked for the IRS for at least five consecutive years may become enrolled without taking the examination, provided their work at the IRS involved application and interpretation of the federal tax law.
4. Attorneys
5. Other types of tax advisers:
   • Tax accountants who are not CPAs
   • Tax return preparers
   • Accountants in industry and non–profit organizations
6. Education and training:
   • CPA or EA might obtain MST or MBT.
   • Attorney might obtain LLM in Taxation.
   • Continuing education requirements.
   • On–the–job training.

Objective 2:
To understand what tax advisers do

The Work of a Tax Adviser

1. Private practice (outside advisers) versus in–house advisers.
2. The commonly performed tax functions performed by tax advisers:
   • compliance,
   • audit assistance,
   • tax planning, and
   • tax analysis.
3. Others engaged in tax work – individuals employed by federal and state tax agencies

Objective 3:
To know the professional rules of conduct and the penalty provisions in the tax law that influence a tax adviser's duties and responsibilities Rules of Conduct Applicable to Tax Advisers

1. Commonly encountered rules: Rules: Applicable to:
   1. Circular 230 CPAs, EAs, attorneys, and tax advisers authorized to engage in limited practice before the IRS
   2. AICPA Code of Professional Conduct CPAs who are members of the AICPA
   3. AICPA Statements on Responsibilities in Tax Practice (SRTP) CPAs who are members of the AICPA
   4. NAEA Code of Ethics and Rules of Professional Conduct EAs who are members of the NAEA
   5. Internal Revenue Code Penalties CPAs, EAs, attorneys, and all other return preparers and tax advisers
2. Other rules of conduct tax advisers or practitioners may be subject to:
   • Company rules of conduct.
   • Taxing agency rules of conduct.

Let's Meet Some Tax Advisers

1. The tax advisers introduced below work in the following places:
   • International accounting firm
   • Local CPA firm
   • Local EA firm
   • International law firm
   • Tax department of a large company
2. Rules of conduct in practice by the interviewees:
   • Systems in place to ensure that they, as well as colleagues, are aware of and follow applicable rules of conduct.
   • Risk management.
   • Review procedures, and peer reviews through the AICPA.
   • Two–opinion policy under which any position recommended by an attorney for a client be reviewed by at least two partners in the firm.
   • Use of practice guides and checklists.
3. Words of advice to students considering a career in tax
   • Interest and aptitude for the intellectual challenge of tax work.
   • Excellent communication, analytical and interpersonal skills.
   • Ability to understand clients and to build a relationship.

Introduction

1. Largest source of federal tax revenues is the income tax.
2. Largest source of state tax revenue is the sales and use tax.

Objective 2:
To realize why different types of taxes exist Helpful Background to Understanding Different Types of Taxes

1. Why do taxes exist?
   • To fund government.
   • To encourage and discourage certain activities.
2. Why don't we have just one type of tax?
   • Revenue predictability.
   • Revenue stability.
   • Taxpayer considerations.
   • Additional economic considerations – income versus consumption taxes, economic theories underlying different types of tax systems.
   • Historical and political reasons.
3. What is a "tax"? A payment to the government is considered a "tax" if it:
   • is a required payment to the government;
   • is required under the legislature's authority to impose taxes; and
   • will be used for public or governmental purposes, rather than as a payment for a privilege granted or service rendered to the payer.
4. Why is the term "tax" significant?
   • Individuals may deduct certain types of taxes (but it must be a tax).
   • Some states have a supermajority vote requirement to raise taxes.

Objective 3:
To know the basics about each of the different types of taxes, how they are classified, the types of taxpayers they apply to, the basics of how they operate, and how they are distinguishable, as well as some of the more important current issues concerning certain types of taxes

Classification Schemes

1. Taxes can be categorized in at least two ways:
   1. By considering the effect of the tax on taxpayers of differing income levels (by examining the tax as a percentage of taxpayers' income).
   2. By considering what is subject to tax.
2. Taxes as a percentage of a taxpayer's income:
   • Progressive.
   • Regressive.
   • Flat or proportional.
3. Classification of taxes based on what is taxed:
   • Tax liability = Tax base x Tax rate.

1. Basis for understanding types of taxes – consider:
   1. Which level(s) of government (federal, state, city, or county) typically assesses this type of tax?
   2. Is the tax progressive, regressive or flat?
   3. On whom is the tax assessed?
   4. Who completes the required tax form?
   5. How costly might it be for the government to administer the particular tax?
   6. How costly might it be for taxpayers to comply with the tax?
   7. Would the tax be more significant to a capital intensive business or a labor intensive one?
   8. Is the tax a stable and predictable revenue source for the government? What factors might hinder its stability?
   9. Is it a type of tax for which tax planning is likely?
2. Taxes based on the value of property
   • Property taxes or ad valorem taxes.
     • Basics.
     • Multistate considerations.
     • Tax planning.
     • Issues.
3. Transaction taxes: Sales and use taxes and excise taxes
   • Excise tax basics.
     • Tax planning.
     • Issues.
   • Sales and use tax basics.
     • Use tax.
     • What is taxed?
       1. Resale exemption.
       2. Incentive exemptions.
       3. True object test.
     • Multistate issues:
       1. Quill and mail order sales (remote sellers).
       2. Nexus.
     • Tax planning.
     • Issues:
       1. Application to intangibles and services (and growth of these items in today's economy).
       2. Mail order sales.
       3. Regressivity.
       4. Cascading.
     • Other types of transaction taxes:
       1. Transciency occupancy tax.
       2. Severance tax.
4. Employment taxes
   • Basics: FICA, FUTA, SECA.
   • Tax planning.
   • Issues:
     1. Worker classification.
     2. What are considered wages subject to employment taxes?
     3. What special reporting and withholding requirements apply to tips earned by employees?
     4. When are employment taxes to be deposited with the IRS?
5. Transfer taxes – estate and gift taxes, and generation skipping transfer tax
   • Basics (including unified credit and rate structure).
   • Multistate taxation.
   • Tax planning.
   • Issues.
6. Other types of taxes
   1. Customs, duties, and tariffs.
   2. Real estate transfer taxes.
   3. Documentary transfer taxes.
   4. Stock transfer taxes.
   5. Capital stock taxes.

1. Multistate taxation basics:
   1. Nexus.
   2. Public Law (P.L.) 86–272.
   3. Apportionment formulas.
   4. Throwback rules.
2. State income taxation of individuals.

Objective 4:
To understand how federal and state taxes and tax systems are interrelated Additional Considerations in Understanding Different Types of Taxes

1. Impact of federal tax laws on state governments:
   1. Where both federal and state governments assess a tax, such as gasoline excise taxes, a rate or base change by one will affect the other.
   2. Federal treatment of state and local bond interest (affects interest rates).
   3. Revenue impact to states of modeling their state income tax on the federal income tax.
2. Impact of state tax laws on the federal government:
   1. Changes in state excise tax rates affects federal excise tax collections.
   2. Impact of whether the state imposes taxes that individuals may deduct on their federal income tax returns.
3. Interaction among taxing authorities:
   1. Sharing of tax return examination results.
   2. Combined filing for individuals – Telefile.
4. Tax competition:
   1. Expanding use of incentives by state and local governments to entice businesses.

To understand and be able to explain some of the legal and tax differences among entity types

Introduction

1. Legal versus federal tax definitions.
2. Further discussion in Chapters 14 to 17.

1. C corporations
   • Relationship between shareholders and corporation.
   • Formed per Corporations Code of a particular state.
   • Importance of legal status to a C corporation and its shareholders.
   • Meaning of "C."
   • Double taxation.
   • Tax rate structure; maximum tax rate of 35%.
   • No limits on number or type of shareholders.
   • May choose any tax year (unless is a personal service corporation).
   • Form 1120 due by 15th day of third month following year end.
   • Consolidated returns allowed by affiliated group.
   • Advantages and disadvantages.
   • Special types of C corporations: PSC, PHC.
2. Subchapter S corporations
   • Is a special type of C corporation under federal tax law.
   • Small business corporation:
     1. be incorporated in the U.S. (a domestic corporation);
     2. have 75 or fewer shareholders;
     3. only have individuals, estates and certain types of trusts, and certain tax–exempt organizations as shareholders (no corporation or partnership may be a shareholder);
     4. have no shareholder who is a non–resident alien (a person who is neither a U.S. citizen nor a U.S. resident); and
     5. have only one class of stock.
   • Pass–through entity.
   • Form 1120S due by 15th day of third month following year end; Schedule K–1s for shareholders.
   • Advantages and disadvantages.
3. Partnerships
   • General or limited.
   • Usually can be formed informally, except for limited partnerships.
   • LLPs.
   • Pass–through entity.
   • Form 1065 due by the 15th day of the fourth month after the end of the tax year; Schedules K–1 to partners.
   • Advantages and disadvantages.
   • PTPs.
4. Limited liability companies
   • Usually taxed as a partnership.
   • Advantages of a corporation without the disadvantages of double taxation or S corporation eligibility restrictions.
   • Usually must register with the Secretary of State, file articles of organization, and perhaps pay a registration fee.
   • Advantages and disadvantages.
   • Members, not partners.
5. Federal tax rules for distinguishing between corporations and partnerships
   • Check–the–box regulations.
6. Sole proprietorships
   • A business owned by an individual who is not a corporation or LLC under state law.
   • Is not a separate entity from its owner.
   • Individual also referred to as self–employed.
   • Unlimited liability for business debts.
   • Simple to form. Need EIN if will have employees.
   • Schedule C, Form 1040 due by April 15.
   • Tax rate structure; maximum tax rate of 39.6%.
   • Advantages and disadvantages.
   • Employee versus independent contractor (worker classification).
     1. 20–factor test

   1. Instructions. 2. Training. 3. Integration. 4. Services Rendered Personally. 5. Hiring, Supervising, and Paying Assistants. 6. Continuing Relationship. 7. Set Hours of Work. 8. Full Time Required. 9. Doing Work on Employer's Premises. 10. Order or Sequence Set.

   11. Oral or Written Reports. 12. Payment by Hour, Week, Month. 13. Payment of Business and/or Traveling Expenses. 14. Furnishing of Tools and Materials. 15. Significant Investment. 16. Realization of Profit or Loss. 17. Working for More Than One Firm at a Time. 18. Making Service Available to General Public. 19. Right to Discharge. 20. Right to Terminate.

7. Trusts and estates
   • Definitions of terms – trustee, beneficiary, grantor, fiduciary.
8. Tax–exempt entities
   • Rationale.
   • UBTI.
9. Government entities
10. Specialized entities – FSCs, REITs, RICs.

Objective 4:
To realize that tax planning and decisionmaking vary according to the type of business entity they are done for

Comparison of Different Business Entities

1. See comparison chart at end of chapter.
2. Different entities – different decisions
   • Distributions.
   • How to borrow – entity or owner level.

1. Constitutional foundation of the federal government's tax authority is covered by looking at the role of each of the three branches of government in the tax process.
2. Types of tax authority issued by each branch and its relevance to tax research is covered in Chapter 6.

Objective 1:
To know by what constitutional authority Congress enacts federal tax legislation

The U.S. Constitution and Taxation

1. Article I, Section 8 of the U.S. Constitution provides: The Congress shall have power to lay and collect taxes, duties, imposts and excises, to pay the debts and provide for the common defense and general welfare of the United States; but all duties, imposts and excises shall be uniform throughout the United States.
2. Section 9 of Article I: No capitation, or other direct tax shall be laid, unless in proportion to the census or enumeration herein before directed to be taken. No tax or duty shall be laid on articles exported from any state.
3. Taxing powers in Constitution affected by concern over "taxation without representation."
4. Direct versus indirect taxes.
5. Events leading up to the 16th Amendment.
6. The Sixteenth Amendment The Congress shall have power to lay and collect taxes on income, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.
7. Income tax of 1913 versus the income tax of today.

Objective 2:
To understand the legislative process, the players involved in it, the documents it produces, and the set–up of the Internal Revenue Code

The Role of Congress in Federal Income Taxation

1. Makes changes to Title 26 of the U.S. Code – the Internal Revenue Code of 1986.
2. The Internal Revenue Code
   • Subtitles, chapters, subchapters, parts, subparts, sections.
3. The Legislative Process
   • The origination clause at Article I, Section 7 of the U.S. Constitution provides:

     All bills for raising revenue shall originate in the House of Representatives; but the Senate may propose or concur with amendments as on other bills.

   • House Ways and Means, and Senate Finance committees and their chairs.
   • Make changes to the IRC, and approve tax treaties (Senate).
   • Steps required for Congress to pass tax legislation.
   • Line–Item Veto (in June 1998, this Act was held to be unconstitutional).
   • Technical corrections.
   • Legislative histories.
4. Considerations in changing the tax law
   • Pay–as–you–go.
   • Raising revenue to reduce budget deficits.
   • Renewal of expiring tax provisions (extenders).
   • Closing loopholes.
   • Tax law changes to stimulate certain economic or social activity.
5. Other Congressional offices that assist with tax legislation.
   • Joint Committee on Taxation.
   • Congressional Research Service.
   • General Accounting Office (GAO).
   • Congressional Budget Office (CBO).

Objective 3:
To be able to explain the role of the Treasury Department and the Internal Revenue Service (IRS) in the tax administrative process

The Role of the Administration in Federal Income Taxation

1. Treasury Department and IRS.
2. The Department of the Treasury
   • Secretary of the Treasury.
3. The Internal Revenue Service (IRS)
   • IRS mission statement provides a broad overview to this agency:

     The purpose of the Internal Revenue Service is to collect the proper amount of tax revenue at the least cost to the public in a manner warranting the highest degree of public confidence in our integrity, efficiency, and fairness.

   • Structure of IRS and role of IRS Commissioner and District Offices.
   • Interesting facts and statistics.
   • IRS examination and appeals process.
     1. DIF score.
     2. Matching.
     3. TCMP audits.
     4. CEP audits.
   • When a taxpayer disagrees with the IRS examination results – Appeals.
   • IRS interaction with state tax agencies and authorities.
   • IRS restructuring.

Objective 4:
To know the hierarchy and nature of the courts involved in tax cases and understand how a taxpayer and the government can end up in court

The Role of the Judiciary in Federal Income Taxation

1. Courts become involved in the tax process when a tax return examination cannot be settled at the Appeals Division level because the taxpayer and IRS fail to agree on how the issues can be resolved.
2. A taxpayer generally may begin a judicial proceeding in one of three different courts: U.S. Tax Court, District Court, or U.S. Court of Federal Claims. These three courts are referred to as courts of original jurisdiction o trial courts. The losing party may appeal the case to the next higher court, known as an appellate court. After the Court of Appeals hears a case the losing party may file a petition to have the U.S. Supreme Court hear the case. United States Supreme Court Appellate Courts U.S. Court of Federal Claims Regional Circuit Courts of Appeal Trial Courts U.S. Court of Federal Claims United States District Court U.S. Tax Court
3. Tax Court
   1. Established in 1924 as the Board of Tax Appeals (BTA).
   2. In 1942 renamed as the Tax Court of the United States.
   3. As an Article I court, the Tax Court is not subject to some of the same rules as courts established under Article III dealing with the judiciary, such as lifetime appointments for judges.
   4. Small case procedure is available if the tax deficiency at issue is $25,000 or less.
   5. Headquartered in Washington, D.C., but cases are heard in about 80 cities throughout the U.S.
   6. 19 judges appointed by the President with advice and consent from the Senate.
   7. Judges serve 15–year terms.
   8. Proposed tax liability does not have to be paid before the petition is filed or before the trial begins.
   9. Golsen rule.
4. District Courts
   1. Serve specific geographical areas throughout the United States.
   2. The 94 District Courts hear many types of cases, not just tax cases.
   3. A taxpayer may obtain a jury trial in District Court if an issue of fact is involved (juries do not decide questions of law).
5. U.S. Court of Federal Claims.
   1. A federal level court with nationwide jurisdiction.
   2. The taxpayer must pay the assessed tax first and then file a claim for refund.
   3. Hears more than just tax cases.
   4. There are 16 judges serving on the Court of Federal Claims who are appointed for 15–year terms by the President with the advice and consent of the Senate.
   5. Headquartered in Washington, D.C., but hears cases throughout the U.S.
6. Regional Courts of Appeals.
   1. Twelve regional Courts of Appeal, including one in the District of Columbia.
   2. Most cases are heard by a three–judge panel.
   3. The judges for the circuit courts serve lifetime appointments.
7. U.S. Supreme Court.
   1. The final level of appeal possible in any case.
   2. Nine justices; each appointed for life by the President with the advice and consent of the Senate.
   3. While the Court receives about 5,000 appeal requests each year, it only accepts about 150 of them.
   4. Petitioning party starts with a petition for writ of certiorari.
8. Who represents the government in tax cases?
   • Tax Court – Chief Counsel within the IRS and Treasury Department represents the Commissioner.
   • Other courts – the Tax Division within the Department of Justice represents the U.S.
9. Final points about tax cases
   1. IRS acquiescence and non–acquiescence.
   2. Alternative dispute resolution.

Purpose of Tax Research

1. To find the correct and best answer to a tax question.
2. Types of situations warranting tax research.
   • Research for tax planning.
   • Research for completed transactions.
   • Research related to tax audits.
3. Documentation.
4. Standards of conduct.

Objective 2:
To be familiar with the key steps and tools used in tax research

Objective 3:
To know the types of documents (authority) used in tax research

Objective 4:
To be able to perform simple tax research and find primary authority in a tax library

The Tax Research Process

1. Keys to effective tax research
   1. Understand the research tools and process so that research can be performed correctly and efficiently.
   2. Understand the tax law so that tax issues can be identified.
2. Research tools:
   1. Tax services.
   2. Other research materials.
3. Basic tax research steps:
   1. Identify the purpose and stage of the research process.
   2. Gather all facts and background data.
   3. Identify the tax issue(s).
   4. Identify and review the Internal Revenue Code section(s) applicable to the issue.
   5. Identify key words related to the issue.
   6. Find additional authority.
   7. Evaluate authority.
   8. Reach a conclusion.
   9. Document the research results: Research memos and letters.
   10. Additional considerations.
4. Research assistance from the IRS.
   • Private letter rulings.

   Types of Tax Authority

   1. Primary versus secondary.
   2. Primary authority from Congress:
      1. Internal Revenue Code and legislative histories.
   3. Primary authority from Treasury and IRS:
      1. Regulations:
         • Interpretive or legislative.
         • Final, temporary, or proposed.
         • Treasury Decision (final or temporary regulation).
      2. Notices.
      3. Revenue Rulings.
      4. Revenue Procedures.
      5. Letter rulings: PLRs and TAMs.
      6. IRS acquiescence or non–acquiescence.
   4. Primary authority from federal courts.
      1. Regular versus memorandum decisions from the Tax Court.
      2. Where to find tax cases other than Tax Court decisions.
   5. Finding primary authority.
      1. See chart in textbook.
      2. What is available in the university library.
      3. Citation system.
   6. Types of secondary authority:
      1. Treatises.
      2. Journals.

   Tax Research Tips and Example

   1. "How to use" section of a tax service and help screens.
   2. Check date of last update.
   3. What type of primary authority is provided in the tax service.
   4. How are electronic searches performed?
   5. Review sample research memo and research steps in the textbook.

Objective 2:
To know Adam Smith's four maxims of tax policy

Introduction

1. Purpose of this chapter
   • To provide you an overview to policies underlying the federal income tax system so that these policies can then serve as a foundation to the rules and concepts covered in subsequent chapters.
   • Don't try to memorize example, but instead use them as tools to understand the policy.
2. Tax policy rhetoric.
3. "Policy" means a principle that guides decision–making.
4. General to less specific perspectives on tax policy:
   • General perspective – federal government primarily relies on the income tax.
   • Less general perspectives – how the income tax burden should be distributed, and how the income tax rules should interact with economic policy decisions.
   • More narrow perspective – how to define "taxable income."

1. Differing perspectives.
   1. Example: What is a "fair" tax system or rule?
2. Adam Smith's maxims of tax policy
   1. Equality.
   2. Certainty.
   3. Convenience of payment.
   4. Economy in collection.
3. Additional perspectives of good tax policy
   1. Appropriate government revenues.
   2. Simplicity.
   3. Neutrality.
   4. Economic growth and efficiency.
4. Distractions to good tax policy
   1. Revenue goals may override simplicity (certainty) goals.
   2. Frequent changes to the tax law.
   3. Legislators and others have come to expect a lot from the income tax system.
   4. The income tax law must deal with complex transactions.
   5. The income tax law is shaped by competing political factors and economic theories.

Objective 3:
To be able to explain the ten policies that underlie the current federal income tax law and to provide at least one example of each

Policies Underlying the Federal Income Tax System

1. The definition of income is influenced by the need to raise revenue.
   • Tax versus GAAP.
   • Accounting for inventory.
   • Prepaid income.
   • Restrictions on deductions.
   • Restrictions on the use of acquired losses.
   • Alternative minimum tax.
2. The income tax law can serve as a mechanism to influence certain types of activities and to discourage others.
   • Sources of ideas.
   • Preferential rules directed towards certain industries or businesses.
   • R&E expenditures.
   • Ordinary and necessary and public policy.
   • Social provisions
   • Disincentives with respect to certain merger and acquisition activity.
   • Excise taxes.
   • Green incentives.
3. Income should be measured on a worldwide basis.
   • Territorial versus worldwide system.
   • Inbound versus outbound transactions.
   • Use of foreign subsidiaries and branches.
   • Intercompany transfer pricing rules.
   • Foreign earned income exclusion.
   • Tax treaties.
   • Foreign tax credit.
4. Recognition of gain and/or loss should be deferred in certain types of transactions.
   • Wherewithal to pay principle.
   • Insufficient change in overall investment.
   • Tax–deferred versus tax–free.
   • Tax–deferred dispositions.
   • Formation of corporations and partnerships.
   • Corporate reorganizations.
5. Design of the tax law must consider administrative convenience and certain equitable principles.
   • Fairness, administrative convenience, and equitable treatment.
   • Installment sales method.
   • Dividends–received deduction (DRD).
   • Carryovers.
6. In some situations it may be appropriate to use the time value of money concept to measure taxable income.
   • Applicable federal rate and imputing interest; OID.
   • Economic performance rule for accrual basis taxpayers.
   • Bad debts of service providers.
   • Below–market loans.
7. Changes in financial and other types of transactions may lead to changes in the tax law.
   • Tax shelters and passive activities (§469).
   • Mergers and acquisitions.
   • Publicly–traded partnerships.
8. The federal tax law should distinguish between capital and ordinary income and losses.
   • What is not a capital asset:
     1. Inventory and assets held primarily for sale to customers in the ordinary course of the taxpayer's trade or business.
     2. Depreciable property and real property used in a trade or business.
     3. A copyright, literary, musical, or artistic composition, letter or memorandum or similar property held by the taxpayer who created the asset by his personal efforts, or for whom the letter or memorandum or similar property was created.
     4. Accounts or notes receivable acquired in a business for services rendered or from the sale of property described in (1) above.
     5. U.S. government publications received from the government, but not by purchase at the public price. For example, a copy of the Congressional Record given to a Congressman is not a capital asset to him if he did not pay the public price.
   • Disposition of assets.
   • Sale of an entire business.
9. To administer the income tax certain types of information are needed in addition to the details of taxable income.
   • Information returns and matching.
   • Reporting of wage and investment income.
   • Information on certain large acquisitions and recapitalization transactions.
   • Information on asset acquisitions.
   • Information reporting and recordkeeping on certain foreign relationships and transactions.
10. Procedures and penalties are needed to ensure proper compliance.
    • Voluntary compliance.
    • Tax gap:
      1. Difference between amount of tax owed and amount collected.
      2. Federal government has about a 17% tax gap.
    • Various compliance initiatives:
      1. Compliance 2000.
      2. Market Segment Specialization Program (MSSP).
      3. But, tempered with Taxpayer Bill of Rights provisions.
      4. Balance between a) unnecessary intrusion into taxpayer affairs and increased complexity of the tax law, and b) the need to have a high compliance rate so that everyone is paying their "fair share" of taxes.
    • Enforcement tools of the IRS.
    • Payor withholding requirements.
    • Cash reporting.
    • Burden of proof.

Objective 4:
To be capable of applying relevant criteria to analyze current proposals for changing the tax laws

Use of Tax Policies in Analyzing Proposals

1. Consideration of Adam Smith's maxims.
2. Likelihood of achieving the stated goal.
3. What alternatives should be considered?
4. Is the goal of this proposal best achieved by use of the tax laws?
5. Other. Is this policy best administered at the federal level or the state and local level? Would government resources better be spent in some other manner to reach the same goal?

Objective 5:
To realize why the tax law is so complex and know what types of efforts are being made to simplify it

The Federal Income Tax Law and Complexity

1. Not a recent problem.
2. What is "simplification"?
   1. reduces mechanical complexity and recordkeeping.
   2. reduces compliance and administrative costs,
   3. preserves underlying policy objectives and principles of existing law.
   4. Is not a tax cut for particular taxpayers or industries,
   5. Does not create abusive tax planning opportunities.
   6. Does not cause significant changes in the tax burden among taxpayers.
3. AICPA simplification activities:
   1. Identification of the causes of complexity.
   2. Identification of the problems caused by complexity.
   3. Creation of a Tax Complexity Index.
4. "Tax Complexity Analysis" suggested by the IRS Restructuring Commission.
5. Additional causes of complexity:
   1. The budget process (PAYGO).
   2. The legislative process.
   3. Conflicting goals (for example: tax benefit versus complexity).
   4. Congress is out of touch with compliance burdens.
6. Simplification efforts of Treasury and IRS:
   1. Simplify regulations by providing general guidance, rather than detailed rules to cover every possible transaction.
   2. Safe harbor provisions and de minimis rules.
   3. Check–the–box regulations (Chapter 4).
7. How easy is it to simplify the tax law? Students should consider this when reading the rest of the textbook.

• Income tax liability = taxable income x tax rate. This chapter focuses on the tax rates applicable to corporations and individuals. Subsequent chapters focus on measuring taxable income.

Objective 1:
To know the tax formula and the terms used in it, as well as the period for measuring tax liability and the due dates for paying it

The Tax Formula and Tax Payment Dates

1. The basic formula: Tax base x tax rate = gross tax liability – tax credits = net tax liability.
2. Deductions versus credits.
3. The general formula to compute taxable income is as follows:
   Gross receipts from all sources
   Less: exclusions [not reported on the tax return]
   Less: cost of goods sold
   Gross income
   Less: allowable deductions
   Taxable income
4. Time period for measuring net tax liability:
   1. Tax year can be a 12–month period ending on the last day of a particular month, or a 52–53 week year.
   2. Fiscal year: a tax year other than a calendar year.
   3. Taxpayer selects its tax year by using it on its first income tax return and continuing to use it thereafter. If the business later wants to change its tax year, generally, it must first obtain permission from the IRS.
5. Time of payment:
   • Withholding.
   • Quarterly estimated tax payments.

Objective 2:
To understand how tax liability is determined for different types of business entities

Business Entity Considerations in Determining Tax Liability

1. Coverage of the individual and corporate tax rates is sufficient to address business entities.

Objective 3:
To be able to calculate a corporation's tax liability if given information on its taxable income

The Corporate Tax Calculation

1. Four–tiered graduated rate structure: 15%, 25%, 34%, and 35%.
2. Qualified personal service corporations apply a single tax rate of 35%.
3. Two surtaxes exist to reduce or eliminate any benefit higher income corporations obtain from the lower tax brackets.
   1. A corporation with $335,000 or more of taxable income will pay tax at a rate of 34% on all of its income until its taxable income exceeds $10 million. That is, the 5% surtax will be fully phased out.
   2. A corporation with $18,333,333 or more of taxable income will pay tax at a rate of 35% on all of its income. That is, the 3% surtax will be fully phased out.
4. Additional corporate taxes:
   • Personal holding company tax.
   • Alternative minimum tax.

Objective 4:
To be able to identify an individual's filing status and calculate an individual's tax liability if given information on that person's taxable income

The Individual Tax Calculation

1. The calculation of an individual's income tax requires an understanding of more definitions than is required for the corporate income tax calculation.
2. Taxable income formula for individual taxpayers
   Gross income
   Less: deductions from gross income
   Adjusted gross income
   Less: either the standard deduction or itemized deductions
   Less: exemption amount(s)
   Taxable income
3. Individual tax calculations:
   • Based on filing status.
   • Five–tier graduated rate structure: 15%, 28%, 31%, 36%, and 39.6%.
   • The tax rate schedules are adjusted for the effect of inflation each year, while the corporate brackets are not. The rationale for the adjustments is to prevent bracket creep.
4. Filing status and related definitions:
   1. An individual treated as married if they are married on the last day of the tax year.
   2. Some filing statuses apply only if the taxpayer has a dependent.
   3. Five tests for a person to be a taxpayer's dependent:
      1. Relationship or member of the household test.
      2. Marriage test – married persons can only be dependents if they do not file a joint return with their spouse. If married persons file a joint return solely to obtain a refund of all of the tax that was withheld from their paycheck (such as because no income tax is owed), filing a joint return will not disqualify the person as a dependent under this test.
      3. Citizen or resident test – the person must be a U.S. citizen or resident. Alternatively, the person must be a resident of Canada or Mexico.
      4. Gross income test – the person's gross income for the taxable year must be less than the exemption amount. Non–taxable social security benefits do not count in measuring the person's gross income under the gross income test.
         • The gross income test is ignored if the person is the taxpayer's child or stepchild, and is either i) under age 19 at the close of the tax year, or ii) under age 24 at the close of the tax year and a student. A person is a student if she was a full–time student for at least five calendar months of the year at an educational institution.
      5. Support test – the taxpayer must have provided over half of the person's support for the tax year. Support includes food, shelter, clothing, medical and dental care, education, and similar items. If the person is the taxpayer's child and a student, scholarship funds received by the person are not considered in applying the support test.
         • Special rules apply if the person is a child of divorced parents, and to determine which taxpayer meets the support test when two or more taxpayers contribute towards the person's support, but no one taxpayer provides over half of the person's support.
   4. Filing statuses:
      • Married taxpayers filing jointly. – Unless file separately or are treated as married individuals living apart.
      • Surviving spouse. – Uses the MFJ table. – Spouse died during either of the two immediately preceding tax years, and the individual, a) maintains as her home a household that for the entire tax year is the principal place of abode of their child who the taxpayer may claim as a dependent, b) furnishes more than half of the cost of maintaining the household during the tax year, c) did not remarry, and d) was eligible to file a joint tax return for the year the spouse died.
      • Head of household. – Must not be married at the end of the tax year (unless are considered not married under the special rule for married individuals living apart explained earlier); must not be a surviving spouse; must not be a non–resident alien at any time during the tax year; and must meet one of the following requirements:
        1. maintain as their home a household that for over half of the tax year is the principal abode, as a member of the household, of: i) a son, stepson, daughter, or stepdaughter, or a descendant of a son or daughter (such as a grandchild); if the son, stepson, daughter, stepdaughter or descendant is married, then the person must also qualify as the taxpayer's dependent (or would but for the special rule for children of divorced parents), or ii) any other person who the taxpayer may claim as a dependent (such as a foster child), or
        2. maintain a household that is the principal place of abode of the taxpayer's father or mother for the tax year, and the taxpayer is entitled to claim them as a dependent.
      • Single.
      • Married individuals filing separate tax returns.
   5. Marriage penalty: Is a consequence of joint returns and a graduated rate structure. However, some married couples enjoy a marriage bonus.
5. Tax rate schedule versus tax tables.
6. Special tax rates for individuals:
   1. Net capital gain income.
   2. Kiddie tax.
   3. Higher marginal tax rate due to exemption phase–out for higher income individuals.
7. Additional individual taxes
   1. Self–employment tax.
   2. Social security and Medicare tax on tip income not reported to an employer.
   3. Household employment taxes.

Objective 5:
To comprehend the purpose and basics of the alternative minimum tax (AMT)

Alternative Minimum Tax (AMT)

1. Why it exists.
2. The starting point to compute AMT is taxable income. Various adjustments are made to taxable income to derive alternative minimum taxable income (AMTI). If AMTI exceeds an AMT exemption amount ($40,000 for a corporation, $45,000 for MFJ individuals, and $37,750 for single individuals), then AMT potentially applies.
3. The AMT tax rate for corporations is 20%, while a graduated rate structure of 26% and 28% applies to individuals. This gross tax amount is reduced by the taxpayer's alternative minimum tax foreign tax credit (if any) to derive tentative minimum tax.
4. If tentative minimum tax is greater than the taxpayer's regular tax liability, the excess, referred to as AMT, is owed by the taxpayer in addition to regular tax liability. If the tentative minimum tax is not greater than the taxpayer's regular tax liability, no AMT is owed.
5. Involves several special rules and definitions and is further covered in Chapters 14 and 16.

Objective 6:
To understand how knowledge of the components and operation of the tax formula affect tax planning for different types of business entities

Tax Planning

1. In general:
   • Tax planning (avoidance) versus tax evasion.
   • Importance of marginal tax rate in tax planning.
   • Tax planning through the tax formula:
     – reduce the tax base;
     – reduce the tax rate;
     – utilize tax credits.
2. Pass–through entity planning considerations:
   • Partners may have different concerns and tax situations.
   • Some tax rules apply differently to different types of partners.
3. Tax planning and choice of entity:
   • Is particularly relevant when tax rates change.

Objective 2:
To appreciate that differences exist among taxable, accounting, and economic income, and understand how differences between taxable and accounting income are reflected on a corporate or partnership tax return

Objective 3:
To know how to apply gross income concepts and rules to determine if an item is taxable to a taxpayer

Introduction

1. Types of income.
   1. Accounting income.
   2. Taxable income.
   3. Economic income—includes all increases in wealth, whether or not realized.
2. Realization principle is generally followed in computing both accounting and taxable income.
3. Generally, the conservatism principle and often the matching principle are not followed in computing taxable income.
4. Book–tax differences are reported on business tax returns (other than Form 1040, Schedule C) on Schedule M–1, Reconciliation of Income (Loss) per Books With Income per Return.
   • Reasons for book–tax differences:
     1. Timing differences. For example, income may be reported in an earlier or later year than is required for tax purposes.
     2. Permanent differences. Different definitions of accounting and taxable income leads to reporting differences—for example, tax–exempt interest income.
5. Taxable income formula:
   Gross receipts (with exclusions omitted)
   Less: cost of goods sold
   Gross income
   Less: allowable deductions
   Taxable income
   
   • Taxable income is dependent on two sets of rules:
     1. The specific tax law provisions that define income and deductions, as well as limitations that exist for deductions.
     2. The overall method of accounting used by the taxpayer (for example, cash, accrual, or hybrid) and the method used for specific items, such as inventory (lower of cost or market, FIFO, LIFO, etc.), and bad debts.

1. The 16th Amendment to the U.S. Constitution allows Congress to lay and collect taxes on income "from whatever source derived." However, income was not defined.
2. Income is broadly defined for tax purposes
   1. The "including (but not limited) to" phrase indicates that Congress intended the list of items constituting gross income to serve as examples, rather than as an all–inclusive list.
   2. Exclusions—While the definition of gross income is broad, Congress has specified that certain items be excluded from gross income. Exclusions are often referred to as items of legislative grace because if Congress had not specifically provided for their omission from gross income, they would fall within its definition. Exclusions are not the same as deductions and they are not reported on the tax return.
3. Form of receipt—cash, property, or services—is not relevant in determining if a taxpayer has income. Thus, bartering can generate taxable income.
4. Income refers to the return from capital or labor or both, rather than a return of capital (Eisner v. Macomber).
   1. Examples: wages, interest, dividends, rents, gains from disposition of property.
   2. Exclusions: interest on state and local bonds, educational savings bonds, gain from sale of a principal residence, certain fringe benefits.
5. Income can also be defined as "undeniable accessions to wealth, clearly realized and over which the taxpayers have complete dominion." (Commissioner v. Glenshaw Glass Company).
   1. More on damages:

      Fact pattern	Not income	Income	Excluded
      Punitive damages received.		X
      Damages received on account of personal physical injury or sickness.			X
      Damages received as a substitute for lost revenues or profits.		X
      Damages received to restore lost capital.	X

   2. Debt proceeds: Borrowed money is not an accession to wealth over which the borrower has control because of the borrower's corresponding obligation to repay the debt, thus, it is not income.
      1. Cancellation of debt (COD) income results when debt is forgiven, unless an exclusion applies.
      2. Generally, borrowers may only exclude income from discharge of indebtedness if they are insolvent (liabilities are greater than the fair market value of the taxpayer's assets) or in a bankruptcy proceeding. Insolvent borrowers may exclude debt discharge income only to the extent of their insolvency. Certain tax attributes, such as an NOL carryover, of the borrower must be reduced for the COD income.
   3. Deposits are not income because the recipient does not have complete dominion over the funds.
   4. Illegal income are considered part of gross income.
   5. Found money is also income under the Glenshaw Glass definition.
   6. Exclusions relevant to the Glenshaw Glass definition of income:
      1. Gifts and inheritances.
      2. Life insurance proceeds.
   7. Substance over form: Some funds received by a taxpayer may look like income, but in substance, are not income.
      1. Rebates.
      2. Expense reimbursement (such as employer–reimbursement of employee business expenses).
   8. Imputed income.
      1. Imputed income generally refers to income that is not based on a specified amount of money, but is instead some type of economic benefit to the taxpayer.
      2. Many types of imputed income, such as the benefit derived from living in a home you own, are not treated as income, due to compliance and administrative difficulties of measuring such income.
      3. On the other hand, some types of imputed income, particularly interest on below–market loans is treated as income.
         • Demand versus term loans.
   9. Who is income taxed to?
      1. "Fruit–of–the–tree doctrine" (Lucas v. Earl)—income must be taxed to the party that earned it (fruit must be attributable to the tree from which it fell).
      2. Also, a taxpayer who controls the source of income, is generally the one to whom the income is taxable (Helvering v. Horst).
   10. Special income provisions for individuals:
       • For example, alimony, prizes and awards, reimbursement for certain moving expenses, unemployment compensation, and Social Security benefits.

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   Objective 4:
   To understand that certain types of income have special tax implications Not All Income Is Treated The Same

   1. Capital gain income versus ordinary income. These types of income must be distinguished because of the following provisions.
      1. Lower tax rate on certain capital gains derived by non–corporate taxpayers.
      2. Capital losses may be used against capital gain income.
   2. Wages and self–employment income must be distinguished from investment income and non–taxable benefits.

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   Objective 5:
   To be able to define cost of goods sold and explain how it fits into the determination of gross income

   Cost of Goods Sold

   1. COGS is calculated using the following formula:

      Beginning inventory
      plus: Purchases
      plus: Cost of labor
      less: Ending inventory
      Cost of goods sold

   2. Inventory considerations:
      • Inventoriable costs: Direct labor, direct materials, and indirect costs. The specific elements of indirect costs are not exactly the same for tax (UNICAP rules) and GAAP purposes.
      • Further discussion in Chapter 11 on tax–accounting methods.
   Summary
   1. Generally, income must result from a realization event (as opposed to an unrealized increase in value).
   2. Gross income is income from any source derived, unless there is a specific exclusion in the tax law.
   3. Income can be derived in any form (money, property or services).
   4. Income is a return from capital or labor or both combined (as opposed to a return of capital).
   5. Income is an accession to wealth, clearly realized and over which the taxpayer has complete control.
   6. Income is taxable to the person who earned it.
   7. Cost of goods sold, as measured for tax purposes, reduces gross receipts to derive gross income.

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   Chapter 10 Outline

   Objective 1:
   To be capable of applying general concept and specific tests to determine if an item is an allowable deduction

   Allowable Business Deductions

   1. "Deductions are a matter of legislative grace."
   2. Key terminology for allowable business deductions.
      1. IRC: "There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business."
      2. Restatement of the IRC rule into a multi–part test—to be deductible, an expenditure must
         1. be ordinary;
         2. be necessary;
         3. be paid or incurred during the taxable year;
         4. in carrying on a trade or business;
         5. arise in connection with or proximately result from that trade or business; and
         6. not be subject to a tax law provision that denies, limits, or defers the deduction.
   3. Ordinary.
      1. Used to distinguish between a currently deductible expenditure and one that must be capitalized.
      2. Recent guidance (1992 Indopco decision) from the U.S. Supreme Court:

         "Although the mere presence of an incidental future benefit – "some future aspect" – may not warrant capitalization, a taxpayer's realization of benefits beyond the year in which the expenditure is incurred is undeniably important in determining whether the appropriate tax treatment is immediate deduction or capitalization."

      3. Frequency of the expenditure—"Ordinary ... does not mean that the payments must be habitual or normal in the sense that the same taxpayer will have to make them often. A lawsuit affecting the safety of a business may happen once in a lifetime. The counsel fees may be so heavy that repetition is unlikely. Nonetheless, the expense is an ordinary one because we know from experience that payments for such a purpose, whether the amount is large or small, are the common and accepted means of defense against attack. ... The situation is unique in the life of the individual affected, but not in the life of the group, the community, of which he is a part."
   4. Necessary.
      1. The expense must be "appropriate and helpful" for "the development of the [taxpayer's] business."
      2. The expenditure must also be "reasonable in relation to its purpose" to be considered necessary.
   5. Paid or incurred during the tax year.
      1. Depends on the taxpayer's method of accounting (Chapter 11).
   6. Incurred in carrying on any trade or business."
      1. The business is beyond the start–up phase.
      2. "Trade or business" is not defined in the Code or income tax regulations.
         1. Relevant factors to consider include whether the activity is pursued full–time and with regularity, and whether it is pursued primarily for the production of income as a livelihood rather than as a hobby.
   7. Arise in connection with or proximately result from that trade or business.
      1. This requirement typically involves whether an expenditure is that of the business, or instead is that of an owner or employee of the business.

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   Objective 2:
   To understand some of the special deduction and loss rules included in the federal tax law that apply to business and investment activities

   Provisions That Deny, Limit, or Defer An Otherwise Allowable Deduction

   1. Denial of deduction provisions.
      1. Fines and similar penalties paid to a government for violation of any law.
      2. Federal income taxes.
      3. Land and other non–deductible property.
      4. Expenses of producing tax–exempt income.
      5. Entertainment expenditures are only deductible if the entertainment is either,
         1. "directly related to" the active conduct of a trade or business, or
         2. in the case of entertainment that directly precedes or follows a substantial and bona fide business discussion, is "associated with" the active conduct of a trade or business.
         • The cost of a lavish or extravagant meal is not deductible.
         • No deduction is allowed for entertainment if the required documentation is not maintained.
      6. Dues paid for membership in any club organized for business, pleasure, recreation, or other social purpose.
      7. Lobbying and political expenditures.
   2. Deduction limitation provisions.
      1. Only reasonable compensation is deductible.
      2. Publicly traded corporations may only deduct compensation of up to $1 million each for the top five executives. Some exceptions exist, such as where the compensation is performance–based.
      3. Charitable contributions.
      4. Meals and entertainment—only 50% of the cost is deductible.
      5. Deduction for business gifts is limited to $25 per recipient per year.
   3. Deferral of deduction provisions.
      1. Bad debt deductions—specific charge–off method must be used, rather than the reserve method.
      2. Related parties must match the time that expenses and income are reported with respect to transactions between them.
      3. Deferred compensation—to be deductible in the year earned, an accrual–method employer must pay it within 2 1/2 months after year end. Otherwise, it is not deductible until the year the employee reports it as income.
      4. Interest capitalization rule.
         1. Similar to FAS No. 34.
         2. Interest must be capitalized during the production period if the taxpayer has,
            • Designated property—self–produced real or tangible personal property that (i) is either personal property with a 20–year life or real property, or (ii) has an estimated production period exceeding two years, or (iii) has an estimated production period exceeding one year and estimated cost exceeding $1 million; and
            • Interest expense paid or incurred during the period that the property is being produced.
         3. Traced versus avoided cost debt.
         4. Inventoriable costs—no offset against gross receipts until becomes part of cost of goods sold.
         5. Passive activity loss limitation rule.
            1. A taxpayer subject to this rule may only deduct expenses from passive activities when he has income from passive activities. Excess deductions may be carried forward and used in a subsequent year when the taxpayer either has passive activity income or disposes of the passive activity.
            2. A passive activity is either a trade or business in which the taxpayer (owner) does not materially participate or a rental activity.
            3. The passive activity loss limitation only applies to individuals, trusts, estates, personal service corporations, and closely–held corporations.

         Special Deduction Rules

         1. Deductible taxes include real property taxes paid to state, local, or foreign governments, personal property taxes paid to state or local governments, and income taxes paid to state, local, and foreign governments (unless a foreign tax credit is claimed in lieu of a deduction for foreign income taxes).
         2. Start–up expenditures—Taxpayers may elect to ratably amortize capitalized start–up expenditures over a period of five years once business begins.
         3. R&D expenditures—are to be deducted as incurred, unless the taxpayer has elected the capitalization and amortization method.
         4. Structural expenditures—two provisions:
            1. A taxpayer may to elect to currently expense up to $15,000 of expenditures incurred to remove architectural and transportation barriers.
            2. A tax credit is available to certain small businesses with respect to expenditures incurred to provide access for disabled individuals.
         5. Expenses for the production of income.
            1. Individuals may deduct ordinary and necessary expenses paid or incurred
               • for the production or collection of income,
               • for the management, conservation, or maintenance of property held for the production of income, or
               • in connection with the determination, collection, or refund of any tax.
            2. These expenses are considered miscellaneous itemized deductions which are only deductible to the extent they exceed 2% of an individual's AGI.
         6. Deductions related to activities not engaged in for profit (a hobby).
            1. The allowable deductions are limited to the amount of gross income from the activity.
            2. Hobby expenditures are considered miscellaneous itemized deductions subject to the 2% of AGI limitation.
      Rules on Losses
      1. Individuals may only deduct losses that i) are incurred in a business, ii) result from any transaction entered into for profit (such as sale of stock), or iii) result from casualty or theft.
      2. Casualty losses.
         1. If the fair market value of the destroyed property is less than its adjusted basis, the business may treat the amount of the adjusted basis as the casualty loss amount, reduced by any insurance reimbursement.
         2. If an individual's personal–use property is destroyed by a casualty and the fair market value is lower then the adjusted basis (cost) of the property, the individual may only treat the fair market value amount as a deductible casualty loss, less any insurance reimbursement.
      3. Losses from capital assets may only be used against capital gain income. However, individuals may also offset a capital loss against up to $3,000 of non–capital gain income.
      4. Related party losses are disallowed.
         • The related party buyer of the property may use the seller's unusable loss to reduce the buyer's gain when the buyer later sells the property to a non–related party.
      5. Net operating losses (NOLs).
         • NOLs may be carried back two years to reduce prior years' income with any remaining NOL carried forward a maximum of 20 years to offset taxable income.

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      Objective 3:
      To be able to explain common differences between expenses and losses shown on a financial statement versus allowable deductions shown on a tax return and how the differences are reported on Schedule M–1

      Reporting Allowable Deductions and Losses

      1. Most deductions are reported on the first page of the tax return (Schedule C for individuals filing Form 1040). Some deductions, such as charitable contributions and casualty losses, may require special reporting forms.
      2. Schedule M–1—timing and permanent differences.

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      Objective 4:
      To know the basic recordkeeping procedures and considerations that apply when documenting deductions and losses

      Recordkeeping

      1. The scrutiny paid to deductions means that a business's records should be maintained and be clear as to what the expenditure was for.
      2. The Code includes a provision requiring taxpayers to keep permanent books of account or records "sufficient to establish the amount of gross income, deductions, credits, or other matters required to be shown by such person in any return of such tax or information."
      3. Travel, entertainment, and gifts.
         1. If a taxpayer does not have adequate records for these types of expenditures, no deduction is allowed.
         2. These expenditures must be substantiated by adequate records or sufficient evidence that indicate:
            1. the amount of the expenditure;
            2. the time and place of the travel, entertainment, amusement, recreation, or use of a facility or property, or for a gift, the date it was given and its description;
            3. the business purpose of the expense (business reason or the nature of the business benefit derived or expected to be derived from the expenditure); and
            4. the business relationship to the taxpayer of the persons entertained, or who used the facility or who received the gift (such as that person's occupation, name, title, and company).
      4. Charitable contributions.
         1. Taxpayers may not deduct any charitable contribution of $250 or more unless written acknowledgment of the donation is obtained from the donee organization.
         2. Generally, if a taxpayer makes non–cash donations in excess of $500, a special reporting form must be attached to the tax return to describe the donation.
         3. A non–cash contribution worth $5,000 or more will likely require that a certificate of appraisal be included with the return.

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      Chapter 11 Outline

      Objective 1:
      To understand how GAAP and federal income tax provisions differ with respect to the timing of revenues and expenses, and how these differences are reported on a business tax return

      Introduction

      1. To compute taxable income, the following rules are needed:
         1. rules as to what items received by the taxpayer are includible in gross income and what expenditures are deductible; and
         2. the tax–accounting methods used by the taxpayer.
      2. Selection of methods of accounting can be a part of the tax–planning process for a business.
      3. Accounting methods involve timing.
         1. . Accounting methods deal with the timing of the reporting of income and expenses. Methods deal with when items are reported, not whether they are reportable.
         2. Generally, most businesses use the accrual method for tax purposes.
         3. Accounting methods include not only a taxpayer's overall method of accounting, such as the cash method or the accrual method, but also the method used in reporting particular items, such as inventory or depreciation.
      4. Selecting methods of accounting.
         1. Generally, taxpayers select their methods of accounting by using them on their first tax return.
         2. To change later involves first obtaining permission from the IRS.
         3. The guiding principle in selecting accounting methods is that the method must "clearly reflect" the taxpayer's income.

         GAAP versus Tax Rules

         1. The tax law does not follow the principles of (1) matching and (2) conservatism.
            1. GAAP: Provide useful information to users of financial statements.
            2. Tax: Protect the fisc.
         2. Tax–accounting methods sometimes result in income being reported at the earliest possible time and expenses being reported at the latest possible time — just the opposite outcome from application of the matching and conservatism principles.

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      Objective 2:
      Know how to apply the income and expense timing rules for a cash–method taxpayer and be able to tell whether a taxpayer is eligible to use the cash method of accounting

      Cash Method of Accounting

      1. Income is reported when received and deductions are reported when paid.
      2. Prepaid expenses: A three–part test is used to determine when a cash method taxpayer may deduct a prepaid expense.
         1. The expenditure is an actual payment rather than a deposit.
         2. There is a business reason (other than tax avoidance) for paying the expenditure early.
         3. Deducting the expenditure in the tax year of the prepayment does not materially distort the taxpayer's income.
      3. Doctrine of constructive receipt.
         1. Cash–method taxpayers must report income that is either actually or constructively received.
         2. Income has been constructively received if it is credited to the taxpayer's account, or set aside for him, or otherwise made available so that he may draw upon it at any time. And, the income must not be subject to substantial limitations or restrictions.
      4. Who may use the cash method?
         1. This question is best answered by considering who must use the accrual method:
            1. Any business that is required to account for inventory must use the accrual method to report its sales and purchases.
            2. A C corporation with average annual gross receipts over the prior three–year period in excess of $5 million must use the accrual method of accounting. This rule also applies to any partnership that has at least one partner that is a C corporation. However, if the C corporation is a qualified personal service corporation, it does not need to use the accrual method, regardless of its gross receipts level.
         2. Inventory is something held for sale to customers (as opposed to supplies that are consumed in the process of providing services to customers).
         3. QPSC: A QPSC is a C corporation that meets both a function test and an ownership test.
            1. The function test is met if 95% or more of employee time is spent providing services in the field of health, law, engineering, architecture, accounting, actuarial science, performing arts, and/or consulting.
            2. The ownership test is met if at all time during the tax year 95% or more of the corporate stock is held directly or indirectly by employees or retired employees performing services in one of the function fields.

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      Objective 3:
      To know how to apply the income and expense timing rules for an accrual–method taxpayer

      Accrual Method of Accounting

      1. Revenues: An accrual–method taxpayer must report income in the tax year when the following (the all–events test) are satisfied.
         1. All events have occurred which fix the right of the taxpayer to receive the income. Generally, this occurs at the earliest of the date
            1. the required performance occurs,
            2. payment is due, or
            3. payment is made.
         2. The amount of the income can be determined with reasonable accuracy.
      2. Expenses: An accrual–method taxpayer may not deduct an expenditure until:
         1. All events have occurred which establish the fact of the liability giving rise to the deduction;
         2. The amount can be determined with reasonable accuracy; and
         3. Economic performance has occurred with respect to the liability.
            • When economic performance (EP) is met depends on the type of liability involved:
              1. If the taxpayer's liability relates to services or property provided to it, EP occurs when the services or property are provided to the taxpayer.
              2. If the taxpayer's liability relates to its use of property, EP occurs ratably over the period of time the taxpayer is entitled to use the property.
              3. If the taxpayer's liability relates to property and services it provides to someone (such as with warranty work on products the taxpayer sells), EP occurs when the taxpayer incurs costs in providing the property or services.
              4. For liabilities that do not fall into one of the above categories (such as taxes, insurance premiums, prizes, and damages), EP occurs when payment is made to the person to whom the liability is owed.
            • A recurring item exception may allow taxpayers an earlier deduction than would otherwise be allowed under the EP rules if the following requirements are met:
              1. The all–events test (fixed and determinable parts of the deductibility test) is met by the end of the tax year;
              2. EP occurs within 8 1/2 months after year end (or the return filing date, if earlier);
              3. The liability is generally expected to occur each year ("recurring"); and
              4. Either a) the amount is not material or b) the accrual results in a better matching of the liability with its related income than would result from following the general EP rules.

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         Objective 4:
         To understand the basic tax rules governing inventory

         Basic Tax Rules on Inventory Accounting

         1. General rule: In order to reflect taxable income correctly, inventories at the beginning and end of each taxable year are necessary in every case in which the production, purchase, or sale of merchandise is an income–producing factor.
         2. Three sets of rules are relevant to measure inventory:
            1. Rules to distinguish inventoriable costs from period costs (UNICAP).
            2. Cost flow assumptions (FIFO, LIFO, specific identification).
            3. Valuation rules (cost, or lower–of–cost–or–market; plus special writedown rules for subnormal goods). Inventory writedown tax rules are very strict as to required documentation.

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         Objective 5:
         To be aware of special tax–accounting methods and rules

         Special Tax–Accounting Methods and Rules

         1. Payments received in advance (taxable) versus deposits (non–taxable).
            1. Deposit: The taxpayer does not have "complete dominion" over the funds at the time the deposits were received.
            2. Advance payments for goods: Special rule may allow for some deferral by an accrual–method taxpayer.
            3. Advance payments for services: Accrual–method taxpayer can adopt method to defer reporting of income if all services will be provided by the end of the next tax year.
         2. Installment sales method.
            1. An installment sale is one where the seller is to be paid over a period of time that extends beyond the year in which the sale was made.
            2. Under installment sales method, income is reported using gross profit percentage as payments are received from the buyer.
         3. Long–term contracts.
            1. A long–term contract is one for the manufacture, building, installation, or construction of property where the contract is not completed within the tax year in which it was entered into. For a manufacturing contract to be a long–term contract, it must be either for the manufacture of unique items or for items that normally take more than 12 months to manufacture.
            2. Generally, taxpayers must use the percentage–of–completion method to account for long–term contracts.
         4. A taxpayer engaged in more than one business may adopt different tax–accounting methods for each business. A taxpayer has more than one business if each business is separate and distinct, and complete and separable books and records are kept for each business.
         5. R & E accounting methods.
            1. General method: Expense as incurred (same as for GAAP).
            2. Elective method: Capitalize R & E expenditures and then amortize the capitalized amount ratably over no less than five years, beginning with the month in which the taxpayer first realizes benefits from the R & E.
         6. How a taxpayer changes a method of accounting.
            1. Must obtain permission from the IRS National Office.
            2. Generally, when a taxpayer changes its method of accounting, the taxpayer must adjust taxable income for a Section 481 adjustment to prevent omission or duplication of income or deductions.
         Book–Tax Differences
         1. Most of the book–tax differences covered in Chapters 9 and 10 were permanent differences because they dealt with a situation where a type of income or expense was not includible on a tax return but was includible on financial statements.
         2. Book–tax differences resulting from the use of different accounting methods for book and tax purposes result in timing differences.

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         Chapter 12 Outline

         Objective 1:
         To know what is meant by "taxation of property transactions"

         What Are "Property Transactions?"

         1. Topics covered:

            Transaction	Relevant Tax Rules
            Acquisition and improvement of property.	Capitalization and basis rules. Cost recovery rules.
            Disposition of property.	Calculation of the amount of gain or loss. Characterization of the gain or loss (such as capital gain or ordinary gain). Loss limitation rules.
            Loss of property.	Involuntary conversion rules. Worthlessness rules. Abandonment rules. Casualty loss rules.

         2. Topics that are only for tax, not financial reporting: capital gains and losses, tax–deferred transactions.
         3. What is property? Areas where this question is relevant:
            • Property rights versus services (capital gain versus ordinary income; §351 and §721).
            • Asset versus non–asset (person's name/likeness is not an asset).
         4. Nature of a transaction.
            • Sale versus license: A transaction will most likely be classified as a sale if one or more of the following conditions exists:
              1. A portion of each periodic payment made by the customer is specifically to acquire an equity interest in the property.
              2. The customer will acquire title to the property once they make a stated amount of payments.
              3. The total amount to be paid by the customer for a relatively short period of use is an "inordinately" large proportion of the total amount to be paid to obtain title to the property.
              4. The periodic payments materially exceed the fair rental value.
              5. The agreement includes a purchase option which allows the customer to obtain the property for a nominal amount relative to the total amount of periodic payments to be made.
              6. A portion of each periodic payment made by the customer is designated as interest.

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         Objective 2:
         To understand the provisions governing capitalization

         Basis and Capitalization Rules

         1. Basis refers to the cost of an asset with certain adjustments.
         2. Capitalization means treating an expenditure as increasing the basis of a tangible or an intangible asset, rather than currently deducting it.
            1. Expenditures to acquire or create an asset with a life greater than one year must be capitalized.
            2. All costs incurred to create an asset are to be capitalized to determine the asset's basis.
            3. Costs that provide a long–term benefit (some type of intangible asset) must be capitalized.

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         Objective 3:
         To be able to define the basic terms used in the area of taxation of property transactions

         Terminology and Basic Rules for Property Transactions

         1. Determination of the amount of gain or loss from the disposition of property involves the following steps:
            Step 1—Calculate the realized gain or loss:
            

            Amount realized
            Less: adjusted basis
            Realized gain (loss)

            Step 2—Determine how much of the realized gain or loss must be recognized (reported on the tax return).
            1. Amount realized is the sum of cash received plus the fair market value of any non–cash property received, plus any debt assumed by the buyer, less selling expenses.
            2. Adjusted basis is the original cost of an asset plus capitalized improvements, less depreciation allowed or allowable during the time the taxpayer owned the asset.
            3. Identification of stock: Must use FIFO approach, unless seller specifically identified to their broker which shares were sold and have a confirmation document indicating the specific shares sold.
            4. Personal use property converted to business use: Basis is the lower of cost or fair market value at the conversion date.
            5. Substituted basis property.
               1. Transferred basis property: A common example is property that a taxpayer received as a gift. Generally, the recipient's basis in the gift will be the same as the donor's basis. However, if at the time the gift is made, the fair market value of the property is less than the donor's basis in the property (loss property), the recipient must use the fair market value as her basis in determining any loss from the transfer.
               2. Exchanged basis property: In tax–deferred transactions, such as involuntary conversions, the taxpayer uses the basis in its old property as its basis in the new property acquired in the exchange.
            6. Basis of inherited property: Generally, the basis of any property received from a decedent is the fair market value of the property at the decedent's date of death, resulting in either a step–up or step–down in basis.
            7. Realized gain (loss) is the excess of the amount realized over the adjusted basis of the property that was sold or otherwise disposed of. Every property disposition has a realized gain or loss (or $0 if the amount realized equals the adjusted basis). However, not every property disposition has a recognized gain or loss, as explained below.
            8. Unless there is some exception provided in the tax law, a taxpayer must recognize (report) the amount of the realized gain or loss on its tax return.
         2. Characterization — Step 3.
            Step 1—Calculate the realized gain or loss.
            Step 2—Determine how much of the realized gain or loss must be recognized.
            Step 3—Determine the character of the recognized gain or loss.
            1. Capital assets are any assets, whether or not used in a trade or business, that do not fall into one of the following five categories:
               1. Inventory and assets held primarily for sale to customers in the ordinary course of the taxpayer's trade or business.
               2. Depreciable property and real property used in a trade or business.
               3. A copyright, literary, musical, or artistic composition, letter or memorandum or similar property held by the taxpayer who created the asset by his personal efforts, or for whom the letter or memorandum or similar property was created.
               4. Accounts or notes receivable acquired in a business for services rendered or from the sale of property described in (1) above.
               5. U.S. government publications received from the government, but not by purchase at the public price. For example, a copy of the Congressional Record given to a Congressman is not a capital asset to him if he did not pay the public price.
            2. Capital gains and losses result when a capital asset is sold or exchanged. Gain is long–term if the asset was held for over one year; otherwise, it is short–term. Non–corporate taxpayers apply a netting process to determine the amount of capital gain or loss includible in taxable income and the tax rate that applies.
            3. Non–corporate taxpayers with a net capital gain may apply lower tax rates than would apply if that amount of income were instead ordinary income. A net capital gain is the excess of long–term capital gains over long–term capital losses over the excess of short–term capital losses over short–term capital gains.

               Nature of the capital asset	Maximum tax rate
               Capital assets held for over 18 months* by individuals in the 28% tax bracket or higher individuals in the 15% tax bracket	20% 10%
               Capital assets held over one year, but not more than 18 months*	28%
               Capital assets held one year or less	ordinary income tax rate
               Collectibles (such as art, antiques, gems, stamps, coins, wine) held over one year	28%
               Gain attributable to depreciation claimed on real property	25%
               Section 1202 stock held for over five years (defined later)	14%
               Capital asset purchased after December 31, 2000, and held for over five years	18%
               Capital asset held over five years and sold after December 31, 2000, by an individual in the 15% bracket	8%

               * The IRS Restructuring and Reform Act of 1998 reduced the holding period for the 10%, 20%, and 25% rates from over 18 months to over one year, effective for amounts taken into account on or after January 1, 1998.
            4. Corporations with a net capital loss: A corporation may only apply capital losses against capital gains. Excess capital losses are carried back three years and forward five years.
            5. Non–corporate taxpayers with a net capital loss: Any excess of capital losses over capital gains may be applied against up to $3,000 of ordinary income, with the excess carried forward indefinitely.
            6. IRC §1231 assets:
               • The tax rule applicable to IRC §1231 assets represents the best of both worlds — a net gain is treated as a capital gain, and a net loss is treated as an ordinary loss. However, depreciation recapture rules may change this result (Chapter 13).
               • An IRC §1231 gain (or loss) is,
                 1. any recognized gain (or loss) from the sale or exchange of property used in the trade or business, and
                 2. any recognized gain (or loss) from the compulsory or involuntary conversion (such as by destruction or condemnation) of property used in the trade or business, or any capital asset held for over one year that is held in connection with a trade or business or a transaction entered into for profit (such as corporate stock held for investment).
               • Property used in the trade or business is defined as either depreciable property or real property used in the trade or business (such as equipment and land) held for over one year, that is not inventory, property held primarily for sale to customers in the ordinary course of a trade or business, or copyrights or certain government publications that do not meet the definition of a capital asset.
            7. Assets that are neither capital assets nor IRC §1231 assets: inventory, accounts receivable, and depreciable property held for one year or less. Gain or loss on these assets will always be ordinary.
         3. Loss limitation rules:
            • Related party losses.
            • Losses of individuals, unless from a transaction entered into for profit (such as sale of stock at a loss), or from a casualty or theft.
            • Capital losses (explained earlier).
            • Loss from wash sales of stock or securities (no loss deduction is allowed with respect to any sale or other disposition of stock or securities if within the period beginning 30 days before and ending 30 days after the disposition, the taxpayer purchases substantially identical stock or securities or has entered into a contract or option to purchase identical stock or securities).

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         Objective 4:
         To understand the tax provisions governing losses that arise without an actual disposition of property

         Losses Which Arise without an Actual Disposition of Property

         1. Worthless securities.
            • If a security which is a capital asset becomes worthless during the tax year, the resulting loss is to be treated as if it was derived from a sale or exchange occurring on the last day of the tax year.
            • A corporation need not be in bankruptcy for there to be sufficient evidence that its stock is worthless.
         2. Abandonment of property.
            • A loss equal to the asset's adjusted basis may be recognized, assuming the asset was used in the taxpayer's trade or business.
         3. Casualty losses.

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         Objective 5:
         To understand the importance of the capital gains debate

         Special Capital Gain Provisions

         1. Sale or exchange of patents.
            • Under certain circumstances, sale or exchange of a patent is treated as a sale or exchange of a capital asset held for over one year.
            • If the creator does not transfer all substantial rights to the use of the patent, other tax rules apply to determine the character of the income produced (likely to be ordinary income from licensing an intangible asset).
         2. Losses on small business stock (§1244 small business stock).
            • Up to $50,000 ($100,000 if MFJ) of the loss per year may be treated as ordinary.
            • Small business stock is that of a corporation with capitalization of $1 million or less as determined at the time the stock is issued. The individual shareholder must have purchased the stock directly from the corporation (rather than purchasing it from an existing shareholder). During its five most recent tax years, the corporation must have derived over 50% of its gross receipts from non–passive sources.
         3. 50% gain exclusion for certain small business stock (§1202 qualified small business stock).
            • A qualified small business is a domestic C corporation with gross assets of $50 million or less. Generally, the shareholder must acquire the stock at original issue (from the corporation). During substantially all of the time the shareholder held the stock, the corporation must have met the active business requirement where at least 80% (by value) of the corporation's assets (including intangible assets) are used in the active conduct of one or more qualified trades or businesses.
            • 42% of the excluded gain is treated as a preference item for alternative minimum tax (AMT) purposes.
            • Non–corporate shareholders who sell qualified small business stock that has been owned for over six months and who purchase other qualified small business stock within 60 days, may elect to defer recognition of any gain.
         Capital Gains Debate
         1. Capital gains preferences began with the Revenue Act of 1921 and have changed many times since then.
         2. Suggestions for additional preferences continue to be discussed, such as lower rates for capital gains, sliding scale exclusions, indexing, and preferences for corporations.
         3. Common issues raised in the capital gains debate:
            1. The lowering of the tax rates by the Tax Reform Act of 1986 removed the need for capital gain preferences.
            2. Tax preferences for capital gains and losses only benefit the wealthy.
            3. Capital gain preferences will improve the rate of savings in the U.S. and improve international competitiveness.
            4. Indexing will further complicate the tax law.
            5. Capital gain preferences will cause the government to lose money.
         4. Additional considerations in the capital gains debate:
            1. Would it be simpler to just remove the capital versus ordinary distinction from the tax law?
            2. Does preferential treatment of capital gains encourage investors to invest in assets yielding appreciation rather than those yielding current income in the form of interest and dividends? If yes, what is the effect on the economy?
            3. What revenue could be generated for the government by taxing an individual's net appreciation in capital assets held at date of death?
            4. Do the current income tax rules hinder business investment by providing rules that favor investment in a principal residence over other types of investments, such as stock?
            5. Should any change in the taxation of capital gains also apply to corporations?

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         Chapter 13 Outline

         Objective 1:
         To know the general rules for computing tax depreciation and be able to compute depreciation for commonly encountered tangible and intangible assets

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         Objective 2:
         To have a working knowledge of special depreciation rules

         Tax Depreciation—Definitions and General Rules

         1. Terminology:
            1. Depreciation: A reasonable allowance for the exhaustion, wear and tear, or obsolescence of property used in a trade or business or held by the taxpayer for the production of income.
            2. MACRS: The tax law separates tangible property into nine different categories with each category assigned a useful life. Referred to as cost recovery due to the specified lives and no salvage value considerations, but concept is similar to depreciation.
         2. Depreciation reminders:
            1. Depreciation is only allowed on assets used by taxpayers in their trade or business or held for the production of income.
            2. Non–wasting assets, such as land, are not depreciable.
            3. Depreciation begins when the asset is placed in service—when it is in a "state of readiness and availability for a specifically assigned function" in a trade or business.
         3. MACRS calculations.
            1. MACRS calculations are based on three factors:
               1. The applicable depreciation method.
               2. The applicable recovery period.
               3. The applicable convention.
            2. General MACRS.
               1. Method: (a) the double–declining balance (DDB) method for most tangible personal property, and (b) the straight–line method for real property.
                  • Or, the taxpayer may elect to use the 150% DB method or the straight–line method rather than the DDB method. Such an election applies to all of that type of property placed in service that year.
               2. Recovery Period: The Recovery Period Chart (Figure 13–1) is used for particular types of tangible personal property, while the recovery period for real property is 27.5 years for residential rental property and 39 years for other real property.
                  • Residential rental property is any building or structure where 80% or more of the gross rental income is from dwelling units. A dwelling unit is a house or apartment that provides living accommodations. However, a dwelling unit does not include a unit in a hotel or motel if over 50% of the units are used on a transient basis.
               3. Convention: An assumption as to when during the tax year an asset was placed in service and when during the tax year an asset is disposed of or taken out of service.
                  • Real property — mid–month convention.
                  • Tangible personal property — generally the half–year convention, but if over 40% of the tangible personal property placed in service during the tax year is placed in service during the last three months of tax year, the mid–quarter convention is used.
         4. Intangible assets.
            1. MACRS rules don't apply to intangible property.
            2. Intangible assets may only be amortized if the taxpayer can prove that it has a determinable useful life and an ascertainable value.
            3. In certain situations, the tax law has specified a life for what would otherwise be an asset without a determinable life. For example, the tax law allows corporations and partnerships to elect to amortize their organizational expenditures, such as legal fees, over a period not less than 60 months. Also, taxpayers may elect either a 48–month or 60–month life for package design cost.
            4. Most acquired intangibles have a 15–year life, including goodwill (IRC §197).
            5. If software is not custom software acquired as part of the acquisition of a business, it is amortized ratably over 36 months rather than 15 years.

            Special Depreciation Rules

            1. The ADS (alternative depreciation system):
               1. The ADS applies in the following situations:
                  1. Where the tax law specifically states that the ADS rules are to be used.
                  2. Where the taxpayer properly elects to use ADS rather than GDS.
                  3. To determine the recovery period where the taxpayer has elected to use 150% DB rather than the DDB method.
               2. All types of property must be depreciated using the straight–line method.
               3. The ADS lives are typically longer than the GDS lives (See Figure 13–1).
               4. The following types of property must be depreciated using ADS:
                  • any tangible property used predominantly outside the U.S.;
                  • any tax–exempt use property (generally, property leased to a tax–exempt entity);
                  • any tax–exempt bond–financed property; and
                  • certain imported property.
               5. Elective ADS and 150% DB use: A taxpayer may irrevocably elect to use ADS rather than GDS MACRS. Also, if a taxpayer elects to use 150% DB rather than DB, it must also use the ADS recovery periods, rather than the GDS recovery periods.
            2. Exceptions to MACRS
               1. MACRS treatment is specifically denied for certain public utility property, films and video tape, sound recordings, and property eligible for the units–of–production method where the taxpayer properly elects not to apply MACRS.
            3. Income forecast method: An asset, such as film, can be depreciated at a rate equal to the ratio of the income the asset produces for the year over the estimated total income expected from the film.
            4. Units–of–production method.
            5. $18,500 expensing election.
               1. Taxpayers acquiring tangible personal property may elect to expense up to $18,500 of its cost in the year it is placed in service, in addition to the depreciation calculated for that initial year.
               2. The annual expensing amount increases to $19,000 in 1999, $20,000 in 2000, $24,000 in 2001, and $25,000 in 2003 and thereafter.
               3. The amount expensed is treated as depreciation and, thus, reduces the property's basis.
               4. Two limitations apply: (1) if the taxpayer places in service over $200,000 of eligible property during the year, the maximum expensing amount must be reduced dollar–for–dollar by the excess of the property's cost over $200,000; (2) the expensing amount may not exceed the amount of the taxpayer's active business income for the tax year.
            6. Leasehold improvements: Recovery period is the GDS life regardless of the lease term.
            7. Special rules applicable to land.
               1. Generally, if the landscaping is located in such close proximity to a structure that it would be destroyed when the structure is eventually replaced, it is depreciable.
            8. Special rules applicable to artwork, antiques, and other appreciating assets.
               1. Generally such property is only depreciable if it is "used" in the taxpayer's business.
            9. Annual depreciation limitations for certain types of property.
               1. Passenger cars: The dollar amounts are adjusted annually for inflation. For autos placed in service in 1997, the depreciation deduction limits for each tax year were:

                  1st year (1997)	$3,160
                  2nd year	$5,000
                  3rd year	$3,050
                  each succeeding year	$1,775

               2. Listed property used 50% or less for business.
                  • Such property must be depreciated using ADS MACRS.
                  • Listed property includes any passenger car; any other property used for transportation; any property of a type generally used for entertainment, recreation, or amusement; any computer or peripheral equipment; and any cellular telephone or other similar telecommunications equipment.
                  • If the business–use percentage of listed property falls to 50% or less in a later year, the taxpayer must recapture the "extra" depreciation taken in prior years.
            10. Depletion applies to mines, oil and gas wells, other types of natural deposits, and timber. The tax law generally allows a taxpayer to use either cost depletion or percentage depletion.
            11. Depreciation for AMT purposes.
                1. For property placed in service after 1998, AMT depreciation is computed using 150% DB rather than DDB, but the same recovery period is used for regular tax and AMT purposes.
                2. If units–of–production is used for regular tax, not AMT adjustment is needed.

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         Objective 3:
         To understand the rationale behind the depreciation and IRC §1231 recapture provisions and be able to compute recapture amounts for commonly encountered assets

         Depreciation Recapture and Other Provisions Affecting the Character of Gain

         1. Depreciation recapture.
            1. Depreciation recapture rules apply when a taxpayer disposes of depreciable or depletable property at a gain.
            2. Purpose. To prevent taxpayers from claiming ordinary deductions through depreciation and later realizing an IRC §1231 capital gain upon disposition.
            3. Personal property (IRC §1245 property): Full recapture whereby gain is treated as ordinary income to the extent of depreciation previously claimed on the asset.
            4. Real property (IRC §1250 property): Partial recapture whereby gain is treated as ordinary income to the extent depreciation claimed exceeded what the straight–line amount would have been.
            5. Special depreciation recapture rule for §1250 property of C corporations is based on the following formula:

               Depreciation recapture that would exist if the property had instead been IRC §1245 property (full recapture)
               less: any IRC §1250 recapture amount
               Excess
               x 20%
               Ordinary income recapture amount

         2. IRC §1231 recapture.
            1. §1231 includes an anti–manipulation rule to prevent taxpayers from timing the disposition of assets in a manner so as to "maximize their capital gains and ordinary losses."
            2. Under this recapture provision, taxpayers must treat any net IRC §1231 gain for the year as ordinary gain to the extent of IRC §1231 ordinary losses reported in the past five years.
            3. This provision only applies when a net IRC §1231 gain follows a period of net IRC §1231 losses in the prior five years.
         3. Ordinary gain from certain related–party dispositions.
            1. If a depreciable asset (in the hands of the seller) is sold to a related party, the gain is characterized as ordinary.
            2. The definition of related parties is not as broad under this provision as it is for other tax provisions.

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         Objective 4:
         To understand the rules that apply to determine gain or loss (and basis) when an entire business is sold (or purchased)

         Sale of an Entire Business

         1. Taxpayers must allocate purchase price among the various assets sold in order that the correct amounts of IRC §1231 gains or losses, capital gains or losses, and depreciation recapture may be determined. This detailed information is also needed if an installment note was used because the installment sale method might not be available for all of the assets.
         2. The residual method is used to allocated purchase price among the assets acquired/sold. After purchase price is allocated to all assets other than goodwill and going concern value, any remaining purchase price is allocated to goodwill and going concern value.

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         Objective 5:
         To comprehend the principles behind the provisions on tax–deferred exchanges and be able to compute realized gains and losses and basis for property involved in like–kind exchanges and involuntary conversions

         Tax–Deferred Exchanges

         1. Rationale:
            1. Wherewithal–to–pay principle.
            2. In certain transactions, the transfer or exchange is viewed as resulting in an insufficient change in overall investment to warrant taxing any gain (and sometimes loss) at the time of the transaction.
         2. Tax–deferred, not tax–free.
         3. While the tax–deferred exchange provisions are similar in concept, they differ in terms of whether they apply to both gains and losses, whether they are mandatory or elective, and the time frames that must be satisfied.
         4. Like–kind exchanges.
            1. The like–kind exchange rule allows for deferral of a realized gain or loss from an exchange solely in kind of either, (a) property held for productive use in a trade or business, or (b) property held for investment.
            2. Is mandatory, not elective, and applies to defer both gains and losses.
            3. Requirements:
               1. The property must not be a type of property ineligible for like–kind exchange treatment, such as stock, securities, inventory, partnership interests, and U.S. property exchanged for foreign property.
               2. The properties exchanged must be like–kind to each other.
                  • "Like–kind" refers to the nature or character of the property, not to its grade or quality.
               3. The transaction must be an exchange, not a sale.
               4. The property must be used in a trade or business or held for investment.
            4. Taxpayer's basis in the property received:

               Adjusted basis of property exchanged (given up)
               Less: money or fair market value of non–like–kind property received
               Plus: gain recognized
               Less: loss recognized
               Basis of property received

            5. Instead of a direct exchange, a deferred exchange may be used and may be accomplished by using an accommodater or qualified intermediary.
         5. Involuntary conversions.
            1. Involves both mandatory and elective provisions, and only gains are deferred, not losses.
            2. The involuntary conversion rule applies if property is involuntarily converted due to theft, seizure, condemnation, or threat or imminence thereof. If the property is converted directly into property similar or related in service or use, no gain is recognized. This provision is mandatory.
            3. If cash or other property is received, the taxpayer may elect to defer the gain. In order to defer the realized gain, the taxpayer must purchase property that is similar or related in use or service (or buy stock and acquire at least 80% control of a corporation owning such property), and elect to have the involuntary conversion rule apply. The replacement period begins on the date of disposition or threat of condemnation and ends (i) two years after the close of the first tax year in which part of the conversion gain is realized, or (ii) the close of a later date per application by the taxpayer that is approved by the IRS.
            4. "Similar or related in service or use" standard:
               1. Trade or business property: The functional–use test applies and requires that the same type of property be acquired.
               2. Investor property: The owner must replace the property with property that has similar risks.
            5. Gain is recognized to the extent the taxpayer does not timely and properly reinvest the proceeds.

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         Objective 6:
         To have a working knowledge of the basis and gain exclusion rules that are applicable to the disposition of an individual's principal residence

         Gain Exclusion Rule Applicable to a Principal Residence

         1. Prior to mid–1997, the tax law included both an elective gain exclusion for individuals age 55 or older (a once–in–a–lifetime provisions), and a mandatory gain deferral provision. In 1997, the deferral rule was repealed and the exclusion greatly expanded. The old deferral is still relevant to individuals who still own a home to which they deferred a gain into in the past.
         2. Principal residence: The home a taxpayer lives in and uses for personal purposes. If the individual owns more than one home, he must determine which one is the principal residence based upon the facts and circumstances (such as where they spend most of their time, where they receive mail, etc.). Any portion of a home used as a home office or rental property is not a principal residence.
         3. Old gain deferral rule applicable to sale of a principal residence.
            1. Gain deferred if replacement residence purchased within the period two years before or two years after the sale of the old residence, and all sales proceeds reinvested (with minor adjustments). Referred to as "rolling over" a gain.
            2. The deferred gain was reflected in the basis on the new residence.
         4. Gain exclusion rule applicable to sale of a principal residence.
            1. The exclusion is available to taxpayers of any age and may be used more than once during the taxpayer's lifetime.
            2. An individual may exclude up to $250,000 or realized gain if he has owned and used the home as his principal residence for periods totaling two years out of the five years prior to the date of the sale or exchange. If individuals are married and file jointly and both have met the two–out–of–five–year use requirement, up to $500,000 of the realized gain may be excluded.
            3. Gains in excess of the dollar limits must be recognized.
            4. Rationale for the new rule: (1) eliminates the need to keep records on homes no longer owned and (2) reduces the need to track capital improvements and to distinguish them from repairs. However, records should still be kept if (1) the home will be converted to rental property at a later date, (2) a portion of the home is used as an office , or (3) the home may appreciate beyond the gain exclusion dollar limits.
            5. Gain attributable to depreciation (such as for a home office) may not be excluded (and is likely taxed at a 25% rate).

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         Chapter 14 Outline

         Objective 1:
         To understand the special rules applicable to corporations: net operating loss carryovers, dividends–received deductions, charitable contributions, and debt–versus–equity determinations, as well as the significance of each type of financing to a corporation

         Special Tax Provisions Applicable To C Corporations

         1. Reasons justifying the special corporate provisions covered in this chapter include
            1. The nature of the corporate entity, as well as the relationship between the corporation and its owners (shareholders); and
            2. Differences in both tax terminology and certain tax rules as between corporate and individual taxpayers.
         2. Net operating losses.
            1. A net operating loss (NOL) is generated when a corporation's allowable deductions for a tax year exceed its gross income.
            2. When an NOL is carried over, it is referred to as a net operating loss deduction (NOLD) in the year it is used.
            3. A corporation must first carryback an NOL 2 years, starting with the earliest of the 2 years. If the NOL exceeds taxable income for the carryback years, the excess is carried forward for 20 years (or less if it is used up before the end of 20 years).
            4. A corporation