chapters 2-6. administration of tax law organization of the internal revenue service selection of...

Chapters 2-6

Administration of Tax Law

Organization of the Internal Revenue Service

Selection of Returns for Audit Statute of Limitations Interest and Penalties

Tax Law Sources Legislative

Internal Revenue Code Congressional Committee Reports

Administrative Treasury Regulations Revenue Rulings Revenue Procedures Private Letter Rulings

Steps in the Legislative Process

Figure 2-1, Page 2-5

Tax Law Sources--Continued

Judicial Sources Tax Court, District Court, Claims Court U.S. Court of Appeals U.S. Supreme Court

Primary versus Secondary Sources

Components of Tax Practice

Tax Compliance and Procedure Tax Research Tax Planning and Consulting Financial Planning

The Individual Income Tax Formula

Calculation of Taxable Income:

Total income (income from whatever source derived)$ xxx

Minus: Exclusions (specifically defined items, such as tax-exempt bond interest) (xxx) Gross income $ xxxMinus: Deductions for adjusted gross income (xxx) Adjusted gross income $ xxxMinus: Greater of itemized or standard deduction (xxx) Personal and dependency exemptions (xxx)Taxable Income $ xxx

The Individual Income Tax Formula--Continued

Calculation of Balance Due/Refund

Taxable income (from preceding slide) $ xxx

Times: Applicable tax rate(s) X xx%Income tax before credits $ xxxMinus: Tax credits (xxx) Prepayments (withholding & estimated taxes) (xxx)Balance due or (refund) $ xxx

Definitions

Income §61(a)—income from any source Does not include return of capital or

receipts received from borrowed funds Exclusions

Any item of income specifically excluded by the Internal Revenue Code

Review Exhibit 3-1 Major Exclusions

Definitions--Continued

Gross Income Income from taxable sources and is

reported on the income tax return. (Tax exempt interest is the only exclusion reported on the Form 1040.)

Review Exhibit 3-2 Gross Income Items Listed Under §61(a)

Definitions--Continued Deductions for Adjusted Gross Income

Expenses connected with a trade or business Other expenses

Adjusted Gross Income Established floors and ceilings for itemized

deductions Basis for phase out of itemized deductions

and exemptions Basis for limiting eligibility for other tax

benefits

Definitions--Continued Itemized Deductions

Medical Expenses (§213) State, local and foreign income taxes,

property taxes (§164) Home mortgage and investment interest

(§163) Contributions (§170) Casualties and Thefts (§165) Miscellaneous Itemized Deductions (2% and

Other) (§212)

Definitions--Continued Standard Deduction

Based on filing status Additional deduction 65+ or Blind ($ 950 S, $ 1,200

MFJ) Limited for a dependent: >(Earned Income + $ 250)

or $ 800

Indexed Exemptions

One exemption for each person Cannot be claimed as a dependent by another person Dependency exemptions (5 tests), phase out based

on filing status and AGI level Subject to phaseout at high income levels

Child Tax Credit

In addition to dependency exemption

$1,000 for each dependent child under age 17

Phased out starting at $75,000 (single) and $110,000 (joint)

Determining The Amount of Tax Tax Tables and Tax Schedules Filing Status

Married Filing Jointly (Surviving Spouse) Head of Household (Abandoned Spouse) Single Married Filing Separately

Dependents with unearned income Tax on unearned income of a child < 14

years is figured by reference to the parents’ tax rate if higher than the child’s.

Types of Tax Rate Structures

Individual Income Tax Rates Review of Rate Schedule in Text

Corporate Income Tax Rates Review of Rate Schedule in Text

Marginal Tax Rate “Incremental Amount of Taxable

IncomeThat is Added to the Tax Base”

Capital Gains and Loss Capital Assets

Assets others than those listed in § 1221 (Inventory, Depreciable Property, A/R & N/R,

Copyrights & Compositions, Other Assets) Holding Periods for Sales or Dispositions:

Short term—1 year or less Long term—More than one year

Sales on or after 5/06/03, maximum rate is 15% for most investment type assets. AMT reduces the benefit of this rate reduction to many taxpayers.

Dependency Exemptions Tests—Must Meet All Five

Support (> 50%) Gross Income (Exception for dependent

child < 19 years or full time student < 24 years)

Joint return (Married dependent cannot file a joint return)

Relationship (Dependent must be either related to the taxpayer or reside with the taxpayer)

Citizenship (U.S. citizens, residents or reside in Canada or Mexico)

Average and Effective Tax Rates Average Tax Rate

Total Tax Liability Taxable Income

Effective tax rate Economic Approach: Tax Liability_____

Economic Income Accounting Approach: __Tax Liability_____

Income Before Income

Taxes

Concepts of Income

Economic Concept Income = Consumption + Change in Wealth

Accounting Concept Transaction Approach Realization: (1) A change in the form or substance of a

taxpayer’s property and (2) transaction with a second party

Tax Concept Economic Benefit—cash, other property, debt relief Realization—(1) & (2) above Recognition—Statutory Interpretation

Tax Concept of Income--Continued Administrative Convenience

Valuation and Objectivity Role of the Courts Penalties

Wherewithal to Pay Tax should be collected when the taxpayer

is in the best position to pay the tax Installment sales Prepaid income

Tax Concept of Income--Continued Gross Income Defined §61(a)

Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to) the following items:

See page 3-4 for list of 15 items Reg. 1.61-1(a)

Income must be realized in any form, whether in money, property or services

Economic Benefit Direct—taxable; Indirect—often excludable

Items That Are Not Income Unrealized Income

Increases in value Ordinary Stock Dividends

Self-Help Income Example: Painting your apartment

Rental Value of Personal Use Property Selling Price of Property; gain not the

sales price is taxable. This is the “recovery of capital doctrine.”

When Is Income Taxable?—The Cash Method

Income is reported in the year of actual actual or constructiveconstructive receipt.

Prepaid income is usually taxed when received rather than when earned

Constructive receipt—Income is available so that the taxpayer may draw upon it any time. Cannot defer income recognition by refusing payment until a later taxable year.

Accrual Method Income reported in the year it is earned. Prepaid Income

Income usually taxed in the year of receipt Important Exceptions

Reg. 1.451-5: Taxpayer may defer advance payments for goods (inventory) if the taxpayer’s method of accounting for the sale is the same for tax and for financial accounting purposes

IRS Notice 2002-79 Taxpayer may defer advance payments for services to be performed after the current tax year to the tax year following the year of receipt.

Hybrid Method

Cash Basis Exceptions

Series EE Savings Bonds

Farmers and Ranchers

Inventories (Rev. Proc. 2001-10)

Accrual Basis Exceptions

Prepaid Income Deferral of Advance Payments for

Goods Deferral of Advance Payments for

Services Income Received under the Claim

of Right Doctrine

§61(a) Items of Gross Income

Compensation—(earned income) Business Income—(earned income) Gains from Dealings in Property—

(unearned income) Interest—(unearned or portfolio income)

Tax Exempt Interest Series EE exclusion for college expenses

Rents and Royalties Leasehold improvements—in lieu of paying

rent or paying reduced rent

§61(a) Items of Gross Income--Continued

Dividends Taxable to the extent of a C Corporation’s

earnings and profits Additional dividend distributions are a

return of capital and (when capital is exhausted) capital gain.

Taxed at maximum rate of 15% Stock Dividends

Generally non taxable, adjust the stock basis. Taxable is cash option is available.


Dividends—Continued Capital gain dividends—distributions from a

regulated investment company [LTCG] Constructive Dividends—associated with closely

held corporations, distributions that are intended to (1) result in a deduction to the corporation and taxable income to the shareholder (e.g. unreasonable compensation) or (2) produce a non-reportable benefit to the shareholder (e.g. bargain sale) or (3) deduction to the corporation without income to the shareholder (e.g. purchasing assets for employee’s use)


Income from Life Insurance and Endowment Contracts Insurance proceeds excluded, subsequent

income is taxed Income from Discharge of Indebtedness Income from Pass Through Entities

Partnerships and S Corporations (Schedule K-1)

Income with respect to a decedent Income earned by trusts and estates (K-1)

To Whom is Income Taxable? Assignment of Income

Lucas vs. Earl 2 USTC ¶496 (USSC, 1930) Helvering vs. Horst 40-2 USTC ¶9787 (USSC,

1940) Allocating Income Between Married People

Common Law States (community income limited to jointly owned property)—includes most states

Community Property States (community income vs. separate property (owned before marriage and gifts and inheritances) ID,LA,TX all income community income, AZ,CA,NV,NM,WA-separate income


Alimony and separate maintenance payments Alimony Child Support Property Settlement

Review Concept Summary 4-1, Page 4-21


Pensions and Annuities Current Year Exclusion = Amount Received x Exclusion

Ratio

Expected Return Multiple—term certain or life expectancy

Expected Return = Annual Payment x Expected Return to Recipient Multiple

Exclusion Ratio = Investment in Contract ÷ Expected

Return


Pensions and Annuities—Continued Table 4-1, Page 4-30 Simplified Method for Qualified Retirement

Plan Annuities Table 4-1, Page 4-31 Death of taxpayer results in miscellaneous

itemized deduction of remaining investment Advance Payments 10% Penalty for Early Withdrawal (< 59 ½

years of age) Must begin withdrawal in year following the

year taxpayer becomes 70 ½.

Other Items of Gross Income Prizes, Gambling Awards, Treasure Trove Illegal Income Unemployment Compensation Social Security Benefits

Low Income—Excluded from Gross Income High Income—85% included in Gross Income

Insurance Proceeds and Court Awards Exceptions—Accident and Health Benefits and Face

Amount of Life Insurance The Tax Benefit Rule--§111 Claim of Right—Recipient of disputed amount must

include the amount received in gross income as long as the use of the funds is unrestricted.

Major Statutory Exclusions

Gifts & Inheritances § 102 Subject to Unified Transfer Tax Gifts depend on the intent of the donor

Life Insurance Proceeds § 101 Paid to the beneficiary because of the

insured person’s death. Exclusion not available in exchange for

valuable consideration from a person other than the insurance company.

Major Statutory Exclusions--Continued

Life Insurance Proceeds—Continued If a life policy is sold or surrendered

before the death of the insured, the amount is taxable to the extent

it exceeds the net premiums paid. “Accelerated Death Benefits” excluded. Dividends on life insurance and endowment

policies excluded. Cancellation of ordinary life policy → the

increase in cash surrender value is taxable


Scholarships and Fellowships § 117 Amount paid or allowed to a student (graduate or

undergraduate) to aid degree seeking individuals Exclusion limited to qualified tuition and related

expenses. Distributions from Qualified Tuition Programs §

529 Plans Amounts put in QTP tax free and grow tax free. Beneficiary can withdraw tax free if amounts are use

for qualified higher education expenses—(books, tuition, fee, room and board [must be ½ time student])

Amounts deposited are gifts of a present interest. Donor can change beneficiaries.


Payments for Injury and Sickness § 104(a) “Amount of any damages…received…on account of

personal physical injuries or physical sickness.” “punitive” damages are taxable. § 104(a)(3) excludes amounts collected under an

accident and health policy purchased by the taxpayer. Amounts received from employer sponsored plans are taxable.

§ 101 excludes benefits under a long term care contract (> $210 per day or actual cost)

§104(a)(1) excludes worker’s compensation from gross income


Employee Fringe Benefits

§106 Healthy insurance premiums paid by employer on behalf of employees are excluded from gross income.

Self-employed individuals may deduct medical premiums on Schedule C.

§ 79(a) Premiums on 1st $ 50,000 of group term life insurance coverage excluded from gross income, excess of $ 50,000 included in income based on uniform monthly premium regulations.


Employee Fringe Benefits Under § 132

Review Concept Summary 5-2, Page 5-25 § 132(b) No additional cost § 132(c) Qualified employee discounts § 132(d) Working condition § 132(e) De minimis § 132(f) Qualified transportation fringes § 132(j)(4) Recreation and athletic facilities


Employee Awards §74 Employee achievement awards—tangible

personal property other than cash [for safety or length or service ($ 400 limit)]

§74 Qualified plan awards ($ 400 average cost, $ 1,600 limit)

§119 Meals and Lodging Meals—(excluded if furnished on the

employer’s premises for the convenience of the employer); Lodging (same convenience rules and employee must accept lodging as condition of employment)


Meals and entertainment—generally excluded to the employee under Rev. Rul. 63-144

Employee death benefits—payment must be a gift and not compensation. Gifts are not deductible to the employer.

Dependent care assistant programs—($ 5,000 of assistance), care must be similar to rules for child and dependent care credit)

§127 Educational assistance plans (Employee can exclude up to $ 5,250 for tuition, fees, books, supplies and equipment)


§ 125 Cafeteria Plans Offer employees option of choosing cash (taxable income) or

statutory nontaxable fringe benefits (group term life insurance, medical insurance, adoption expenses, child care.)

Arrangements are binding for one year. Plans may be supplemental or wage reduction arrangements

§ 911(b)(2) Foreign Earned Income Exclusion Personal services in a foreign country Must be a resident or present in a foreign country for at least

330 days in a 12 month period. First $ 80,000 excluded from gross income Housing allowance exclusion also available

Major Statutory Exclusions - Continued

Interest on Certain State and Local Government Obligations

Dividends—Patronage Dividends, Mutual Insurance Dividends and Conventional Stock Dividends are all non taxable.

Educational Savings Bonds


§ 61(a)(12) Income from Discharge of Indebtedness

Debt is cancelled or forgiven Must distinguish from gift, bequest, or

renegotiation of purchase price § 108 Excludes discharge if taxpayer is

bankrupt or insolvent. § 108 (f)(2) excludes certain student loans

where the student must perform certain public services.

Deductions for and from Adjusted Gross Income § 62 Principal Deductions for AGI

Trade or business expenses Reimbursed employee business expenses Losses from sale of trade, business or investment

property Expenses attributable to rent or royalty income Moving expenses Contributions to pension, profit-sharing or

retirement plan arrangements Early withdrawal penalties Alimony Interest on qualified education loans ½ S. E. tax Tuition and related expenses ($ 3,000 limit) Teacher supplies ($ 250)

Deductions from AGI Medical State, local & foreign income & property

taxes Housing and investment interest Losses from personal casualties & thefts Contributions Miscellaneous itemized deduction—2% limit

& 100% deductible

Criteria for Deducting Business & Investment Expenses

Requirements (§§ 162, 212) Related to trade or business or

investment Ordinary (relation to activity) Necessary (appropriate & helpful to

activity) Reasonable in amount Properly documented Taxpayer’s expense

When is an Expense Deductible?

Cash Method of Accounting Deduction when payment is made

Cash or other property is transferred A check is delivered or mailed An item is charged on a credit card

Prepaid Expenses Generally deductible over the period covered Deductible when paid if the period covered does

not exceed one year. Prepaid interest is generally deductible over the

period covered by the loan.

When is an Expense Deductible? Cash Method of Accounting

Prepaid Expenses—Points Deductible when paid if:

The loan was used to purchase or improve the taxpayer’s principal residence.

The loan is secured by the residence Points are an established business practice in the

area Points do no exceed the amount generally charged. Points paid to purchase a principal residence the

closing agreement clearly designates the amount as points and the amount must be computed as a % of the amount borrowed

If not a personal residence amortize over the life of the loan.

When is an Expense Deductible?

Cash Method of Accounting Points—Continued

Points paid to refinance an existing home mortgage cannot be immediately expensed but must be capitalized over the life of the loan.

Points paid by the seller on behalf of the buyer are treated as an adjustment to the price of the residence.

Accrual Method of Accounting

All events test All events to create liability have occurred Amount can be determined with reasonable

accuracy Economic performance test

Service, property, or use of property giving rise to the liability is actually performed for, provided to, or used by the taxpayer

Exception for recurring items

Non-Deductible Expenses § 265 Expenses associated with tax-

exempt interest § 162 (c) Expenditures that are contrary

to public policy Payment of fines and penalties Illegal payments Bribes and kickbacks

Political Contributions and Lobbying Expenses

Business Investigation and Pre-opening Expenses Under § 195

Does not apply if the expenses are incurred by a taxpayer already established in a similar business. Deduct currently.

If the taxpayer investigates a new business: And enters the new business, the expenses,

including start up costs are amortized over a 60 month period

and does not enter the new business, the expenses are non-deductible

However, legal expenses associated with failed acquisition plans may be deductible. (They must be associated with plans to acquire a specific business.)

Special Disallowance Rules—Hobby Losses

Rules is applied upon IRS audit Hobby Expenses are deductible only to the

extent of hobby income (§ 183(b)(2)) Factors to be considered in determining whether

an activity is profit seeking or a hobby Whether the activity is conducted in a business like

manner. The expertise of the taxpayers or their advisers. The time and effort expended. The expectation that the assets of the activity will

increase in value. The taxpayer’s previous success in conducting similar

activities.


Factors to consider in determining whether an activity is profit seeking or a hobby (continued)

The history of income or losses from the activity. The relationship of profits earned to losses incurred. The financial status of the taxpayer Elements of personal pleasure or recreation in the

activity.

Presumptive Rule of § 183 The Code provides the presumption that an activity is

profit seeking if the activity shows a profit in at least three of any five prior consecutive years. (two of seven years for horses)


Determining the amount of the deduction if the activity is a hobby Expenses are deducted in the following

order: Amounts deductible under other Code sections

without regard to the nature of the activity (property taxes and home mortgage interest)

Amounts deductible under other Code sections if the activity had been engaged in for profit but only if those amounts do not affect adjusted basis. (maintenance, utilities, supplies)

Deductible amounts that affect adjusted basis. (depreciation and amortization)

Rental of Vacation Homes §280A allows deductions on

residences used primarily for personal purposes only to the extent of the income generated.

Three possible tax treatments for residences used for both personal and rental purposes: Primarily Personal Use Primarily Rental Use Personal/Rental Uses

Rental of Vacation Homes

Primarily Personal Use If the residence is rented for fewer

than 15 days in a year, it is treated as a personal residence

Rent income is excluded from gross income

Mortgage interest and real estate taxes are allowed as itemized deductions

No other deductions are allowed

Rental of Vacation Homes Primarily Rental Use

Treated as rental property. Residence must be rented for 15 days or more in a year and not used for personal purposes for more than the greater of (1) 14 days or (2) 10 % of the total days rented.

Expenses must be allocated between rental days and personal days. Deduction of expenses to rental days can exceed rent income and produce a loss.

Loss is deductible on Schedule E, but is subject to the passive activity rules.

Rental of Vacation Home Personal/Rental Use

Subject to special allocation rules. Personal/Rental use occurs when the residence is rented for 15 days or more in a year and is used for personal purposes for more than the greater of (1) 14 days or (2) 10% of the total days rented.

Expenses allowed only to the extent of rental income. Three tier approach to allocation: (1) mortgage and

interest (365 days total), (2) maintenance, utilities, insurance (total days of use), (3) depreciation (total days of use).

Must have positive balance to take a deduction.

General Restrictions on the Deductibility of Expenses

Capitalization versus Expense Deduction General Capitalization Requirements §263

(expenses that add to the value, substantially prolong the useful life, change the use of the property)

No current deduction for capital expenditures Maintenance and repair expenditures that

only keep an asset in a normal operating condition are currently deductible.

Capitalization Versus Expense Deduction Election to Deduct Currently, some examples

Soil and water conservation costs Qualified research expenditures Purchase of qualified tangible personal property §

179 Capitalization of Deduction Items § 266, some examples

Annual property taxes, interest on mortgage and other carrying charges incurred on unimproved and unproductive real estate.

Annual property taxes, interest, employment taxes and other necessary expenses incurred in the development, improvement or construction of real property.

Interest and employment taxes incurred in transporting and installing personalty

Transactions Between Related Parties

§ 267 (a)(1)—Disallows losses on sales and exchanges between related parties

Section 267 specifically defers the deduction of the accruing taxpayer until the recipient taxpayer must include it in income.

Relationships and constructive ownership will be reviewed in Chapter 14.

chapters 2-6. administration of tax law organization of the internal revenue service selection of...

Documents

gross income income

total income income

income tax return

tax tax tables

definitions income

item of income

tax credits

gross income expenses