Tax Rate and Insurance Questions

2021 Individual Tax Rate SchedulesSingle
If taxable
income is:
over $0
$9,950
$40,525
$86,375
$164,925
$209,425
$523,600
But not
The Tax is:
over $9,950
……..………….10%
$40,525
$995.00 + 12%
$86,375
$4664.00 + 22%
$164,925
$14751.00 + 24%
$209,425
$33603.00 + 32%
$523,600
$47843.00 + 35%
………….…….. $157804.25 + 37%
Married filing jointly / Qualifying widow(er)
If taxable
income is:
But not
The Tax is:
over over $0
$19,900
…..………….10%
$19,900
$81,050
$1990.00 + 12%
$81,050
$172,750
$9328.00 + 22%
$172,750
$329,850
$29502.00 + 24%
$329,850
$418,850
$67260.00 + 32%
$418,850
$628,300
$95686.00 + 35%
$628,300
……………..
$168993.50 + 37%
of the
amount
over $0
$9,950
$40,525
$86,375
$164,925
$209,425
$523,600
Head of Household
If taxable
income is:
But not
The Tax is:
over over $0
$14,200
……..…………10%
$14,200
$54,200
$1420.00 + 12%
$54,200
$86,350
$6220.00 + 22%
$86,350
$164,900
$13293.00 + 24%
$164,900
$209,400
$32145.00 + 32%
$209,400
$523,600
$46385.00 + 35%
$523,600
……………..
$156355.00 + 37%
of the
amount
over $0
$14,200
$54,200
$86,350
$164,900
$209,400
$523,600
of the
amount
over $0
$19,900
$81,050
$172,750
$329,850
$418,850
$628,300
Married filing separately
If taxable
income is:
But not
The Tax is:
over over $0
$9,950
……..……….10%
$9,950
$40,525
$995.00 + 12%
$40,525
$86,375
$4664.00 + 22%
$86,375
$164,925
$14751.00 + 24%
$164,925
$209,425
$33603.00 + 32%
$209,425
$314,150
$47843.00 + 35%
$314,150
……………..
$84496.75 + 37%
of the
amount
over $0
$9,950
$40,525
$86,375
$164,925
$209,425
$314,150
Copyright 2022 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-322
2022 EDITION
Concepts
in
Federal
Taxation
Kevin E. Murphy
O k lahoma State Univ ersity
Mark Higgins
Saint Louis Univ ersity
Randall K. Skalberg
U niv ersity of Minnesota Duluth
Australia ● Brazil ● Canada ● Mexico ● Singapore ● United Kingdom ● United States
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Concepts in Federal Taxation,
2022 Edition
Kevin E. Murphy, Mark Higgins,
Randall K. Skalberg
Senior Vice President, Higher Ed Product,
Content, and Market Development:
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
BRIEF CONTENTS
Preface xi
Introduction
xix
Part 1
Conceptual Foundations of the Tax Law
1-1
Chapter 1
Chapter 2
Federal Income Taxation—An Overview
Income Tax Concepts
1-3
2-1
Part 2
Gross Income
3-1
Chapter 3
Chapter 4
Income Sources
Income Exclusions
3-3
4-1
Part 3
Deductions
5-1
Chapter 5
Chapter 6
Chapter 7
Chapter 8
Introduction to Business Expenses
Business Expenses
Losses—Deductions and Limitations
Taxation of Individuals
5-3
6-1
7-1
8-1
Part 4
Property Transactions
9-1
Chapter 9
Chapter 10
Chapter 11
Chapter 12
Acquisitions of Property
Cost Recovery on Property: Depreciation, Depletion, and Amortization
Property Dispositions
Nonrecognition Transactions
9-3
10-1
11-1
12-1
Part 5
Income Tax Entities
13-1
Chapter 13
Chapter 14
Chapter 15
Choice of Business Entity—General Tax and Nontax Factors/Formation
Choice of Business Entity—Operations and Distributions
Choice of Business Entity—Other Considerations
13-3
14-1
15-1
Part 6
Tax Research
16-1
Chapter 16
Tax Research
16-3
Appendix A
Appendix B
Appendix C
Appendix D
Tax Return Problem
Tax Rate Schedules and Tax Tables
Tax Forms
How to Decode the Code
A-1
B-1
C-1
D-1
Glossary
Index
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
G-1
I-1
iii
CONTENTS
Preface xi
Introduction xix
Why Study Federal Income Taxation?
xix
Significance of Tax Costs
Conservation of Wealth
Taxes Influence Routine Decisions
Self-Protection
xx
xxi
xxii
xxii
Conceptual Foundations of the
Tax Law 1-1
CHAPTER 1
Federal Income Taxation—An Overview
1-3
1-1 Introduction
1-3
1-2 Definition and Evaluation of a Tax
1-4
1-3 Major Types of U.S. Taxes
1-3a Income Taxes
1-3b Employment Taxes
1-3c Sales Tax
1-3d Property Taxes
1-3e Other Taxes
1-4
1-5
1-7
1-11
1-11
1-12
1-14
1-14
1-15
1-4 Sources of Federal Income Tax Law
1-17
1-5 Federal Income Tax Terminology
1-18
1-5a Income
1-5b Deductions
1-5c Income Tax Rates
1-5d Tax Prepayments
1-5e Tax Credits
1-5f Filing Returns
1-19
1-20
1-20
1-21
1-22
1-23
1-6 The Audit and Appeal Process within
the IRS
1-24
1-6a Tax Return Selection Processes
1-6b Types of Examinations
1-24
1-25
iv
1-25
1-25
1-7 Individual Income Tax Calculation
1-26
1-7a Deductions for Adjusted Gross Income
1-7b Deductions from Adjusted Gross Income
1-8 Tax Planning
1-8a Mechanics of Tax Planning
1-8b Tax Evasion and Tax Avoidance
Part 1
1-2a Definition of a Tax
1-2b Standards for Evaluating a Tax
1-2c Tax Rates and Structures
1-6c Settlement Procedures
1-6d Administrative Appeals
1-27
1-27
1-28
1-29
1-33
1-9 Ethical Considerations in
Tax Practice
1-34
Chapter Summary
Key Terms
Primary Tax Law Sources
Discussion Questions
Problems
Issue Identification Problems
Technology Applications
Discussion Cases
Tax Planning Cases
Ethics Discussion Case
1-36
1-37
1-37
1-38
1-39
1-44
1-44
1-45
1-46
1-46
CHAPTER 2
Income Tax Concepts
2-1
2-1 Introduction
2-1
2-2 General Concepts
2-2
2-2a Ability-to-Pay Concept
2-2b Administrative Convenience Concept
2-2c Arm’s-Length Transaction Concept
2-2d Pay-as-You-Go Concept
2-3 Accounting Concepts
2-3a Entity Concept
2-3b Annual Accounting Period Concept
2-4 Income Concepts
2-4a All-Inclusive Income Concept
2-4b Legislative Grace Concept
2-4c Capital Recovery Concept
2-4d Realization Concept
2-4e Wherewithal-to-Pay Concept
2-2
2-3
2-4
2-5
2-6
2-6
2-9
2-12
2-12
2-12
2-13
2-14
2-16
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
2-5 Deduction Concepts
2-18
2-5a Legislative Grace Concept
2-5b Business Purpose Concept
2-5c Capital Recovery Concept
Chapter Summary
Key Terms
Primary Tax Law Sources
Discussion Questions
Problems
Issue Identification Problems
Technology Applications
Discussion Cases
Tax Planning Cases
Ethics Discussion Case
2-18
2-18
2-20
2-23
2-23
2-23
2-24
2-25
2-34
2-35
2-36
2-37
2-37
Part 2
Gross Income
Contents
v
Technology Applications
Discussion Cases
Tax Planning Cases
Ethics Discussion Case
3-51
3-52
3-52
3-54
CHAPTER 4
Income Exclusions
4-1
4-1 Introduction
4-2
4-2 Donative Items
4-2
4-2a Gifts
4-2b Inheritances
4-2c Life Insurance Proceeds
4-2d Scholarships
4-2
4-4
4-4
4-6
4-3 Employment-Related Exclusions
4-6
4-3a Foreign-Earned Income
4-7
4-3b Payments Made on Behalf of an Employee 4-7
4-3c Employer Benefit Plans
4-13
3-1
4-4 Returns of Human Capital
4-15
CHAPTER 3
Income Sources
3-3
3-1 Introduction
3-4
3-2 What Constitutes Income
3-4
4-5 Investment-Related Exclusions
4-18
3-5
3-6
3-7
4-5a Municipal Bond Interest
4-5b Stock Dividends
4-5c Discharge of Indebtedness
4-5d Improvements by a Lessee
4-18
4-19
4-20
4-21
3-2a Income Is Derived from Labor and Capital
3-2b Income as an Increase in Wealth
3-2c What Constitutes Income: Current View
3-3 Common Income Sources
3-8
3-3a Earned Income
3-3b Unearned Income
3-3c Transfers from Others
3-3d Imputed Income
3-8
3-10
3-14
3-19
3-4 Capital Gains and Losses—An Introduction
3-24
3-4a Capital Gain-and-Loss Netting Procedure
3-4b Tax Treatment of Capital Gains
3-4c Tax Treatment of Dividends
3-4d Tax Treatment of Capital Losses
3-4e Capital Gains and Losses of Conduit Entities
3-25
3-28
3-30
3-31
3-32
3-5 Effect of Accounting Method
3-5a Cash Method
3-5b Accrual Method
3-5c Hybrid Method
3-5d Exceptions Applicable to All Methods
Chapter Summary
Key Terms
Primary Tax Law Sources
Discussion Questions
Problems
Issue Identification Problems
4-4a Workers’ Compensation
4-15
4-4b Damage Payments for Personal Physical
4-15
Injury or Physical Sickness
4-4c Payments from Health and Accident Policies 4-16
Chapter Summary
Key Terms
Primary Tax Law Sources
Discussion Questions
Problems
Issue Identification Problems
Technology Applications
Integrative Problems
Discussion Cases
Tax Planning Cases
Ethics Discussion Case
Part 3
3-33
3-33
3-34
3-36
3-36
3-37
3-38
3-38
3-39
3-40
3-50
4-22
4-23
4-23
4-24
4-24
4-32
4-33
4-34
4-36
4-37
4-37
Deductions
5-1
CHAPTER 5
Introduction to Business Expenses
5-3
5-1 Introduction
5-4
5-2 Reporting Deductions
5-6
5-2a Conduit Entity Reporting
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
5-7
vi
Contents
5-3 Classification of Deductions
5-8
5-3a Profit-Motivated Expenditures
5-8
5-3b Trade or Business or Production-of-Income
Expenses?
5-9
5-3c Rental Activity
5-12
5-3d Personal Expenditures
5-13
5-3e Mixed Business and Personal Expenditures 5-13
5-4 Tests for Deductibility
5-4a Ordinary, Necessary, and Reasonable in
Amount
5-4b Not a Personal Expense
5-4c Not a Capital Expenditure
5-4d Not Frustrate Public Policy
5-4e Not Related to Tax-Exempt Income
5-4f Expenditure Must Be for Taxpayer’s
Benefit
5-15
5-15
5-17
5-18
5-21
5-22
5-23
5-5 Limited Mixed-Use Expenses
5-23
5-5a Hobby Expenses
5-5b Vacation Home Expenses
5-5c Home Office Expenses
5-23
5-25
5-26
5-6 Timing of Deductions—Effect of
Accounting Method
5-6a Cash Method
5-6b Accrual Method
5-6c Related Party Accrued Expenses
5-6d Financial and Taxable Income
Differences
Chapter Summary
Key Terms
Primary Tax Law Sources
Discussion Questions
Problems
Issue Identification Problems
Technology Applications
Comprehensive Problem
Discussion Cases
Tax Planning Cases
Ethics Discussion Case
6-3 Individual Deductions for Adjusted Gross
Income
6-20
6-3a Reimbursed Employee Business Expenses
6-3b Deductions for Self-Employed Taxpayers
6-3c Retirement Plan Contribution Deductions
6-3d Interest on Education Loans
6-3e $300 Charitable Contribution Deduction
for 2020 and 2021
Chapter Summary
Key Terms
Primary Tax Law Sources
Discussion Questions
Problems
Issue Identification Problems
Technology Applications
Integrative Problem
Discussion Cases
Tax Planning Cases
Ethics Discussion Case
6-21
6-24
6-25
6-29
6-30
6-30
6-31
6-31
6-32
6-33
6-42
6-43
6-45
6-47
6-47
6-48
CHAPTER 7
Losses—Deductions and Limitations
7-1
5-28
7-1 Introduction
7-2
5-29
5-31
5-34
7-2 Annual Losses
7-3
7-3 Net Operating Losses
7-4
7-4 Tax-Shelter Losses: An Overview
7-6
7-4a The At-Risk Rules
7-4b Passive Activity Losses
7-7
7-9
5-34
5-36
5-37
5-37
5-38
5-39
5-48
5-49
5-52
5-53
5-54
5-55
CHAPTER 6
Business Expenses
6-1
6-1 Introduction
6-2
6-2 Business Expenses
6-2
6-2a Meal, Auto, Travel, Gift, and Education
Expenses
6-2
6-2b Compensation of Employees
6-11
6-2c Bad Debts
6-12
6-2d Other Business Expenses
6-15
6-2e Qualified Business Income (QBI) Deduction 6-15
7-5 Transaction Losses
7-5a Trade or Business Losses
7-5b Investment-Related Losses
Chapter Summary
Key Terms
Primary Tax Law Sources
Discussion Questions
Problems
Issue Identification Problems
Technology Applications
Comprehensive Problem
Discussion Cases
Tax Planning Cases
Ethics Discussion Case
7-19
7-19
7-22
7-28
7-29
7-29
7-30
7-30
7-40
7-40
7-41
7-42
7-43
7-43
CHAPTER 8
Taxation of Individuals
8-1
8-1 Introduction
8-2
8-2 Filing Status
8-3
8-2a Married, Filing Jointly
8-3
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8-2b Married, Filing Separately
8-2c Single
8-2d Head of Household
8-4
8-4
8-4
8-3 Deductions from Adjusted Gross Income
8-3a Standard Deduction
8-3b Itemized Deductions
8-5
8-5
8-7
8-4 Standard Deduction
Restrictions on Dependents
8-15
8-4a Qualifying Child Tests
8-15
8-5 Calculating Tax Liability
8-18
8-5a Tax on Unearned Income of a Minor Child 8-18
8-5b Income Tax Credits
8-19
8-6 Filing Requirements
8-27
Chapter Summary
Key Terms
Primary Tax Law Sources
Discussion Questions
Problems
Issue Identification Problems
Technology Applications
Integrative Problems
Discussion Cases
Tax Planning Cases
Ethics Discussion Case
8-28
8-28
8-29
8-29
8-30
8-37
8-38
8-39
8-43
8-44
8-45
Appendix to Chapter 8
8-47
8A-1 Schedule EIC (Earned Income Credit) 2020
Earned Income Credit Table
8-47
Part 4
Property Transactions
9-1
CHAPTER 9
Acquisitions of Property
9-3
9-1 Introduction
9-4
9-2 Classes of Property
9-4
9-3 The Property Investment Cycle
9-5
9-3a Adjusted Basis
9-3b Basis in Conduit Entities
9-3c Property Dispositions
9-7
9-10
9-11
9-4 Initial Basis
9-12
9-5 Purchase of Assets
9-12
9-5a Determining the Amount Invested
9-5b Basis of a Bargain Purchase
9-12
9-14
Contents
vii
9-5c Purchase of Multiple Assets
9-5d Purchase of a Business
9-5e Constructed Assets
9-15
9-15
9-17
9-6 Specially Valued Property Acquisitions
9-18
9-7 Basis of Property Acquired by Gift
9-18
9-7a General Rule for Gift Basis
9-7b Split Basis Rule for Loss Property
9-7c Holding Period
9-18
9-19
9-20
9-8 Basis of Property Acquired
by Inheritance
9-20
9-8a Primary Valuation Date
9-8b Alternate Valuation Date
9-8c Distribution Date
9-8d Other Considerations
9-21
9-21
9-21
9-22
9-9 Personal Use Property Converted to
Business Use
9-23
9-9a General Rule for Basis
9-9b Split Basis Rule
9-10 Basis in Securities
9-10a Stock Dividends
9-10b Wash Sale Stock Basis
Chapter Summary
Key Terms
Primary Tax Law Sources
Discussion Questions
Problems
Issue Identification Problems
Technology Applications
Integrative Problem
Discussion Cases
Tax Planning Cases
Ethics Discussion Case
9-23
9-23
9-24
9-24
9-26
9-27
9-29
9-29
9-30
9-30
9-38
9-39
9-40
9-41
9-42
9-43
CHAPTER 10
Cost Recovery on Property: Depreciation,
10-1
Depletion, and Amortization
10-1 Introduction
10-2
10-2 Capital Recovery from Depreciation or
Cost Recovery
10-3
10-3 Section 179 Election to Expense Assets
10-5
10-3a Qualified Taxpayers
10-3b Qualified Property
10-3c Limitations on Deduction
10-5
10-6
10-6
10-4 Modified Accelerated Cost Recovery
System (MACRS)
10-10
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
viii
Contents
10-4a Property Subject to MACRS
10-4b Basis Subject to Cost Recovery
10-4c MACRS Recovery Period
10-4d MACRS Conventions
10-4e Depreciation Method Alternatives
10-4f Using MACRS Percentage Tables
10-4g MACRS Straight-Line Election
10-4h Alternative Depreciation System (ADS)
10-4i Limitations on Listed Property
10-5 Depletion
10-11
10-12
10-12
10-14
10-17
10-19
10-20
10-22
10-24
10-25
10-5a Depletion Methods
10-5b Cost Depletion
10-5c Percentage Depletion
10-6 Intangible Assets
Chapter Summary
Key Terms
Primary Tax Law Sources
Discussion Questions
Problems
Issue Identification Problems
Technology Applications
Integrative Problems
Discussion Cases
Tax Planning Cases
Ethics Discussion Case
Appendix to Chapter 10
10A-1 MACRS Class Lives and MACRS
Depreciation Schedules
10A-1a Rev. Proc. 87-56
Section 1. Purpose
Section 2. General Rules of Application
Section 5. Tables of Class Lives and Recovery
Periods
CHAPTER 11
Property Dispositions
10-26
10-26
10-27
10-28
10-30
10-31
10-31
10-32
10-33
10-39
10-39
10-40
10-41
10-41
10-42
10-43
10-43
10-43
10-43
10-43
10-44
11-1
11-1 Introduction
11-2
11-2 Realized Gain or Loss
11-4
11-2a Amount Realized
11-2b Effect of Debt Assumptions
11-4
11-5
11-3 Character of Gain or Loss
11-6
11-4 Capital Gains and Losses
11-7
11-4a Capital Asset Definition
11-8
11-4b Long-Term versus Short-Term
Classification
11-8
11-4c Capital Gain-and-Loss Netting Procedure 11-9
11-4d Capital Gains and Losses—Planning
Strategies
11-16
11-5 Section 1231 Gains and Losses
11-18
11-5a Definition of Section 1231 Property
11-5b Section 1231 Netting Procedure
11-6 Depreciation Recapture
11-6a Section 1245 Recapture Rule
11-6b Section 1250 Recapture Rule
11-6c Section 1245 and Section 1250
Properties
11-6d Unrecaptured Section 1250 Gain
Chapter Summary
Key Terms
Primary Tax Law Sources
Discussion Questions
Problems
Issue Identification Problems
Technology Applications
Integrative Problems
Discussion Cases
Tax Planning Cases
Ethics Discussion Case
11-18
11-19
11-22
11-23
11-23
11-25
11-26
11-27
11-28
11-29
11-29
11-30
11-39
11-40
11-40
11-42
11-43
11-44
CHAPTER 12
Nonrecognition Transactions
12-1
12-1 Introduction
12-2
12-2 Rationale for Nonrecognition
12-2
12-3 Commonalities of Nonrecognition
Transactions
12-3
12-4 Like-Kind Exchanges
12-7
12-4a Exchange Requirement
12-4b Like-Kind Property Requirements
12-4c Effect of Boot
12-4d Related Party Exchanges
12-4e Carryover of Tax Attributes
12-5 Involuntary Conversions
12-5a Treatment of Involuntary Conversion
Gains and Losses
12-5b Qualified Replacement Property
12-6 Sale of a Principal Residence
12-6a Requirements for Exclusion
Chapter Summary
Key Terms
Primary Tax Law Sources
Discussion Questions
Problems
Issue Identification Problems
Technology Applications
Comprehensive Problem
Discussion Cases
Tax Planning Cases
Ethics Discussion Case
12-7
12-8
12-9
12-13
12-14
12-14
12-15
12-17
12-18
12-19
12-21
12-22
12-22
12-23
12-23
12-28
12-29
12-29
12-30
12-30
12-31
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Contents
14-2 Operations
Part 5
Income Tax Entities
14-2a Sole Proprietorship
14-2b Partnership
14-2c Corporation
14-2d S Corporation
14-2e Planning Commentary
13-1
CHAPTER 13
Choice of Business Entity—General Tax
and Nontax Factors/Formation
13-3
13-1 Introduction
13-4
13-2 Nontax Factors
13-4
13-2a Sole Proprietorship
13-2b Partnership
13-2c Corporation
13-2d S Corporation
13-2e Limited Liability Company
13-2f Limited Liability Partnership
13-2g Planning Commentary
13-3 General Income Tax Factors
13-3a Incidence of Income Taxation
13-3b Double Taxation
13-3c Employee versus Owner
13-3d Fringe Benefits
13-3e Social Security Taxes
13-3f Planning Commentary
13-4 Formation
13-4a Transfers to an Entity
13-4b Basis Considerations
13-4c Organizational Costs
13-4d Accounting Periods
13-4e Accounting Methods
13-4f Planning Commentary
Chapter Summary
Key Terms
Primary Tax Law Sources
Discussion Questions
Problems
Issue Identification Problems
Technology Applications
Discussion Cases
Tax Planning Cases
Ethics Discussion Case
13-5
13-6
13-7
13-8
13-9
13-10
13-10
13-11
13-11
13-15
13-16
13-18
13-19
13-22
14-3 Entity Distributions
14-3a Sole Proprietorship
14-3b Partnership
14-3c Corporation
14-3d S Corporation
14-3e Planning Commentary
14-4 Tax Planning
ix
14-2
14-2
14-4
14-10
14-16
14-19
14-21
14-21
14-22
14-24
14-26
14-29
14-30
14-4a Income Splitting
14-4b Children as Employees
14-4c Family Entities
14-4d Planning Commentary
Chapter Summary
Key Terms
Primary Tax Law Sources
Discussion Questions
Problems
Issue Identification Problems
Technology Applications
Discussion Cases
Tax Planning Cases
Ethics Discussion Case
14-30
14-31
14-32
14-33
14-34
14-34
14-35
14-35
14-36
14-42
14-42
14-43
14-44
14-44
CHAPTER 15
Choice of Business Entity—Other
Considerations
15-1
15-1 Introduction
15-2
15-2 Compensation Plans
15-2
13-23
13-23
13-25
13-29
13-30
13-33
13-34
13-35
13-36
13-36
13-37
13-38
13-43
13-44
13-44
13-45
13-45
15-2a Qualified and Nonqualified Pension Plans 15-2
15-2b Other Pension Plans
15-6
15-2c Distributions
15-11
15-2d Penalties
15-13
15-2e Planning Commentary
15-14
15-2f Stock Options
15-16
15-2g Reasonableness of Compensation
15-22
15-2h Planning Commentary
15-23
15-3 Other Tax Liability Considerations
CHAPTER 14
Choice of Business Entity—Operations
and Distributions
14-1
14-1 Introduction
14-2
15-3a Income Tax Credits
15-3b The Alternative Minimum Tax
15-3c Basic Alternative Minimum Tax
Computation
15-3d Planning Commentary
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15-24
15-24
15-28
15-28
15-33
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Contents
15-4 International Tax Aspects
15-33
15-4a Taxpayers Subject to U.S. Taxation
15-4b Tax Treaties
15-4c Organizational Structure of Foreign
Operations
15-4d Taxation of Nonresident Aliens and
Foreign Corporations
Chapter Summary
Key Terms
Primary Tax Law Sources
Discussion Questions
Problems
Issue Identification Problems
Technology Applications
Discussion Cases
Tax Planning Cases
Ethics Discussion Case
15-34
15-34
15-34
15-37
15-39
15-40
15-41
15-42
15-43
15-48
15-48
15-49
15-49
15-50
Part 6
Tax Research
16-1
CHAPTER 16
Tax Research
16-3
16-1 Introduction
16-3
16-2 Primary Sources of Federal Income
Tax Law
16-4
16-2a Legislative Sources
16-2b Administrative Sources
16-2c Judicial Sources
16-2d Citations to Primary Authorities
16-3 Secondary Sources of Federal Income
Tax Law
16-3a Tax Services
16-3b Computer-Assisted Tax Research
16-3c Citators
16-3d Tax Periodicals
16-4 Tax Research
16-4a Tax Compliance versus Tax Planning
16-4b Step 1: Establish the Facts and
Determine the Issues
16-4c Step 2: Locate the Relevant Authorities
16-4d Step 3: Assess the Importance of the
Authorities
16-4e Step 4: Reach Conclusions, Make
Recommendations, and Communicate
the Results
16-5 Comprehensive Research Example
16-5a Step 1: Establish the Facts and
Determine the Issues
16-5b Step 2: Locate the Relevant Authorities
16-5c Step 3: Assess the Importance of the
Authorities
16-5d Step 4: Reach Conclusions, Make
Recommendations, and Communicate
the Results
16-6 Research Memorandum
16-6a Facts
16-6b Issues
16-6c Conclusions
16-6d Reasoning
Chapter Summary
Key Terms
Primary Tax Law Sources
Discussion Questions
Problems
Research Cases
Income Cases
Deduction Cases
Loss Cases
Entity Cases
Property Cases
Accounting Methods/Procedure Cases
16-21
16-21
16-21
16-21
16-23
16-23
16-23
16-24
16-24
16-24
16-24
16-25
16-25
16-25
16-26
16-27
16-27
16-29
16-32
16-33
16-34
16-35
APPENDIX A
Tax Return Problem
A-1
16-4
16-9
16-11
16-13
APPENDIX B
Tax Rate Schedules and Tax Tables
B-1
16-15
APPENDIX C
Tax Forms
C-1
APPENDIX D
How to Decode the Code
D-1
16-16
16-16
16-17
16-17
16-17
16-18
16-18
16-19
Glossary G-1
Index I-1
16-19
16-20
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PREFACE
Many students view the introductory tax course as an impossible task of learning the
Internal Revenue Code. The Code, which is the statutory basis of the federal income tax
system, is complex and can be intimidating to students and tax professionals. However,
we feel strongly that tax education can be interesting and, with the straightforward yet
complete coverage in Concepts in Federal Taxation, offer a refreshing, thought-provoking
textbook. Designed specifically for the introductory tax course, this book is rigorous
enough for students specializing in taxation, but it will not intimidate those who plan to
pursue other areas of accounting and business.
FUNDAMENTAL STRUCTURE
Conceptual Approach
There are two ways to look at the rules that govern federal taxation: the technical approach
and the conceptual approach. The traditional “technical approach” looks at the reams of
tax authority as thousands of specific and distinct code sections, regulations, ­exceptions,
and qualifications. This approach treats income tax in such great depth that the first-time
tax student has difficulty understanding the myriad rules, exceptions to those general rules,
and exceptions to the exceptions. As a result, students tend to view the first tax course as a
long string of unrelated topics that they must memorize to pass the course.
The “conceptual approach” presents taxation as a small number of unifying
­concepts—principles that apply in the application of specific tax rules and authorities.
These concepts define taxation. An analogy can be made to mathematical operations: by
understanding how multiplication works and memorizing the nine times tables, people
learn to multiply any number by any other number. One can multiply 23 by 25 correctly
without having memorized a times table that includes that pair of numbers. Likewise,
knowing the underlying concepts that shape tax law allows students to understand a wide
range of tax law without committing every line of the Internal Revenue Code to memory.
Organization
Instead of focusing on the individual aspects of taxation, this textbook emphasizes transactions that are common to all tax entities. This allows the text to focus more on the overall scheme of taxation (What is income? What is a deduction? and so on) with individual
tax return preparation a secondary issue. As a result, Chapter 1 introduces the individual
tax formula and briefly discusses the “for” versus “from” adjusted gross income distinction that is unique to individuals, but the mechanics of the individual tax calculation
are not discussed in detail until Chapter 8. Furthermore, itemized deductions are not
accorded the traditional in-depth treatment. Again, the focus is on the more common
itemized deductions, and elaborate technical detail is omitted for the more unusual items.
The text is organized into the following six parts:
• Part I: Conceptual Foundations of the Tax Law
• Chapter 1 provides an overview of the tax system, briefly discusses other types
of taxes, outlines the general income tax calculation, discusses the nature of tax
planning, and introduces ethical considerations of tax practice.
• Chapter 2 develops the conceptual framework and uses it to explain the operation of the tax system in general. Each subsequent chapter begins with a brief
review of the concepts discussed in this chapter.
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Preface
• Part II: Gross Income
• Chapter 3 classifies various sources of income and explains the common problems
encountered within each income classification. Its overview of property transactions differentiates the taxation of capital gains and losses from other sources of
income. The chapter concludes with an introduction to the accounting methods
that affect the recognition of income.
• Chapter 4 classifies allowable exclusions from income according to the purpose
of the exclusion and discusses the problems commonly encountered with exclusions in each category.
• Part III: Deductions
• Chapter 5 provides an overview of the general criteria necessary to obtain a tax
deduction and concludes with a discussion of the effect of a taxpayer’s accounting method on the timing of deductions.
• Chapter 6 addresses specific business expense deductions that are subject to
special rules and limitations.
• Chapter 7 covers deductions for losses. The chapter distinguishes annual losses
from transaction losses, and discusses the limitations on the deductibility of the
two types of losses. This discussion includes the treatment of net operating losses,
the at-risk rules, passive losses, capital losses, and casualty losses.
• Chapter 8 discusses the unique features of the individual income tax calculation,
itemized deductions, and tax credits available to individuals.
• Part IV: Property Transactions
• Chapter 9 introduces the property investment cycle and discusses common acquisition problems.
• Chapter 10 provides the allowable deductions for property expenditures. This
includes the MACRS depreciation system, depletion deductions, and allowable
amortization deductions.
• Chapter 11 discusses dispositions of property and explains the classification and
calculation of the gain or loss from a disposition of property.
• Chapter 12 covers the common nonrecognition situations related to property
dispositions, including exchanges, involuntary conversions, and sales of a principal residence.
• Part V: Income Tax Entities
• Chapter 13 discusses the nontax characteristics that should be considered in
choosing a business entity and the incidence of taxation of each entity and presents the comparative differences at formation of a business.
• Chapter 14 compares the differences in tax treatments during the operation
of an entity and concludes with an overview of the effect of distributions on an
entity and its owners.
• Chapter 15 finishes the life-cycle discussion with coverage of deferred compensation, tax credits, the alternative minimum tax, and international tax aspects of
entities.
• Part VI: Tax Research
• Chapter 16 provides the mechanics of tax research. Problems that require
the student to find particular types of authorities using print, CD-ROM, and
Internet tax services, and research cases for all chapters in the text are provided in
this chapter. Instructors wishing to introduce students to tax research may want
to cover this chapter early in the course.
HALLMARK FEATURES
The most important objective at the introductory level is to gain a conceptual view of income
tax law and then relate those concepts to basic aspects of everyday economic life. Through
continual reinforcement, the concepts quickly become the backbone of understanding. The
2022 edition of Concepts in Federal Taxation has a lineup of outstanding features that will
help students improve their skills and understanding while learning the concepts.
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Preface
Learning Objectives
Each chapter opens with a set of learning objectives to guide students through mastering
the chapter’s material. Learning objectives are shown in the margins near the relevant
chapter content and are also identified in the end of chapter materials to reinforce these
key learning objectives and help students learn more efficiently.
Concept Review
To solidify and expound upon the conceptual foundation presented in Chapter 2, the subsequent chapters begin with a review of the general concepts, accounting concepts, income
concepts, and deduction concepts that have been covered in previous chapters. Page references for each concept allow students to easily locate material and refresh their memory.
concept review
GENERAL CONCEPTS
INCOME CONCEPTS
Ability to pay A tax should be based on the amount that the
taxpayer can afford to pay, relative to other taxpayers. pg. 2-2
All-inclusive income All income received is taxable unless a
specific provision in the tax law either excludes the income from
taxation or defers its recognition to a future tax year. pg. 2-12
Administrative convenience Those items for which the cost
of compliance would exceed the revenue generated are not
taxed. pg. 2-3
Arm’s-length transaction A transaction in which all parties have
bargained in good faith and for their individual benefit, not for
the benefit of the transaction group. pg. 2-4
Related party Family members, corporations that are owned by
family members, and certain other relationships between entities
in which the power to control the substance of a transaction is
evidenced through majority ownership. pg. 2-4
ACCOUNTING CONCEPTS
Annual accounting period All entities must report the results of
their operations on an annual basis (the tax year). Each tax year
stands on its own, apart from other tax years. pg. 2-9
Assignment of income The tax entity that owns the income
produced is responsible for the tax on the income, regardless of
which entity actually receives the income. pg. 2-8
Conduit entity An entity for which the tax attributes flow
through to its owners for tax purposes. pg. 2-6
Substance over form Transactions are to be taxed according to
their true intention rather than some form that may have been
contrived. pg. 2-11
Capital recovery No income is realized until the taxpayer receives
more than the amount invested to produce the income. The
amount invested in an asset represents the maximum amount
recoverable. pg. 2-13
Claim of right A realization occurs whenever an amount is
received without any restriction as to its disposition. pg. 2-14
Constructive receipt Income is deemed to be received when it is
made unconditionally available to the taxpayer. pg. 2-15
Legislative grace Any tax relief provided is the result of a specific
act of Congress that must be strictly applied and interpreted. All
income received is taxable unless a specific provision in the tax
law excludes the income from taxation. Deductions must be approached with the philosophy that nothing is deductible unless a
provision in the tax law allows the deduction. pg. 2-12
Realization No income or loss is recognized until it has been realized. A realization involves a change in the form and/or substance
of a taxpayer’s property rights that results from an arm’s-length
transaction. pg. 2-14
Wherewithal to pay Income is recognized in the period in which
the taxpayer has the means to pay the tax on the income. pg. 2-16
Tax benefit rule Any deduction taken in a prior year that is
recovered in a subsequent year is income in the year of recovery,
to the extent that a tax benefit was received from the deduction. pg. 2-10
Examples
Continually rated as this textbook’s biggest strength, each chapter includes numerous
student-friendly examples. The examples present familiar situations in a question-anddiscussion format that offers detailed explanations.
Example 24 Jorge receives 200 shares of MNO Corporation common stock as a gift
from his grandfather. At the date of the gift, the shares have a fair market value of $20,000.
During the current year, Jorge receives dividends totaling $2,000 on the stock. Recall that
the tax law excludes the value of a gift from the gross income of the recipient. What are the
tax effects for Jorge of the gift from his grandfather?
Discussion: The receipt of the stock as a gift from the grandfather is specifically
excluded from Jorge’s income by the tax law. However, the exclusion applies only
to the value of the gift received and does not exclude from tax any subsequent
­income Jorge receives on the gift property.12 Therefore, Jorge is taxed on the $2,000
in dividends received on the stock.
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Copyright 2022 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
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Preface
Concept Check
Concept Checks appear throughout each chapter to keep students on track by reinforcing the critical tax concepts illustrated.
concept check
The capital recovery concept allows the recovery of capital
invested in an asset. The amount invested in an asset is the
maximum amount recoverable under this concept. Adjusted
basis represents a taxpayer’s unrecovered investment in an asset. Therefore, the maximum loss that can be recognized from
a casualty or theft is the asset’s adjusted basis. An arm’s-length
transaction is one in which all parties to the transaction have
bargained in good faith and for their individual benefit, not
for the benefit of the transaction group. Related party transactions are usually subject to scrutiny by the IRS because the
tax law assumes that related parties do not transact at arm’s
length. The substance-over-form doctrine taxes transactions
according to their true intent rather than some (possibly) contrived form of the transaction. This concept prevents a taxpayer
from recognizing a loss on the sale of stock if it is replaced
within 30 days of (either before or after) the date of sale.
END-OF-CHAPTER MATERIALS
Ensure that students master chapter concepts with a wide array of end-of-chapter assignments designed to do everything from testing basic chapter comprehension to applying
concepts and procedures to complex tax situations.
Chapter Summary
Students can verify their understanding of the key concepts illustrated in the chapter by
reviewing the succinct Chapter Summary, which appears at the end of every chapter.
Key Terms
Part of the difficulty of this course can be traced to its specialized vocabulary. As learning
the terminology serves as a basis for learning how to apply the concepts, each chapter
includes a list of key terms with page references.
Primary Tax Sources
Rather than interrupting the text with extensive footnoting of specific subsections of the
Internal Revenue Code, the primary tax law sources appear at the end of each chapter
with explanatory notations. This approach uses more references to Treasury regulations,
revenue rulings, and court cases than may appear in other introductory tax textbooks.
Discussion Questions and Problems
Communication
Skills
Many of the approximately 1,300 end-of-chapter problems do not call for mathematical
solutions. Rather, they require an explanation of the appropriate treatment, based on the
concepts. These problems are valuable learning tools, which encourage students to apply
the concepts and formulate a solution.
Traditional problems that can be solved by reference to the examples in the chapter
are also provided, and they address every topic in the chapter. In most cases, two or
more problems exist for each topic. A number of problems exist for each learning objective. Problems that require client communication are designated with a Communication
Skills icon.
Issue Identification Problems
These problems ask students to identify the tax issues inherent in a factual situation and
determine the possible tax treatments.
Technology Applications
A complete end-of-chapter section containing problems on Research Skills and Spreadsheet
Skills enhance students’ familiarity with the technology tools needed for problem solving.
Tax
Simulation
• Tax Simulations in Chapters 3–12 teach database searching and writing skills that
are important requirements for understanding tax concepts. These cases can be
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
xv
Preface
solved using only the Code and Regulations, giving students hands-on practice
with the research and writing skills required to complete the tax simulations featured on the CPA Examination.
• Research Skills Exercises require students to research relevant tax topics.
• RIA Research Exercises require students to use the Checkpoint® tax research database to complete the assignment.
• Tax Form Problems containing expanded client information allow students to
complete tax forms obtained from the IRS website without additional instruction.
These problems may be also worked using tax preparation software such as Intuit
ProConnect Tax Software.
• Spreadsheet Skills Problems are designed to make students aware that spreadsheets are useful tax planning tools.
Research
Skills
Tax Form
Skills
Spreadsheet
Skills
Comprehensive Problems
These problems cover several issues discussed within a chapter, requiring students to
develop an advanced understanding by combining and applying multiple concepts.
Integrative Problems
These problems require students to fuse together material learned in previous chapters,
combining it with information found within the current chapter. This approach allows
students to complete a complex tax return in two stages, spreading the work out over
the semester rather than preparing it for a single due date.
Tax Return Problem (Appendix A)
This problem is presented in three phases, which correspond to the organization of
the text. Each phase presents some information in actual tax documents that a taxpayer
might receive from common third-party sources. This approach makes it easier to become familiar with tax reporting and tax compliance forms as the material is covered,
rather than in one burst at the end of the semester. The problem can be worked manually
or with tax preparation software such as ProConnect Tax Software.
Discussion Cases
These cases stimulate thinking about issues raised in the chapter. All case material can be
used to emphasize communication in the tax curriculum.
Tax Planning Cases
These cases require students to use the concepts in the chapter to devise an optimal tax
plan for the facts given.
Ethics Discussion Cases
These cases provide ethical dilemmas related to the chapter material that must be resolved
according to the Statements on Standards for Tax Services of the American Institute of
Certified Public Accountants (AICPA). A link to the complete AICPA statements on
standards is provided.
RECENT REVISIONS
Fine-Tuned End of Chapter Material
All end of chapter content has been thoroughly updated with respect to tax law changes.
This material has also been carefully revised to enhance the readability of the question parts.
Updates Reflect the Latest Tax Laws
This annual edition reflects the latest tax laws and changes to tax codes and regulations
to keep your course current—including the new tax rate schedules and amounts.
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Copyright 2022 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
xvi
Preface
INSTRUCTOR RESOURCES
Concepts in Federal Taxation has been adopted by a wide range of schools and by instructors who have unique philosophies and approaches in their courses. Our supplemental
materials have been developed to have a positive impact on all aspects of the course.
Instructor Companion Website
www.cengage.com/login
Easily download the instructor resources you need from the password-protected, instructor-only website. If you are a new instructor, you will need to register with Cengage
by creating a new instructor account. Instructors will be directed to the Cengage dashboard after logging in. Here, instructors may add any Cengage book to the “bookshelf,”
including the 2022 edition of Concepts in Federal Taxation simply by searching by the
author, title, or ISBN (9780357515785). After adding the book to your “bookshelf,”
you will be able to access the links to the Instructor Companion website and accompanying resources.
Instructor’s Manual
Simplify class preparation with the wealth of teaching tips and advanced assignment ideas
provided in the Instructor’s Manual. A concise overview and detailed lecture outline (including references to relevant problems in the textbook) are provided for each chapter,
along with invaluable teaching ideas—including those for incorporating writing assignments, class/group exercises, and research projects. This rich array of resources is further
enhanced with the inclusion of useful planning documents on designing a course, grading and developing team activities, and sample syllabi that outline the incorporation of
technology, communication, and group assignments in the tax curriculum. Available on
the instructor website.
Solutions Manual
Carefully verified to ensure accuracy, the Solutions Manual reproduces all end-of-chapter
materials from the textbook and provides in-depth discussions of the answers to help instructors efficiently grade assignments. Charts that detail all problems by topic have been
included to simplify planning and assignment selection. In addition, problems requiring
key skills like critical thinking and communication, as well as comprehensive and integrative problems, have been labeled. Available on the instructor website.
Test Bank
The Test Bank helps instructors efficiently assess your students’ understanding with
problems and questions that reflect the textbook’s conceptual approach. The Test Bank
offers a variety of question types—including true/false, matching, multiple choice, short
answer, and comprehensive problems. Test Bank questions are also identified by level
of difficulty for easy selection and have been tagged to Accredited Business Program
and AICPA standards. This is particularly valuable during the accreditation process or
when your school wants to standardize assessment. Available through Cognero, a fullfeatured, online assessment system.
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Preface
STUDENT RESOURCES
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navigate and its comprehensive collection of primary tax law, cases, and rulings is unmatched. Each new copy of this textbook has been automatically bundled with access to
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xvii
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INTRODUCTION
WHY STUDY FEDERAL INCOME TAXATION?
If you are beginning the study of the federal income tax law and plan to become a tax
attorney or accountant, why you are taking this course is obvious. But if you want to
become a management accountant or auditor, why should you study federal income
taxation? Don’t accountants rely on tax specialists to do tax research and prepare tax
returns? Better yet, why should a business executive, an attorney, a physician, or a farmer
take a tax course? Each of them also can, and often does, have professional tax advisers
to take care of his or her tax problems. The heart of the answer lies in the fact that most
economic transactions have an income tax effect.
The income tax law influences personal decisions of individuals. The decision to
buy a house instead of renting one may depend on the after-tax cost of the alternatives.
Although the payment of rent reimburses the owner of the dwelling for mortgage interest and property tax, a tenant cannot deduct the cost of renting a home. However, a
homeowner can save income tax by deducting home mortgage interest and property tax
and perhaps reduce the after-tax cost of buying relative to renting.
Example 1 Zola lives in an apartment she rents for $700 per month. She is considering
purchasing a house, which will require an initial cash outlay of $5,000 and monthly payments of $850. Although none of the $5,000 initial down payment is deductible, $800 of
the monthly payment is deductible as interest expense. Assuming that Zola earns 6% on
her investments and is in the 24% tax rate bracket, what is the after-tax monthly cost of
purchasing the house?
Discussion: Assuming that Zola itemizes her deductions, the $800 interest payment
will be deductible. Her taxable income will be reduced by $800 per month, resulting in
tax savings of $192 ($800 3 24%). This leaves her with a net after-tax house payment
of $608. However, she will lose interest income on the $5,000 investment of $25 per
month [($5,000 3 6%) 5 $300 4 12 5 $25]. She will not have to pay any tax on the lost
interest, resulting in an after-tax interest loss of $19 [$25 2 ($25 3 24%)]. Her net aftertax monthly cost of purchasing the house is $627 ($608 1 $19). Because this is less than
her rent of $700, Zola will come out ahead by $73 per month by purchasing the house.
This analysis of Zola’s investment in a house considers only the tax aspects of
the investment. Clearly, other factors influence the decision to purchase a house—
potential appreciation in value, the intangible value of owning your own home,
and so on. The point is that the tax consequences are one objective factor to consider when making various decisions, but they are rarely the sole or controlling factor.
Other personal decisions are often influenced by tax savings. For example, a taxpayer
may decide to accelerate or defer charitable donations or elective medical treatment to
claim the deductions in the year that results in the most significant tax savings. Even
child-care decisions may be based on the availability of tax savings in the form of a childcare tax credit.
Example 2 On January 1 of each year, Steve gives $2,000 to his church. For 2020, his
income is more than double its usual amount because of a one-time bonus he receives from
his employer. In a typical year, Steve is in the 24% tax rate bracket. Because of his increased
income in 2020, Steve estimates that he will be in the 32% tax rate bracket, but his income
will return to normal in 2021. What steps might Steve take to reduce his tax bill?
Discussion: Instead of waiting until January 1, 2021, to make his regular $2,000
donation, which will reduce his tax by $480 ($2,000 3 24%), Steve could pay the
contribution in 2020. By taking the deduction in 2020 when he is in the 32% tax
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xix
xx
Introduction
rate bracket, Steve saves $640 ($2,000 3 32%) in tax. By accelerating his $2,000
charitable contribution by a few days, he saves an extra $160 in tax ($640 2 $480).
From these examples, you can see that income taxes can and do have an influence on
routine decisions. However, the cost of the income tax is more than just the outlay for
the tax liability. A knowledge of the income tax laws enables taxpayers to make decisions
that can reduce these other costs. By being familiar with the tax laws, an individual can
enter into transactions that will provide the best tax result for both the taxpayer and the
taxpayer’s family. By minimizing the income tax burden, taxpayers conserve wealth that
can be put to other uses. Last, taxpayers are responsible for reporting their correct taxable
income to the government. Knowing the tax laws protects against audits by the IRS that
could result in additional tax owed and penalties for improper reporting of the tax liability.
Significance of Tax Costs
Keeping records and filling out forms to comply with the tax law can consume a substantial amount of time. Table I-1 presents the IRS’s estimates of the time involved in
record keeping, learning about tax law, preparing a return, and assembling the various
commonly filed tax forms. As you can see, the IRS estimates that completing and filing
the basic tax return form (Form 1040) requires more than 22 hours on average. When
you consider that many taxpayers file a multitude of forms and schedules to detail their
tax affairs, the time involved in complying with the tax law is quite substantial.
Tax compliance may also cost a taxpayer money. Taxpayers must weigh the cost of
the time and investment needed to prepare their own tax returns, the out-of-pocket cost
of hiring a tax preparer to prepare the return, and the risk of additional time and monetary costs for any errors. Thus, taxpayers need to choose whether to save money and
spend the time to prepare their own tax returns or to pay to have someone else help
determine the proper amount of income tax.
When deciding whether to prepare their own returns, taxpayers should be aware that
the amount of income tax shown on the return may contain errors or differences of opinion
that may be found in an IRS audit. These differences of opinion can result from a taxpayer’s
or the tax preparer’s lack of familiarity with the tax law and how it applies to the taxpayer.
Similarly, the IRS agent performing the audit may not fully understand the law as it applies
to a particular situation. In addition to clerical mistakes, tax return errors can result from
inadequate communication between a taxpayer and tax preparer. A tax audit may reveal that
the taxpayer either is entitled to a refund or owes more tax. If you are entitled to a refund,
you have lost the use of the money while it was held by the U.S. Treasury. If you have to pay
more tax, you may have to pay extra costs in the form of penalties and interest on the tax
Table I-1
Estimated Average Taxpayer Burden for Individuals by Activity
Average Burden
Average Time (Hours)
Type of Taxpayer
All taxpayers………………………….
Type of taxpayer
Nonbusiness***………………….
Business***………………………..
Percentage
of Returns
Total Record
Tax
Form Completion All
Time* Keeping Planning and Submission Other
Average
Cost
(Dollars)**
100
11
5
2
4
1
$210
70
30
7
19
2
10
1
3
3
5
1
1
130
410
*Detail may not add to total time due to rounding.
**Dollars rounded to the nearest $10.
***You are considered a “business” filer if you file one or more of the following with Form 1040 or 1040-SR: Schedule C, E, or F or Form 2106.
You are considered a “nonbusiness” filer if you don’t file any of those schedules or forms with Form 1040 or 1040-SR.
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xxi
Introduction
you owe. An audit of your return will require an additional investment of your personal time
and, quite likely, additional out-of-pocket costs for professional tax advice. In addition, many
taxpayers are intimidated when facing an income tax audit.
As your involvement in professional activities increases, taxes and the costs of compliance grow in importance. If you are like most taxpayers, you will want to pay the least
tax required by the law. You will also want to spend as little time and money as possible
to satisfy the compliance requirements. As Table I-2 shows, in 2000, an average taxpayer
worked May 1 to pay federal, state, and local taxes and a taxpayer worked almost onethird (33.00 percent) of the year to pay taxes. Major federal income tax cuts enacted from
2001 through 2009 decreased tax freedom day to April 9 in 2010. However by 2019, tax
freedom day has increased to April 16 which represents 29% of the tax year pay federal,
state, and local taxes. As Table I-2 demonstrates, the amounts paid for taxes represent
major expenditures for the typical taxpayer.
Conservation of Wealth
An understanding of basic tax concepts and planning can often help conserve wealth by
reducing taxes. To reduce taxes, you need to be able to recognize potential planning
situations and problems. Because you know your financial affairs better than anyone else,
you are in the best position to spot potential tax-saving opportunities. You should never
wait for your tax adviser to find new ways to save you taxes. Although a competent tax
adviser will know about tax-planning techniques and current tax developments, you will
be more familiar than an adviser is with your financial affairs and objectives. A tax adviser
is best used in the same way you use other professionals. When you visit your physician,
you usually describe the symptom that brought you to the office to help the doctor
identify the proper treatment. When you visit your attorney for a legal problem, you
Table I-2
Tax Freedom Days in the U.S.
Year
Tax Freedom Day
% of Year
1960
April 11
27.70%
1970
April 19
29.60%
1980
April 21
30.40%
1990
April 21
30.40%
2000
May 1
33.00%
2010
April 9
26.90%
2011
April12
27.70%
2012
April 13
29.20%
2013
April 18
29.40%
2014
April 21
30.20%
2015
April 24
31.20%
2016
April 22
30.90%
2017
April 23
30.90%
2018
April 19
29.70%
2019
April 16
29.00%
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xxii
Introduction
take along the information necessary to help the lawyer identify the legal issues. In both
instances, you evaluate information and decide when you need professional assistance.
Likewise, you will need to evaluate information, based on your understanding of the tax
laws, to determine when you need to consult a professional tax adviser.
Example 3
Gwen, 19, is a full-time student at State University. Her parents pay all her
expenses, which total $12,000 a year. Gwen does not have any other source of support,
and she does not pay any income tax. Gwen’s father, Marty, owns a substantial portfolio of
bonds that earns $12,000 in income each year. Marty is in the 32% tax rate bracket.
Discussion: A tax plan could save Marty money by transferring ownership of
the bond portfolio to Gwen, who is in a lower tax bracket. Marty pays $3,840
($12,000 3 32%) in tax on the investment income. The amount of income left after
paying tax is $8,160 ($12,000 2 $3,840).
If Marty gave the bond portfolio to Gwen as a gift (which is not subject to income
tax), she would be taxed on the income at a lower tax rate than her father. Assuming
that Gwen has no other income, her tax on the income would be $1,124. The family
could save $2,716 ($3,840 2 $1,124) in tax by shifting the income to Gwen. The amount
of income left after paying tax is increased to $10,876 ($12,000 2 $1,124).
Taxes Influence Routine Decisions
An auditor, management accountant, attorney, physician, or farmer may never prepare a
business tax return. Yet, they need a general understanding of the tax effects of their daily
business decisions. For example, an auditor might find that an improperly recorded transaction results in an undisclosed tax liability or refund. A managerial accountant may need
to consider the tax effects of buying or selling plant assets or acquiring a new business. To
provide reliable advice to clients, lawyers often need a general understanding of how the
tax laws apply to different types of entities. A doctor may need a general understanding
of fringe-benefit plans that can be set up to keep highly qualified nurses and medical technicians as employees. A farmer can benefit from familiarity with the complex rules that
govern reporting of income from farm production and the deduction of farm expenses.
Individuals can also benefit from a knowledge of the tax laws in their everyday decisions.
Example 4 Isaac wants to remodel his house. During a special promotion, his bank will
finance the purchase with a 7% unsecured personal loan. Isaac knows that he can obtain
a home equity loan from his bank at 8% interest. If Isaac is in the 24% tax bracket, which
loan should he use to finance his remodeling?
Discussion: Interest paid on personal loans is not deductible. However, interest
paid on a home equity loan is deductible and treated as acquisition indebtedness if
the funds are used to substantially improve the taxpayer’s home. If Isaac itemizes
his deductions, the i­nterest on the home equity loan is deductible. This makes the
real after-tax cost of the home equity loan 6.08% [8% 2 (8% 3 24%)]. Therefore,
the home equity loan actually offers a lower after-tax cost than the personal loan.
However, note that if Isaac does not itemize deductions (i.e., he uses the standard deduction), he receives no benefit from the deduction for home equity loan
interest. In this case, the personal loan would have a lower after-tax cost, because
neither loan would produce deductible interest.
Self-Protection
Another reason for being aware of the federal income tax law is self-protection. Perhaps
you have heard others say that all they have to do is give a list of income and deduction
items to their tax return preparer. When they get the completed tax return back and pay
the tax due, their responsibility for complying with the tax law is finished. If any mistakes are made, it is the preparer’s problem. This assumption is erroneous and can lead
to disaster.
Taxpayers are fully liable for additional tax, interest, and penalties due because
of an error on their tax return. If a person paid to prepare a return misinterprets the
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Introduction
information and/or makes a mistake that results in an underpayment of tax, the taxpayer
will have to pay any additional amounts owed to the government. Whether the preparer
will reimburse the taxpayer for the penalties and interest depends on the agreement with
the preparer. Legal recourse against the preparer is available in certain circumstances,
but the cost of obtaining reimbursement (e.g., legal fees, court costs) from the preparer
may be prohibitive. For your own protection, you should always examine the completed
return. Before you sign and file the return, thoroughly review it with your preparer and
be sure you understand any entries that do not seem to be correct. Again, a knowledge
of the tax law can help you catch errors or other misrepresentations made by a tax preparer before the return is filed.
Example 5
Raul gives his tax return preparer a list of income and deduction items to be
reported on his tax return. The income items total $50,000, and the deduction items total
$14,000. When the preparer puts the information on the return, he omits $10,000 of the
income and reports only $40,000 ($50,000 2 $10,000) in income. In addition, the preparer
includes a $2,000 deduction twice so that total deductions are reported as $16,000. As a
result, Raul understates his taxable income by $12,000 ($36,000 correct taxable income 2
$24,000 reported taxable income).
Discussion: If the IRS detects the errors on the return, Raul will have to pay the
IRS the additional tax due on the $12,000 understatement plus penalties and interest. Depending on their agreement for preparing the return, Raul may or may not
recover part of his costs from the preparer. If the preparer does not agree to reimburse Raul for his mistakes, Raul may take legal action to obtain the amount due
from the preparer. However, this can be a costly process and may not be worth the
additional tax, penalties, and interest due.
Clearly, all taxpayers can benefit from a basic knowledge of the tax law. Although
the federal income tax is only one of many taxes that government bodies use to raise
revenue, it is by far the most important in terms of revenue produced and the number of
taxpayers affected. Therefore, this book focuses on federal income tax law.
Federal income tax law is a complex array of statutory, administrative, and judicial
authorities. Because of its ability to affect taxpayer’s decisions, lawmakers frequently
make changes in the tax law to achieve economic, social, and/or political objectives.
This causes the tax law to be in constant evolution. Professional tax advisers spend a significant portion of their time maintaining their knowledge of this changing body of law.
Fortunately, many aspects of the tax law have remained stable over time. The approach
used in this book is to provide a conceptual framework for analyzing how particular
transactions should be treated for federal income tax purposes. The book then presents the general operation of the tax law and explains it in terms of the basic concepts.
Throughout the book, the focus of the discussion is on those aspects of the federal income tax that have remained stable over time. A knowledge of the basic operation of the
tax law will enhance your ability to make the best decisions for your individual situation.
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xxiii
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Chapter 1
Federal Income Taxation—An Overview page 1-3
Chapter 2
Income Tax Concepts page 2-1
E
very society makes choices as to the tax systems that not only raise the
necessary revenues to support government expenditures, but within that
choice are also inherent reflections of societal values. Not only does a
society choose a tax system but the tax system also becomes one of the basic
institutions that in itself shapes and molds the society.
1
iStock.com/car
terdayne
—Karen M. Yeager
P A R T
Conceptual Foundations
of the Tax Law
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1-1
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Federal Income
Taxation—An Overview
1
Learning Objectives:
1 Explain what constitutes a tax and the various types of tax rate structures that
LO
may be used to calculate a tax.
2 Explain the major types of taxes in the United States.
LO
3 Identify the primary sources of federal income tax law.
LO
4 Define taxable income and other commonly used tax terms.
LO
5 Explain the IRS audit process and taxpayer rights within the process.
LO
6 Explain the calculation of taxable income for individual taxpayers and the
LO
unique personal deductions allowed to individuals.
7 Develop a framework for tax planning and discuss the effect of marginal tax
LO
rates and the time value of money on tax planning.
8 Make the distinction between tax avoidance and tax evasion.
LO
9 Explain ethical considerations related to tax practice.
LO
1-1 INTRODUCTION
We have all heard the adage, “There’s nothing certain but death and taxes.” However,
equating death and taxes is hardly a fair characterization of taxation. It is often stated that
taxes are the price we pay for a civilized society. An early decision of the U.S. Supreme
Court described a tax as “an extraction for the support of the government.” Regardless
of your personal view of taxation, society as we know it could not function without some
system of taxation. People constantly demand that the government provide them with
various services, such as defense, roads, schools, unemployment benefits, medical care,
and environmental protection. The cost of providing the services that the residents of
the United States demand is principally taxation. People are introduced to taxation at an
early age. Remember the candy bar that had a price sticker of 90 cents yet actually cost
96 cents? The tax collector is all around us. Upon receiving their first paycheck, many
are surprised that the $100 they earned resulted in a check of only $80 after taxes were
deducted. The point is that taxes are a fact of life. Learning to deal with taxes, and per­
haps using them to your advantage, is an essential element of success in today’s world.
The federal income tax is a sophisticated and complex array of laws that imposes a
tax on the income of individuals, corporations, estates, and trusts. Current tax law has
developed over a period of more than 100 years through a dynamic process involving
political, economic, and social forces. At this very minute, Congress is considering vari­
ous changes in the tax law; the Internal Revenue Service (IRS) and the courts are issu­
ing new interpretations of current tax law, and professional tax advisers are working to
determine the meaning of all these changes.
The purpose of this book is to provide an introduction to the basic operation of the
federal income tax system. However, before looking at some of the specifics, it is helpful
to have a broad understanding of taxes and how the federal income tax fits into the over­
all scheme of revenue production. Toward this end, this chapter briefly discusses what
constitutes a tax, how taxes are structured, and the major types of taxes in the United
States before considering the federal income tax. Next, the primary sources of tax law
authority are introduced. These sources provide the basis for calculating the tax and the
unique terminology of federal income taxation. This chapter also introduces the tax cal­
culation for individuals, the discussion of which serves as a reference for discussions in
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1-3
1-4
Part 1    Conceptual Foundations of the Tax Law
succeeding chapters. The next section of the chapter provides a framework for tax plan­
ning and a discussion of tax avoidance and tax evasion.
Because ethics is an important issue in the accounting profession, the chapter con­
cludes with a brief discussion of the ethical considerations related to tax practice. The
discussion provides the background that will help you detect ethical issues that you will
face if you go on to practice in the tax area.
1-2 DEFINITION AND EVALUATION OF A TAX
1
LO
Explain what constitutes a tax
and the various types of tax rate
structures that may be used to
calculate a tax.
Because this is a tax text, one starting point is to define what is meant by the term tax.
Particular types of taxes and tax rules are often criticized as being loopholes, unfair, or
creating an excessive burden on a particular group of taxpayers. The discussion that fol­
lows presents the four criteria commonly used to evaluate these criticisms. In addition,
three types of tax rate structure are presented as an aid in evaluating whether a particular
tax is “good” or “bad.”
1-2a Definition of a Tax
What is a tax? The IRS defines a tax as “an enforced contribution, exacted pursuant to
legislative authority in the exercise of the taxing power, and imposed and collected for
the purpose of raising revenue to be used for public or governmental purposes. Taxes
are not payments for some special privilege granted or service rendered and are, there­
fore, distinguishable from various other charges imposed for particular purposes under
particular powers or functions of government.”1
A tax could be viewed as an involuntary contribution required by law to finance the
functions of government. The amount of the contribution extracted from the taxpayer
is unrelated to any privilege, benefit, or service received from the government agency
imposing the tax. According to the IRS definition, a tax has the following characteristics:
1. The payment to the governmental authority is required by law.
2. The payment is required pursuant to the legislative power to tax.
3. The purpose of requiring the payment is to provide revenue to be used for public
or governmental purposes.
4. Special benefits, services, or privileges are not received as a result of making the
payment. The payment is not a fine or penalty that is imposed under other powers
of government.
Although the IRS definition states that the payment of a tax does not provide the
taxpayer with directly measurable benefits, the taxpayer does benefit from, among other
things, military security, a legal system, and a relatively stable political, economic, and social
environment. Payments to a government agency that relate to the receipt of a specific
benefit—in privileges or services—are not considered taxes. They are payments for value
received or are the result of a regulatory measure imposed by the government agency.
Example 1
Keith lives in Randal County, which enacted a law setting a 1% property tax
to provide money for county schools. The 1% tax applies to all property owners in Randal
County. All schoolchildren in the county will benefit from the tax, even if their parents do
not own property or pay the tax. Is the 1% property tax a tax according to the definition?
Discussion: The property tax is a tax. The tax is a required payment to a govern-
ment unit. The payment is imposed by a property tax law. The purpose of the payment is to finance public schools. The tax is levied without regard to whether the
taxpayer receives a benefit from paying the tax.
Example 2 Assume that in example 1, the tax is imposed on a limited group of property
owners to finance the construction of sewer lines to their properties. Is the 1% tax a tax as
defined by the IRS?
Discussion: Each payer of the tax receives a direct benefit—a new sewer line.
Therefore, the 1% tax payment is considered a payment to the government unit to
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Chapter 1    Federal Income Taxation—An Overview
reimburse it for improvements to the taxpayer’s property. The taxpayers would
treat the payment as an investment in their property and not as a tax. The 1% tax
in this case is a special assessment for local benefits. An assessment differs from
a tax in that an assessment is levied only on a specific group of taxpayers who
receive the benefit of the assessment.
Certain payments that look like a tax are not considered a tax under the IRS defini­
tion. For example, an annual licensing fee paid to a state to engage in a specific occupa­
tion such as medicine, law, or accounting is not a tax because it is a regulatory measure
that provides a direct benefit to the payer of the fee. A fee paid for driving on a toll road,
the quarter deposited in a parking meter, and payments to a city for water and sewer
services are payments for value received and are not taxes according to the IRS’s defi­
nition. Fines for violating public laws and penalties on tax returns are not taxes. Fines
and penalties are generally imposed to discourage behavior that is harmful to the public
interest and not to raise revenue to finance government operations.
1-2b Standards for Evaluating a Tax
In The Wealth of Nations, Adam Smith identified four basic requirements for a good
tax system. Although other criteria can be used to evaluate a tax, Smith’s four points
are generally accepted as valid and provide a basis for discussion of the primary issues
regarding taxes. These requirements are equality, certainty, convenience, and economy.
Although Smith clearly stated the maxims, taxpayers have different opinions as to whether
the federal income tax strictly satisfies the four requirements.
1. Equality—A tax should be based on the taxpayer’s ability to pay. The pay­
ment of a tax in proportion to the taxpayer’s level of income results in an equi­
table distribution of the cost of supporting the government.
The concept of equality requires consideration of both horizontal and vertical eq­
uity. Horizontal equity exists when two similarly situated taxpayers are taxed the same.
Vertical equity exists when taxpayers with different situations are taxed differently but
fairly in relation to each taxpayer’s ability to pay the tax. This means that those taxpayers
who have the greatest ability to pay the tax should pay the greatest proportion of the tax.
These equity concepts are reflected to a great extent in the federal income tax. Certain
low-income individuals pay no tax. As a person’s taxable income level increases, the tax
rate increases from 10 percent to 12 percent to 22 percent to 24 percent to 32 percent
to 35 percent to 37 percent.
Example 3
Tom and Jerry each earn $15,000 a year and pay $1,500 in tax.
Discussion: The two taxpayers pay the same amount of tax on the same amount
of income. Because they are treated the same, based on the facts given, horizontal
equity exists.
A slight change of facts provides a different result. If Tom is married and supports his spouse and 3 children and Jerry is single with no one else to support, the
tax appears unfair and not vertically equitable. The lack of vertical equity exists
because the taxpayers’ situations are no longer the same, yet they pay the same
amount of tax on the same income.
Example 4
Assume that because of the size of his family, Tom (example 3) pays $500
in taxes. Jerry still pays $1,500.
Discussion: In this situation, vertical equity is considered to be present. Because
he presumably has a greater ability to pay tax, Jerry pays a larger amount of tax
than Tom—Jerry’s income, although equal to Tom’s, supports fewer people.
Some taxpayers consider inequitable the tax law provisions that treat similar income
and deductions differently. For example, a person investing in bonds issued by a city
does not have to pay tax on the interest income. In contrast, interest income earned on
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1-5
1-6
Part 1    Conceptual Foundations of the Tax Law
an investment in corporate bonds is taxed. People who operate proprietorships may deduct
the cost of providing their employees with group term life insurance but may not deduct the
cost of their own group insurance premium. If the proprietor incorporates, the cost of the
insurance for both the shareholder-employee (owner) and employees can be deducted. Thus,
the perception of equality often depends on the taxpayer’s personal viewpoint. Because the
concepts of equity are highly subjective, a tax rule considered equitable by one taxpayer is
often considered unfair by a taxpayer who derives no benefit. Often, when evaluating the
equality of a tax provision, taxpayers do not consider—or are not aware of—the economic,
social, and administrative reasons for what may seem to be an inequity in the tax law.
Example 5
Kate is a single mother who earns $10,000 a year. Maria and her husband,
Ben, earn $75,000 a year. Kate and Maria each pay Neighborhood Day Care $2,000 per
year for taking care of one child while they work. Because the payment is for qualified child
care, Kate is entitled to a $700 reduction in her income tax because of her low income level.
Because of their high income level, Maria and Ben receive only a $400 reduction in their
income tax. Who is more likely to view this treatment as being inequitable?
Discussion: Maria and Ben may view the tax rule as unfair because Kate receives
a larger reduction in tax for the same amount of payment for day care. However,
there is increasing emphasis on tax relief for families. Congress has decided that it
is important that children be adequately cared for while parents are at work. Thus,
Kate’s family is given a larger tax break to help provide child care. Without the
larger tax reduction, Kate might not be able to afford to pay child-care costs. The
difference in treatment could also be based on the ability to pay child-care costs. In
addition, the difference in treatment depicts a situation of vertical equity. Because
Maria and Ben have higher incomes, vertical equity requires that they pay a higher
tax (through receiving a smaller tax credit).
2. Certainty—A taxpayer should know when and how a tax is to be paid. In
addition, the taxpayer should be able to determine the amount of tax to be paid.
Certainty in the tax law is necessary for tax planning. An individual’s federal income
tax return is due on the fifteenth day of the fourth month (usually April 15) after the
close of the tax year. A corporation’s return is due on the fifteenth day of the fourth
month after the close of its tax year.2 The balance of tax due with the return is usually
paid by check to the IRS. However, determining the amount of tax due may not be so
simple. When planning an investment that will extend over several tax years, the ability
to predict with some degree of certainty how the results of the investment will be taxed
is important to the investment decision. Frequent changes in the tax law create uncer­
tainty for the tax planner. In addition to these legislative amendments to the tax law, the
IRS and the courts issue a constant stream of decisions and interpretations on tax issues,
which results in a tax law that is in a continual state of refinement. However, for the
average individual taxpayer, who has wages subject to withholding, receives some inter­
est income, owns a home, pays state and local taxes, and perhaps donates to a church
or other charities, there is little complexity and a great deal of certainty in the tax law
despite the numerous changes to the tax system.
3. Convenience—A tax should be levied at the time it is most likely to be con­
venient for the taxpayer to make the payment. The most convenient time for
taxpayers to make the payment is as they receive income and have the money
available to pay the tax.
Most taxpayers would argue that it is not convenient to keep records, determine the
amount of tax due, and fill out complex forms. However, certain aspects of the income
tax law make it more convenient than it might be otherwise. Based on the pay-as-yougo concept, taxes are paid as close to the time the income is earned as is reasonable.
The pay-as-you-go system results in the collection of the tax when the taxpayer has the
money to pay the tax. This tax payment system applies to all taxpayers, including the
self-employed and those who earn their income from investing activities. This system is
discussed in more detail later in this chapter.
Copyright 2022 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-322
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Chapter 1    Federal Income Taxation—An Overview
The federal income tax is based on self-assessment and voluntary compliance with
the tax law. Taxpayers determine in privacy the amount of their income, deductions, and
tax due. The tax calculated by the taxpayer is considered correct unless the IRS detects
an error and corrects it or selects the return for an audit. The federal income tax system
relies on the honesty and integrity of taxpayers in determining their tax payments. This
system of self-assessment and voluntary compliance promotes convenience for taxpayers.
4. Economy—A tax should have minimum compliance and administrative
costs. The costs of compliance and administration should be kept at a minimum
so that the amount that goes to the U.S. Treasury is as large as possible.
The IRS operates on a budget of about one-half of 1 percent of the total taxes col­
lected. However, the IRS’s budget does not reflect the full cost of administering the tax
law. A taxpayer’s personal cost of compliance can be substantial. Taxpayers often need
to maintain accounting records for tax reporting in add…