ACCT 4221 Income Tax II Notes Chapter 1: Understanding and Working with the Federal Tax Law Revenue

Needs y Many states have amendments precluding deficit spending. The Federal government has no such prohibition in place. National debt reached more than 13.5 trillion ($43,500 per person) in October 2010. Congress is often guided by revenue neutrality so new laws do not increase or decrease aggregate revenue. This doesn t mean that everyone s tax liability is the same, just that one person s savings may be another s cost in one year.

Economic Considerations y Control of the Economy o Depreciation write-offs are often used as a means to control the economy. Shorter asset lives and accelerated depreciation should encourage investment in depreciable property acquired for business use. Conversely, long asset lives and straight-line depreciation decreases tax incentives for capital outlays. o 179 allows taxpayers to immediately expense a portion of depreciable assets. Also, the 50% rule allows up to 50% depreciation taken in first year in certain cases. Encouragement of Certain Activities o Encourages technological development by having favorable treatment of R&D expenditures.  Can be deducted in year incurred or, alternatively, capitalized and amortized over a period of 60 months or more. o Inventors are treated well. Patents can qualify as capital assets and their disposition automatically carries long-term capital gains treatment. o Ecological 60 month amortization period allowed for costs incurred in installation of pollution control facilities.  Credits for home energy conservation and low emission vehicles. o Credits for rehabilitation of low income housing o Preferential treatment for saving retirement plans.  Keogh plans and IRAs are deductible and contributions accumulate tax free. Encouragement of Certain Industries o Farmers expense rather than capitalize soil expenses, water conservation, fertilizers  Election to defer recognition of gain on receipt of crop insurance proceeds. o Write off rather than capitalize extraction costs of oil and gas o Domestic production activities deduction to encourage US manufacturing. Encouragement of Small Business

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Shareholder in a small business corporation can obtain an ordinary deduction for any loss recognized on a stock investment. Normally would receive a less attractive capital loss treatment. Obviously, lower tax rates apply to businesses with less income, which generally is the case for small businesses. If a corporation has taxable income in excess of $100,000, the benefits of the lower brackets are phased out until all income is taxed at the maximum rate of 34%. Once taxable income reaches $10 million, the rate becomes 35%.

Social Considerations y Incentives and benefits: o Refundable earned income tax credit. Tries to replace welfare. o Nontaxability of health plan benefits provided by employers. o Nontaxability to employee of premiums paid by employer for group term life insurance. o Contribution and income earned on pension/profit sharing plans made by employer are not taxed until distributed. o Deduction for contributions to charitable organizations. o Deductions, credits, and exclusions designed to encourage higher education (American opportunity tax credit, lifetime learning credit, Coverdell education savings account). o Credits for taking care of minor or disabled dependents o Disallowance of tax deduction for certain expenditures deemed contrary to public policy (fines, penalties, illegal kickbacks bribes, gambling glosses). o Adoption tax credit

Equity Considerations y Equity is not what appears fair or unfair to any one taxpayer or group of taxpayers. It is what the law recognizes. o Alleviating the Effect of Multiple Taxation  To compensate for inequity of paying state, local, and federal taxes, the Federal tax law allows taxpayer to claim a deduction for state and local taxes. Does not neutralize multiple taxation since it depends on taxpayer s Federal income tax rate.  The imposition of a separate income tax on corporations leads to multiple taxation on the same income.  For corporate shareholders, for whom triple taxation is possible, the law provides a deduction, usually 70% of the dividends earned by the company from stock in another company. o The Wherewithal to Pay Concept  Taxpayer lacks means with which to pay the tax.  Recognized gain is merely postponed and not necessarily avoided

Particularly suited to situations in which the taxpayer s economic position has not changed significantly as a result of a transaction. Mitigating the Effect of the Annual Accounting Period Concept  Effect is to divide each taxpayer s life into equal annual intervals for tax purposes.  Installment method of recognizing gain on sale of property allows taxpayer to spread tax consequences over the payout period. Coping with Inflation  Because of the progressive nature of the income tax, any wage adjustment to compensate for inflation can increase the income tax bracket of the recipient. Erosion of purchasing power.  Congress recognized this and began to adjust various income tax components based on the rise in the CPI over the prior year. 

Political Considerations y y Special Interest Legislation Political Expediency o Congress is sensitive to popular feeling of public. Ex: establishing alternative minimum tax for corporations. Social and Local Influences o Interest received on state and local obligations is excluded from gross income.

Influence of the Internal Revenue Service y The IRS as the Protector of Revenue o Laws passed to close loopholes  Use of a fiscal year by personal service corporations, partnerships, S corps, and trusts to defer income recognition to the owners  Use of cash basis method of accounting by large corporations  The deduction of passive investment losses and expenses against other income  Shifting of income to lower-bracket taxpayers through the use of revisionary trusts o Congress given IRS authority to prevent taxpayers from acquiring corporations to obtain a tax advantage when the principal purpose of the acquisition is the evasion or avoidance of Federal income tax. Administrative Feasibility o Some tax laws are there to make it easier on the IRS.  Withholding income periodically  Accrual basis taxpayers should pay taxes on prepaid income in year received, not when earned. This approach is contrary to GAAP but consistent with the wherewithal to pay concept. o Provisions for collecting revenue as penalties and interest.

Audits conducted by the IRS are made simpler with fewer itemized deductions  An increase in the amount of the standard deductioncan achieve this

Influence of the Courts y Federal courts have influence tax law in two concepts o Formulated judicial concepts that serve as guidelines in application of tax provisions o Key decisions have led to changes in the IRC. Judicial Concepts Relating to Tax Law o Substance over form. Described as telescoping or collapsing , skipping steps to arrive directly at final result reached.  Ex: lady wants to give gift of $26,000 to girl. Max is $13,000 without tax. Gives her $13,000, gives boy $13,000, and boy gives girl $13,000. Substance over form says she gave the girl $26,000 and is subject to the tax. o Arm s length concept. Asks if unrelated parties would have handled the transaction in the same way. o Continuity of interest concept  Permits tax free treatment only if the taxpayer retains a substantial continuing interest in the property transferred to the new business. Applies to controlled corporations, corporate reorganizations, and transfers to partnerships. o Business purpose concept  Applies to transactions involving corporations. A sound business reason that motivates the transaction must be present in order for the prescribed tax treatment to result. Judicial Influence on Statutory Provisions o Some court decisions have been of such consequence that Congress has incorporated them into statutory tax law.  Tax benefit rule should not be taxed on the recovery of an amount previously deducted unless the deduction produced a tax savings.

Working with Tax Law Tax Sources y Learning to work with tax law involves 3 basic steps: o Familiarity with the source of the law o Application of research techniques o Effective use of planning procedures

Statutory Sources of the Tax Law y The Origin of the IRC o 1939 Internal Revenue code codified all Federal tax provisions in logical sequence and placed them in separate part of Federal statutes. Recodified in 1954. Renamed in 1986 due to Tax Reform Act of 1986.

The Legislative Process o Federal tax legislation originates in the HOR, where it is first considered by the House Ways and Means Committee. Tax bills originate in the Senate when they are attached as riders to other legislative proposals. o If acceptable to the HWM committee, the proposed bill is referred to the entire HOR. If approved, sent to Senate, where referred to Senate Finance Committee. o Sent to whole Senate. If disagreement between Senate and HOR, Joint Conference Committee settles differences. If no differences, sent to president for approval or veto. If veto, can be overridden by two thirds vote and becomes part of IRC. o (insert graph from p 1-18) Arrangement of the Code o Subtitle A. Income Taxes  Chapter 1. Normal Taxes and Surtaxes y Subchapter A. Determination of Tax Liability o Part 1. Tax on Individuals  Sections 1-5 o Part 2. Tax on Corporations  Sections 11-12 o Easiest just to mention the section because they don t start over with new subtitles.

Administrative Sources of the Law y y All either issued by the U.S. Treasury Department or the IRS Treasury Department Regulations o Anyone taking position contrary to a finalized Regulation must disclose that fact on form 8275 or form 8275-R to avoid penalty o Since Regulations interpret the Code, they are arranged in the same sequence, however they are prefixed by a number that indicates the type of tax to which they relate. Reg 1.2 refers to reg 1 (income tax law) code 2. o Temporary regulations are sometimes issued where immediate guidance is critical. Have same authority as final Regulations and may be cited as precedent for three year. o May also be issued as a proposed Reglation. o Temp regs that are issued with prop regs have more weight than traditional prop regs. o Proposed, final, and Temporary Regulations are published in the federal register. Final Regulations are issued as Treasury Decisions (TD). Revenue Rulings and Revenue Procedures o Revenue Rulings are official pronouncements of the National Office of the IRS.  Do not carry legal force as Regs and usually deal with more restricted problems  Comes from a taxpayer requesting a letter ruling that the IRS deems deserves official publication. o Revenue Procedures deal with internal management practices and procedures of the IRS.

Both RR and RP and TDs are published weekly in the Internal Revenue Bulletin. Semiannually, the bulletins for a 6 month period are gathered together and published in a bound volume called the Cumulative Bulletin. Other Administrative Pronouncements o Letter rulings are issued for a fee by the IRS upon taxpayer s request. Generally only apply to taxpayer who asks for ruling.  201031004 was issued in 2010, 31st week, 4th ruling issued that week. o Around 2,000 letter rulings are issued annually. Revenue rulings are around 40. o Technical advice memoranda are issued weekly. Similar to letter rulings but relate to audits by IRS. Deal with completed rather than proposed transactions. o Determination letters are like letter rulings but the issuing source is the Area Director rather than the National Office of the IRS.  Not published, made known only to requesting party. Involved completed rather than proposed transactions. o

Judicial Sources of the Tax Law y The Judicial Process in General o If no settlement has been reached at the agent or conference level, the dispute can be taken to Federal courts.  Trial court, then appellate court.  4 trial courts: y Federal District Court y U.S. Court of Federal Claims y Tax Court y Small Cases Division of the Tax Court  There is no appeal from the Small Cases Division. Limited to $50,000 or less. Informal, decisions not precedent for any other court decision, decisions are not reviewable by any higher court.  *see figure 1.1 age 1-24  Stare decisis precedential cases. Does not apply outside jurisdiction. Trial Courts o *see section on page 1-24 Appellate Courts o Generally a 3 judge panel will hear a case but occasionally the full court will hear controversial conflicts. o If the IRS loses it normally does not appeal. This does not mean it agrees with decision or will not litigate in the future. o District Courts, the Tax Court, and the Court of Federal claims must abide by the precedents set by the Court of Appeals of jurisdiction.  A particular Court of Appeals need not follow the decisions of other appeals courts.

y y

 All courts must follow the decisions of the U.S. Supreme Court. Appealing from the Tax Court o Tax Court is a national court. o Will decide a case as it feels the law should be applied only if the Court of Appeals aof appropriate jurisdiction has not yet ruled on the issue or has previously decided a similar case in accordance with the Tax Court s decision.  If the Court of Appeals of appropriate jurisdiction has previously held squarely on point otherwise, the Tax Court will conform even through it disagrees with the holding. This policy is known as the Golsen Rule. Appeals to the U.S. Supreme Court o Done by Writ of Certiorari. Grant requires 4 members to approve hearing. o Rarely hears tax cases. Only rules with conflict among Courts of Appeals. Judicial Citations o Name, volume number, reporter series, page or paragraph number, and court (where necessary). Judicial Citations The U.S. Tax Court o Issue 3 decisions differing in substance and form  Regular decisions y Involve novel issues not previously addressed by the Tax Court. y Can be relied upon as precedent. y Published in Tax Court of the United States Reports (T.C.) o Each volume covers 6 month period y Morton L. Ginsberg, 130 T.C. 88 (2008)  Memorandum decisions y Deal with situations needing application of already established law. y Can be relied upon as precedent. y Published by CCH and RIA (formerly P-H) y Nick R. Huges, T.C. Memo. 2009-94  Summary opinions y Issued in small tax cases and may not be used as precedent. y John H. Wong, T.C. Summary Opinion 2009-152 y Starting in 2001, reported on U.S. Tax Court website o Before 1943, the Tax Court was called the Board of Tax Appeals and decisions were published as the United States Board of Tax Appeals Reports (B.T.A.) Judicial Citations The U.S. District Courts, Claims Court, and Courts of Appeals o District Court, Claims Court, Court of Appeals, and Supreme Court decisions dealing with Federal tax matters are reported in both the CCH U.S. Tax Cases (USTC) and the IRA American Federal Tax Reports (AFTR). o Federal District Court decisions dealing with both tax and nontax issues are also published by West.

If the IRS loses in a decision, it may indicate whether it agrees or disagrees with the results by publishing an acquiescence or a nonacquiescence.  Published in the Internal Revenue Bulletin and the Cumulative Bulletin as an Action on Decision. Judicial Citations The U.S. Supreme Court o Like all other federal tax cases (except those of U.S. Tax Court) Supreme Court decisions are published by Commerce Clearing House in the USTCs and by RIA in the AFTR. o

Other Sources of the Law y Effect of Treaties o US signs certain tax treaties (tax conventions) with foreign countries to render mutual assistance in tax enforcement and to avoid double taxation. o The Technical and Miscellaneous Revenue Act of 988 provided that neither tax law or tax treaty takes general precedence. In conflict, most recent wins. Tax Periodicals o May provide good starting place for research. o Indexes available for locating tax articles include Federal Tax Articles (CCH) and Index to Federal Tax Articles (Warren, Gorham, and Lamont).

Working With the Tax Law Locating and Using Tax Sources y Tax law consists of legislative (Code section, treaties), administrative (Regs an Rulings), and judicial (court cases) pronouncements. Tax research process will begin with a tax service.

Commercial Tax Services y y y Due to changes, categorizing tax services has become almost an impossible tax. Old classification of annotated (organized by IRC) vs. topical (organized by major topic) is no longer appropriate. Commercial services include: o Standard Federal Tax Reporter o Tax Research NetWork o United States Tax Reporter, etc.

Using Online Services y y y y Use specific keywords Take advantage of connectors to place parameters on the search. Ex: enclosing words in quotes will search for the exact phrase. Be selective in choosing a database. Ex: don t include judicial decisions if case law is not needed. Consider using table of contents or index instead of keyword searching.

Working with the Tax Law Tax Research

Tax research involves the following procedures: o ID and refining the problem o Locating the appropriate tax law sources o Assessing the validity of the tax law sources  Interpreting the IRC y Cross referencing between code sections is often poor or nonexistent. Code sections are enacted at different times by Congresses that are operating under stringent deadlines.  Assessing the Validity of a Treasury Regulation y In a challenge, burden of proof is on taxpayer. y If taxpayer loses challenge, negligence penalty may be imposed  Assessing the Validity of Other Administrative Sources of the Tax Law y Revenue Rulings issued by the IRS carry less weight than Treasury Department Regulations. y Rulings are important, however, in that they reflect the position of the IRS on tax matters.  Assessing the Validity of Judicial Sources of Tax Law y Primary sources of tax law include the Constitution, legislative history materials, statutes, treaties, Treasury Regulations, IRS pronouncements, and judicial decisions. y The IRS regards only primary sources as substantial authority. y Second materials such as legal periodicals, treatises, legal opinions, general counsel memoranda, technical advice memoranda, and written determinations can be useful, but are not authority.  Assessing the Validity of Other Sources o Arriving at the solution or at alternative solutions while giving due consideration to nontax factors o Effectively communicating the solution to the taxpayer or the taxpayer s representative  Good communication should contain the following elements: y A clear statement of the issue y In more complex situations, a short review of the factual pattern that raises the issue y A review of the pertinent tax law sources (Code, Regs, rulings, judicial authority) y Any assumptions made in arriving at the solution y The solution recommended and the logic or reasoning in its support y The references consulted in the research process o Following up on the solution (where appropriate) in light of new developments.

Working with the Tax Law Tax Planning y The main purpose of tax planning is to reduce the taxpayer s total tax bill.

Nontax Considerations o Tax considerations can operate to impair the exercise of sound business judgment. Thus, the tax planning process can lead to ends that are socially and economically objectionable. Components of Tax Planning o Defer income and accelerate deductions. o Preferable to deferring income is complete avoidance. Ex: choosing nontaxable fringe benefits over fully taxable future pay raise. o If the recognition cannot be avoided, its deferral will postpone income tax consequences. o Income can also be shifted to persons in lower tax brackets through gifts. o If the income cannot be avoided, deferred, or shifted, the nature of the gain can be converted. By changing the classification of property, income taxes can be reduced. o In summary:  Avoid recognition of income (usually by resorting to a nontaxable source or nontaxable event)  Defer the recognition of income (or accelerate deductions)  Convert the classification of income (or deductions) to a more advantageous form (e.g. ordinary income into capital gain) o Choose the business entity with the desired tax attributes. o Preserve formalities by generating and maintaining supporting documentation o Act in a manner consistent with the intended objective.