Chapter1Introduction to Federal Taxation and Understanding the

Chapter
1
Introduction to Federal Taxation and Understanding the Federal
Tax Law
OBJECTIVES
After completing Chapter 1, you should be able to:
1. Identify types of taxes used by federal and state governments
to raise revenues.
2. Understand the methods of tax collection and the trends
shown by tax collection statistics.
3. Differentiate between tax avoidance and tax evasion.
4. Recall the underlying rationale of the federal income tax and
its historical development.
5. Describe the route a tax bill takes until enacted into law.
6. Define the basic tax concepts and terms of federal income
taxation.
INTRODUCTION
Federal taxation is the fuel by which Americans power their
“Ship of State.” The tax structure which supports our federal
government has gone from quill and ink records of
revolutionary assessments to lightning speed computers which
calculate and validate millions of income tax returns submitted
by individuals and corporations. Federal taxes, in addition to
the income tax, include a variety of other taxes covering estates,
gifts, and customs, as well as excise taxes, and other minor
categories of tax. Our governments can thus select among a
variety of tax alternatives to produce the revenues required to
operate national programs and carry out national policies.
Taxes are big business. Unfortunately, many business decisions
are made in the United States today without regard to federal
tax consequences. Individuals are concerned with personal
income tax decisions and gift and estate tax decisions, while
corporations concern themselves with corporate taxes, personal
holding company taxes, and accumulated earnings tax decisions.

Further, businesspersons must concern themselves with the
choice of business entity: corporation, partnership, or S
corporation. Differences in tax costs can be considerable.
Advantages and disadvantages are virtually unlimited. This
book presents information which is required knowledge if you
make business decisions.
While most businesspersons (and many advisors) think about
how to make decisions in nontax terms, the tax accountant bears
the burden of introducing tax considerations. The topics
presented in this book must be viewed in terms of decision-
making—therefore, tax planning and tax research are of the
utmost importance. Tax decisions are not made in a vacuum.
Lawyers, accountants, financial managers, and a host of other
experts work as a team in the decision-making process. This
book is intended to serve as a guide for accounting students and
for MBA students interested in gaining insight into and
expertise in the tax complexities of business decision-making.
OVERVIEW
This chapter presents information on the magnitude of federal
taxes collected and on taxpayer obligations. Then, a brief
historical account is presented of federal tax collections prior to
and after the adoption of the Sixteenth Amendment to the
Constitution, which enabled Congress to levy “taxes on
incomes, from whatever source derived.” Following this is an
introductory discussion of the federal legislative process and an
analysis of the social, political, and economic rationale
underlying the federal tax law. Finally, basic tax concepts are
explained.
Fundamental Aspects of Federal Taxation
¶1101
SOURCES OF REVENUE
Types of Taxes
From the very beginning, with the ratification of the Sixteenth
Amendment to the Constitution, through various Revenue Acts
and many court cases, a set of tax laws has evolved that raised
$3.0 trillion, net of refunds, on over 250 million tax returns

processed by the IRS in 2018. This was higher than the $2.98
trillion raised in 2017. The federal government uses a number of
different types of taxes to generate the cash flow it needs for
operating the government. The following is a listing of the
various types of federal taxes:
Income taxes
Corporations, individuals, fiduciaries
Employment taxes
Old age, survivors, disability, and hospital insurance (federal
insurance contributions, self-employment insurance
contributions), unemployment insurance, railroad retirement
Estate and gift taxes
Estate, gift, and generation-skipping transfers
Excise and customs taxes
Alcohol, tobacco, gasoline, other
Over the years individuals have borne the burden in the arena of
tax payments. Individual taxes account for approximately 52.45
percent of total tax collections. Corporate income tax
collections account for approximately 6.75 percent of total tax
receipts. This is a dramatic decrease from the 9.85 percent of
total receipts that were collected from corporations in 2017.
Historically, Americans have been staunch supporters of the
federal government’s tax efforts. The rate of participation and
compliance is one of the highest in the world. Realistically, the
impact of estimating withholding provisions and the threat of
government audits have aided in the outstanding record of the
Internal Revenue Service.
Individual Income Taxes
Presently the United States government taxes income, transfers,
and several transaction-type items (excise, customs, etc.). The
major source of revenues is the tax on individuals (see Table 2).
In 2018, individuals contributed 52.45 percent of the gross
internal revenue collected. Since 1943, the U.S. has been on a
pay-asyou-go system. Income taxes withheld by employers
increased from $1.87 trillion in 2017 to $1.97 trillion in 2018.
In 2018, 122 million individual taxpayers received a tax refund

which totaled almost $395 billion.
Corporate Income Taxes
Corporate income taxes accounted for 6.75 percent of the total
revenue collected by the U.S. government in 2018. The Tax
Reform Act of 1986 reduced the top corporate income tax rate
from 46 percent to 34 percent. The Revenue Reconciliation Act
of 1993 raised the corporate income tax rate to 35 percent. The
American Jobs Creation Act of 2004 created many business
incentives. The corporate tax rate has changed from 1 percent in
1913 to a high of 52 percent between 1952 and 1962. The Tax
Cuts and Jobs Act reduced the corporate rate from 35 percent to
a flat 21 percent. Generally, corporations are subject to tax
based on net income without regard to dividends distributed to
their shareholders.
Estate and Gift Taxes
Estate and gift taxes accounted for only 0.76 percent of the total
revenue collected by the government in 2018. The estate tax, as
we know it today, was enacted on September 8, 1916, and is
levied on the transfer of property. The gift tax was originally
enacted in 1924, was repealed in 1926, and then was restored in
1932.
Excise and Customs Taxes
Excise and customs taxes are levied on transactions, not on
income or wealth. Examples of excise taxes are the taxes on
alcohol, tobacco, and gasoline. The government collects the tax,
usually at an early stage of production. In 2018, 2.41 percent of
the government’s revenue, or $72.4 billion, came from excise
taxes.
Customs taxes are levied on certain goods entering the country.
There are several reasons why the government levies this tax
but by far the most important reason is the protection of U.S.
industry from foreign competition.
State and Local Taxes
Just as the federal government needs an ever-increasing amount
of dollars to satisfy its requirements, so do the states and local
communities. State and local taxes are also big business. The

major source of revenue for state governments is the income tax
and the sales tax. For local communities, the property tax is a
major source of revenue. Approximately 31.1% of state
revenues are generated by the property tax. State governments
raised $1,409.6 billion in 2018, up from $1,360.3 billion in
2017. California collected the most in state taxes followed by
New York and Texas.
Value-Added Tax
The value-added tax (VAT) is of fairly recent origin and much
more popular overseas than in the United States. The concept of
a VAT was first proposed by a German industrialist and
government consultant, Dr. Wilhelm von Siemens, in 1918. In
the next three decades much discussion took place. France was
the first major country to adopt the VAT. In 1919, France
instituted a general sales tax. This stayed in place until 1948,
when it was replaced with a tax on production at each stage of
the manufacturing process.
There are many forms of taxation, but basically all taxes can be
categorized as direct taxes or indirect taxes. The federal income
tax on individuals and corporations is a direct tax. Indirect
taxes are those levied on producers or distributors with the
expectation that these taxes will be passed on to the ultimate
consumer. The VAT is an example of an indirect tax. It is
merely a sales tax assessed at any or all levels of production
and distribution. It is applied only on the value added to the
product in an early stage of production or distribution. Notice
that the VAT is a tax on products, not on business entities. The
major drawback of the VAT is that it is extremely regressive.
EXAMPLE 1.1
A sweater is produced at a cost of $10. If the VAT is 5 percent,
then each taxpayer, regardless of income level or ability to pay,
must pay the fifty cents for VAT.
The VAT continues to be discussed as an attractive source of
revenue in the United States. Each 1 percent of VAT would be
expected to raise $12 billion. Even with the exclusions for food
and medicine, $7.6 billion would be raised per percentage point

of tax. Despite these attractions, the VAT worries many
Americans. First, it is a very regressive tax. Second, there is
some concern that ultimately the VAT will partially replace the
personal income tax. Proponents of the VAT, however, maintain
that its use would help shrink the “tax gap” (discussed
at ¶1121). That is, the element of the population not currently
paying taxes would have to pay a VAT tax, since it is a layered
sales tax.
Flat Tax
The past several years have seen heated discussions about using
a flat tax. Proponents of a flat tax point to the lower cost of
administration and the ease of preparation by Americans as the
major benefits. A flat tax would take an individual’s total
income minus an allowance for family size and apply one tax
rate. This rate would apply to all individuals. There would be no
deductions.
Various senators and representatives have presented proposals
for consideration. A flat tax has been proposed composed of two
tax forms—one for individuals and one for businesses. Their
proposal would tax individuals on total income minus an
allowance based on family size and then apply a 17 percent tax
rate. For businesses, the tax rate would be the same 17 percent,
but it would be applied against the firm’s gross revenue minus
costs of purchases, wages, salaries, capital equipment,
structures, land, and pensions. To date, none of these propos als
has been successful.
Fair Tax
The Fair Tax is a consumption tax. The proponents of the fair
tax would replace the Internal Revenue Code with a
consumption tax. In many respects it would resemble the sales
tax that many states now collect. Proponents suggest that low
income individuals would receive a rebate from the government
as a way to reduce the regressive nature of the tax.
KEYSTONE PROBLEM
The federal government currently uses many forms of taxation,
both direct and indirect, to raise revenue. Would it not be more

effective and less burdensome just to employ a single tax? What
would you consider to be a more effective and efficient system
of raising revenue?
¶1121
TAX COLLECTION AND PENALTIES
Returns
The Internal Revenue Service processed over 250 million
federal tax returns and supplementary documents in 2018—a
slight increase from 2017. This is in comparison to 143 million
tax returns processed in 1980. It collected $3.0 trillion in 2018,
slightly more than it collected in 2017. Taxes and tax
collections are indeed big business. Table 1, derived from the
1980 Annual Report of the Commissioner of the Internal
Revenue Service and the 2018 Internal Revenue Service Data
Book, details the magnitude of work required to support our
government. Approximately 61 percent of all returns are filed
by individuals. In 2018, individuals filed 152.9 million returns,
for a total of approximately $1.57 trillion. In 2018, corporate
collections decreased to $202.7 billion.
Table 1. NUMBER OF RETURNS FILED BY PRINCIPAL
TYPE OF RETURN
(Figures in Thousands)
Increase or Decrease Between 1980 and 2018
Type of Return
1980
2017
2018
Amount
Percent
Grand Total
143,446
245,412

250,321
106,875
74.51
Income tax, total
107,827
187,407
190,613
82,786
76.78
Individual
93,143
150,691
152,938
59,795
64.20
Declaration of estimated tax
8,699
22,230
22,387
13,688
157.35
Fiduciary
1,877
4,046
4,239
2,362
125.84
Estate and Trust
1,390
2,995
3,097
1,707
122.81
Corporation
2,718
6,893

7,256
4,538
166.96
Estate tax
148
34
34
-114
(77.03)
Gift tax
216
245
246
30
13.89
Employment tax
26,499
30,680
30,943
4,444
16.77
Exempt organizations
444
1,528
1,603
1,159
261.04
Excise tax
909
1,018
1,049
140
15.40
Supplemental documents
6,064
22,275

25,833
19,769
326.01
Sources: 1980 Annual Report of the Commissioner of the
Internal Revenue Service and Internal Revenue Service Data
Books 2017 and 2018.
Tax Collections
Tax collections have increased dramatically between 1980 and
2018. This was due in part to the growth in the economy. Table
2 gives data on tax collections from 1980, 2017, and 2018.
Obviously, the increase in tax collections from 1980 to 2018 is
staggering—$2,482,206,627,000. Now, notice the detail.
Corporate taxes have increased 179.99 percent between 1980
and 2018, while individual income taxes have increased 447.5
percent. Estate and gift taxes have increased 253 percent in the
same period. Keep these figures in mind as you read the
chapters that follow.
Just as the dollar amounts have increased in tax collections, so
has the number of returns filed. From 1980 to 2018, the number
of corporate income tax returns increased by 166.96 percent.
During the same time period, the number of individual income
tax returns increased by 64.2 percent. The number of
individuals requesting an individual income tax refund
decreased slightly in 2018 to 122.2 million.
Table 2. GROSS INTERNAL REVENUE COLLECTIONS (net
of refunds)
(Figures in Thousands)
Source
Percent of 2018 Collections
1980
2017
2018
Increase or Decrease Between 1980 and 2018

Amount
Percent
Grand total
100.00
519,375,273
2,979,742,266
3,001,581,900
2,482,206,627
477.92
Income taxes, total
59.20
359,927,392
1,775,102,989
1,776,891,763
1,416,964,371
393.68
Corporation
6.75
72,379,610
293,634,315
202,652,958
130,273,348
179.99
Individual
52.45
287,547,782
1,481,468,674
1,574,238,805
1,286,691,023
447.47
Employment taxes, total
37.62
128,330,480
1,061,451,074

1,129,344,468
1,001,013,988
780.03
Old-age, survivors, disability, and hospital insurance
37.13
122,486,499
1,047,371,143
1,114,343,147
991,856,648
809.77
Unemployment insurance
0.29
3,309,000
8,124,886
8,681,693
5,372,693
162.37
Railroad retirement
0.21
2,534,981
5,955,045
6,319,628
3,784,647
149.30
Estate and gift taxes, total
0.76
6,498,381
22,732,968
22,943,348
16,444,967
253.06
Excise taxes, total
2.41
24,619,021
61,856,711
72,402,321

47,783,300
194.09
Books 2017 and 2018.
Tax Audits and Penalties
The U.S. tax system is a voluntary compliance tax system. The
total number of federal tax returns filed in 2018 was
250,321,000 of which 152,938,000 were filed by individual
taxpayers. The IRS conducted examinations of 991,168 returns,
and on the basis of these examinations, it recommended
additional tax and penalties of almost $26.5 billion.
Although audits of individual returns made up the bulk of the
examinations (892,187 returns), they resulted in only $9.05
billion of the total recommended collections, while audits of
corporate returns yielded $14.38 billion. Of course, audits do
not always favor the IRS, as evidenced by the fact that, of the
individual returns examined, almost 30,000 resulted in
additional refunds; this amount was down from 34,000 in 2017.
Until recently, there had been an upsurge in the number of
taxpayers who illegally sought, either openly or covertly, to
reduce or eliminate their tax obligation. However, the IRS has
responded to the challenge by taking advantage of the
developing computer technology. Computers already scrutinize
tax returns, check errors, and perform a number of routine,
repetitive tasks with speed, efficiency, and great accuracy. The
IRS continues to match almost all information returns that
businesses are required to submit on magnetic media to verify
that correct amounts are reported on taxpayers’ returns.
Information returns include W-2 Forms listing salary and 1099
Forms listing other income.
In 2018, the IRS audited almost one million individual income
tax returns or 0.6 percent of all individual tax returns. The
percentage of returns audited was the same as the previous
year. Table 3 presents information on the percentage of returns
audited by type of return.

For years, the audit rate for individual returns had been
declining. For fiscal year 2018, the audit rate for individual
returns was 0.6 percent. In FY 1997 it was 1.28 percent, and in
FY 1995 it was 1.67 percent.
Table 3. PERCENTAGE OF RETURNS AUDITED
Type of Return
Percentage Audited
2017
2018
Individual
0.6
0.6
Partnership
0.4
0.2
Corporation
1.0
0.9
Estate
8.2
8.6
Gift
0.8
0.9
Excise
1.4
1.3
Employment
0.2
0.1
Sources: Internal Revenue Service Data Books 2017 and 2018.
Because of severe budget deficits during the late 1980s and
1990s, the personnel needed to audit the growing number of
returns filed have not been added. A major reason for the
decline in audit rates has been staff reduction at the IRS and the

movement of IRS personnel to focus on customer service. Since
the late 1980’s, staff in the examinations division was reduced
by over 30 percent. Table 4 graphically depicts the percentage
of returns audited by the Internal Revenue Service. The IRS
budget in FY 2018 was $11.7 billion. This is up from FY 2017
when it was $11.5 billion.
Table 4. PERCENTAGE OF RETURNS AUDITED—1980—
2018
Book 2018.
Naturally, for certain types of taxpayers and those with higher
incomes, the probability of audit is much greater. Individuals
with income of over $100,000 were most likely to be audited.
The Internal Revenue Service has acknowledged that the
problem of tax evasion is indeed a serious one. The “tax gap,”
that is, the total revenue lost through tax evasion, has increased
from $81 billion in 1981 to $345 billion in 2001 and to $450
billion in 2006. IRS officials estimate that enforcement
activities along with late payments have recovered $65 billion
of the tax gap for 2006 resulting in a net tax gap in 2006 of
$385 billion. The IRS updated the study and the average annual
tax gap for 2008–2010 was $458 million. Enforcement activities
recovered $52 billion for a net annual tax gap of $406 billion.
In September 2019 the IRS released a new set of data for tax
years 2011, 2012, and 2013. The net result is that the tax gap
has remained substantially unchanged. The IRS estimated that
61 percent of the tax gap was caused by individuals and the
remainder by corporations. Today, the voluntary compliance
rate is estimated by the Commissioner of Internal Revenue to be
83 to 85 percent. Each percentage point of noncompliance costs
the government $26 billion in lost revenue.
The Tax Reform Act of 1986 closed many of the loopholes
associated with tax shelters. Since 1988 the IRS has been using
a revised audit-selection formula that is aimed at high-income

returns. Further, the Tax Acts of 1986 and 1987, the Technical
and Miscellaneous Revenue Act of 1988, and the Revenue
Reconciliation Acts of 1989, 1990, and 1993 changed the
penalties imposed on taxpayers for not complying with the tax
laws.
The Improved Penalty and Compliance Act, which was
incorporated into the Revenue Reconciliation Act of 1989,
revamped the civil tax penalty provisions of the Internal
Revenue Code. The goal was to create a fairer, less complex,
and more effective penalty system. The Act made changes in the
following broad areas:
1. Document and information return penalties
2. Accuracy-related penalties
3. Preparer, promoter, and protestor penalties
4. Penalties for failures to file or pay tax
¶1131
TAXPAYER OBLIGATIONS
Tax accountants, lawyers, and businesspersons, since the
inception of the first federal income tax law, have concerned
themselves with choosing among the various forms a transaction
may take. There is an acute awareness among tax accountants
that tax consequences of an action may differ depending upon
procedural variations and alternative approaches to a business
decision. The increasing complexity of the modern tax laws
serves only to accentuate the problem.
Because of the extreme difficulty experienced in trying to
differentiate between tax avoidance and tax evasion, Congress
enacted, in the 1954 Internal Revenue Code, a provision which
illustrates circumstances that constitute prima facie evidence of
the tainted purpose. The 1986 Code contends with the problem
of criminal tax evasion in Section 7201, entitled “Attempt to
Evade or Defeat Tax.” It reads:
Any person who willfully attempts in any manner to evade or
defeat any tax imposed by this title or the payment thereof
shall, in addition to other penalties provided by law, be guilty
of a felony and, upon conviction thereof, shall be fined not

more than $100,000 ($500,000 in the case of a corporation), or
imprisoned not more than five years, or both, together with the
costs of prosecution.
The goal of every businessperson should be profit
maximization. The government endorses this goal. Tax
avoidance is legal and a legitimate pursuit of a business entity.
Tax Avoidance
All citizens have the prerogative to arrange their transactions
and affairs in such a manner as to reduce their tax liabilities. A
good businessperson is obligated to search out those
transactions and to time those events which will lower the tax
liability. Judge Learned Hand, in S.R. Newman, declared many
years ago:
Over and over again courts have said that there is nothing
sinister in so arranging one’s affairs as to keep taxes as low as
possible. Everybody does so, rich or poor; and all do right, for
nobody owes any public duty to pay more than the law
demands: taxes are enforced extractions, not voluntary
contributions. To demand more in the name of morals is mere
cant. CA-2, 47-1 USTC ¶9175, 159 F.2d 848.
There is a clear demarcation between tax avoidance and tax
evasion. The saving of tax dollars requires specific actions so as
to avoid the tax liability prior to the time it would have
occurred according to law. It requires the proper handling of
affairs so that items of income are subjected to a lower tax rate
than would apply if no action had been taken. In some
instances, it requires the postponing of income which is subject
to taxation until a time when the individual’s tax bracket would
be lower.
Tax Evasion
To be guilty of evading taxes, the individual must already have
a tax liability. All actions must be definitely complete, and in
spite of this liability, the taxpayer does not report income. The
courts have ruled that it is not wrong to find a form of a
transaction that does not lead to any tax liability. However,
there is a legal obligation to disclose a tax liability based on

completed transactions, and the refusal to report the tax liability
is illegal.
The Tax Court in Berland’s Inc. of South Bend (16 TC 182,
acq., 1951-2 CB 1, Dec. 18,057) said that the purpose of tax
evasion must be the “principal” purpose, and the taxpayer is not
guilty of tax evasion merely because the tax consequences of
the particular transaction are considered. Furthermore, the Tax
Court said:
The consideration of the tax aspects of the plan was no more
than should be expected of any business bent on survival under
the tax rates then current. Such consideration is only part of
ordinary business prudence.
What frequently distinguishes tax avoidance from tax evasion is
the intent of the taxpayer. The intent to evade tax occurs when a
taxpayer knowingly misrepresents the facts. Intent is a mental
process, a state of mind. A taxpayer’s intent is judged by his or
her actions. The taxpayer who knowingly understates income
leaves evidence in the form of identifying earmarks, referred to
as “badges” of fraud. Internal revenue agents are on the lookout
for these badges of fraud. The more common badges are:
1. Understatement of income. The IRS considers the failure to
report entire sources of income, such as tips, or specific items
where similar items are included in income, such as dividends
received, as an indication that there may have been an
understatement of income. Other such indications include the
unexplained failure to report substantial amounts of income
determined by the IRS to have been received, the concealment
of bank accounts or other property, and the failure to deposit
receipts to a business account contrary to normal practices.
2. Claiming of fictitious or improper deductions. To the IRS, a
substantial overstatement of deductions is a badge of fraud that
could warrant a further look at the taxpayer’s books. Other
indications of improper deductions are the inclusion of
obviously unallowable items in unrelated accounts and the
claiming of fictitious deductions or dependency deductions for
nonexistent, deceased, or self-supporting persons.

3. Accounting irregularities. Accounting practices that are
considered a badge of fraud include the keeping of two sets of
books or no books, false entries, backdated or postdated
documents, inadequate records, and discrepancies between book
and return amounts.
4. Allocation of income. The distribution of profits to fictitious
partners and the inclusion of income or deductions in the return
of a related taxpayer with a lower tax rate than that of the
taxpayer are indications of an intentional misstatement of
taxable income.
5. Acts and conduct of the taxpayer. Aside from the improper
reporting of income or deductions, a taxpayer’s conduct can
give the IRS reason to question the propriety of a return. For
example, false statements, attempts to hinder an examination of
a return, the destruction of books or records, the transfer of
assets for purposes of concealment, or the consistent
underreporting of income over a period of years are badges of
fraud.
The presence of one or more of these badges of fraud does not
in itself mean that the return is fraudulent. However, it should
alert an examiner that additional probing and inquiry are
necessary. Internal Revenue Manual, Sec. 4.10.
Corporate Tax Avoidance
Normally, the Commissioner and the courts accept a corporation
as being distinct from its shareholders. However, if it appears
that a sham transaction has taken place, then the Commissioner
has grounds for taking action. Judge Learned Hand, in
summarizing many cases on the subject of tax avoidance v. tax
evasion, stated in National Investors Corp. v. Hoey:
To be a separate jural person for purposes of taxation, a
corporation must engage in some industrial, commercial, or
other activity besides avoiding taxation: in other words, that the
term “corporation” will be interpreted to mean a corporation
which does some “business” in the ordinary meaning; and that
escaping taxation is not “business” in the ordinary meaning. 44-
2 USTC ¶9407, 144 F.2d 466, 467-68 (CA-2 1944).

Section 269 of the Internal Revenue Code provides the
Commissioner with a very important tool in judging whether or
not a corporate acquisition is tax avoidance or merely a sham. If
the Commissioner feels that there is no principal purpose for the
tax-free acquisition, “such deduction, credit, or other
allowance” may be disallowed. The key defense by the taxpayer
is to substantiate that there was indeed a “principal purpose.” If
there is a principal purpose, nothing stops the taxpayer fr om
having other purposes, such as the saving of taxes. Kershaw
Mfg. Co., Inc., 24 TCM 228, TC Memo. 1965-44, Dec.
27,268(M).
Taxpayer’s Assessment of Tax Liability
In order to decrease potential tax liability, the taxpayer must
choose the action that will allow the greatest tax savings. An
example of a tax savings device is investment in municipal
bonds instead of corporate bonds. The interest derived from
corporate bonds is taxable income, whereas the interest received
from municipal bonds is tax free. In the above example, the
taxpayer does not have to hide the fact that there is a lower tax
liability on the profit.
When contemplating a transaction, the taxpayer makes an
assessment of the tax liability. Naturally, any doubtful issues
are resolved in the taxpayer’s own favor. Certainly, there is
nothing fraudulent about using this procedure. On the other
hand, if the taxpayer knowingly overstates expenses, thereby
reducing the tax liability, then the taxpayer is guilty of tax
evasion.
¶1151
BRIEF HISTORY OF THE FEDERAL INCOME TAX
The origin of taxation in the United States dates back to the
Constitution and, therefore, the Constitution is the ultimate
source of the power to tax. Originally, the Constitution
empowered Congress “to lay and collect taxes, duties, imports
and excises, to pay the debts and provide for the common
defense and general welfare of the United States.” In granting
this power, Congress also limited the power of taxation in that

“all duties, imports, and excises shall be uniform throughout the
United States, that direct taxes should be laid in proportion to
the population.” It was within these confinements that many
cases tested the constitutionality of the early tax laws—a test
many of the taxes did not pass. During the late 1800s, the terms
“uniform” and “direct taxes” were very important concepts.
Income Tax Law of 1894
In the late 1880s, support was mounting at the state level for an
income tax. In Ohio, the State Democratic Convention approved
a graduated income tax in the summer of 1891. Reflecting on
the mood of the country at that time, William Jennings Bryan
supported an income tax as preferential to a tax on tobacco and
beer which he felt would put an unfair hardship on the poor.
Although this proposed tax and others like it were never passed,
they encouraged others to investigate the possibilities of a
federal income tax. Ultimately this led to the actual passage of
the Wilson Tariff Bill of 1894. This bill was not an income tax
bill; however, an amendment was attached to the bill which
allowed for an income tax. The provisions of this income tax
law stated that the tax would commence on January 1, 1895, and
continue until January 1, 1900. It was a 2 percent tax on all
“gains, profits, and income” over $4,000 “derived from any kind
of property, rents, interest, dividends, or salaries, or from any
profession, trade, employment, or vocation.” Income was
defined to include interest on all securities except federal bonds
which were exempt by law of their issuance from any federal
taxation. The Act also imposed a 2 percent tax on net profits of
corporations but not on partnerships.
There was much criticism of this law. Concerns arose that
provisions such as the $4,000 exemption made the law
discriminatory against certain groups. Consequently, many
cases were brought before the courts. The major point raised by
opponents of the Act was whether or not such a tax on income
derived from property was a “direct tax” in the sense commonly
understood in the Constitution. A direct tax was held to be a tax
on the land and, therefore, had to be apportioned among the

states.
The Supreme Court declared the law unconstitutional in the
famous Pollock v. Farmers’ Loan & Trust Co. case, 157 U.S.
429, 15 S.Ct. 673 (1895). It characterized the income tax as a
“direct tax” and stated that the Constitution provides that “no
direct tax shall be laid, unless in proportion to the census or
enumeration hereinbefore directed to be taken.” Therefore, the
Court invalidated a significant portion of the law and rendered
income tax apportionment impossible. Further, the Court
considered the property tax a direct tax and excise and duties
taxes as indirect taxes. The Court stated, in a five-to-four
decision, that a tax on real estate and on personal property is a
direct tax and, therefore:
unconstitutional and void, because not apportioned according to
representation, all these sections constituting one entire scheme
of taxation, are necessarily invalid.
The Court expressed, in one of its longest opinions, no opinion
on whether or not the income tax provisions were
unconstitutional. Thus, with this decision, the first federal
income tax law since the Civil War in the United States was
declared to be unconstitutional.
Corporation Excise Tax of 1909
Support for an income tax was growing even though the courts
had voided all attempts made by Congress. Government was
becoming more costly and new sources of revenue were
essential. The Spanish American War produced a great need for
funds, and many believed that an income tax was the only
solution. In the Pollock decision, the Supreme Court voted five
to four that the tax was unconstitutional. By late 1908, it was
abundantly clear that only by passage of a constitutional
amendment would the government receive the power needed to
impose a federal income tax. Therefore, an amendment was
passed by Congress in 1909. However, because of the length of
time required to ratify a constitutional amendment, Congress
simultaneously passed the Corporation Excise Tax of 1909. The
Supreme Court had ruled in the Pollock case that an “excise

tax” was not required to be apportioned. Further, the Court
indicated in several cases that an income tax on corporations
would be upheld if it were deemed an excise tax levied on
corporations for the privilege of carrying on or doing business
as a corporation, granted the amount of tax due was based upon
the net income of the corporation.
The Tax Act of 1909 was the first Act to be upheld by the
courts that taxed corporate profits. Prior to this time, corporate
profits were tax free except for a short period of time during the
Civil War. The 1909 Act provided that corporations would pay
an annual special excise tax. This tax amounted to 1 percent on
net income over $5,000 exclusive of dividends from other
corporations.
As can be imagined, many influential people objected to the
1909 Act. By 1910, fifteen cases challenging the Act had
reached the Supreme Court. In a unanimous decision, the
Supreme Court upheld that the Tax Act of 1909 was not a direct
tax, but an indirect tax and “an excise upon the particular
privilege of doing business as a corporate entity.”
The Revenue Act of 1909 was a tax for the privilege of doing
business as a corporation, even though the assessment was on
the net income of the corporation. A unani mous Supreme Court
upheld the law in Flint v. Stone Tracy Co., 220 U.S. 107, 31
S.Ct. 342 (1911).
When examining the differences between the 1895 law which
was held to be unconstitutional and the 1909 law which was
upheld as constitutional, the difference is indeed in only a few
words, changing a tax upon income to a tax measured by
income. Justice Day wrote the opinion for the Supreme Court
and stated that the difference was “not merely nominal, but rests
upon substantial difference between the mere ownership of
property and the actual doing of business in a certain way.”
Sixteenth Amendment and the Revenue Act of 1913
Taxation laws as we know them today derive their authority
from the Sixteenth Amendment as passed by Congress on July
12, 1909. The amendment stated:

The Congress shall have power to lay and collect taxes on
incomes, from whatever source derived, without apportionment
among the several States, and without regard to any census or
enumeration.
Alabama became the first state to ratify the amendme nt in the
same year that it was passed—1909. On February 25, 1913, the
final vote for ratification was received.
Congress now was given the clear authority to enact a tax on
income from whatever source derived. Taxes could be either
direct or indirect and could be imposed without regard to any
census or enumeration.
On October 3, 1913, pursuant to the power granted by the
Sixteenth Amendment, Congress enacted the Revenue Act of
1913 which imposed a tax on the net income of individuals and
corporations. The Revenue Act of 1913 was retroactive to
March 1, 1913. This date is important for tax purposes because
this is the date which is sometimes used as a basis for
computing gains and losses. Simultaneous to the enactment of
the Revenue Act, the Corporation Excise Tax was repealed.
The Revenue Act of 1913 serves as the basis for the income tax
laws of the United States. However, it would never have been
passed without its two precedents, the Income Tax Law of 1894
and the Corporation Excise Tax of 1909. These two laws laid
the foundation and framework for an income tax. The Supreme
Court ruling in the Pollock case made it mandatory that an
amendment to the Constitution be passed to allow for a direct
tax on income.
1913 to Date
Following the passage of the Sixteenth Amendment, there have
been many changes in the tax law. Many of the more important
changes in our federal taxing system are outlined below. Some
of the data for 1916–1962 came from World Tax Series:
Taxation in the United States, CCH (Commerce Clearing
House), 1963, pp. 117–118.
1913
The Revenue Act of 1913—Normal tax and surtax approved.

Personal exemptions established.
1916
The Revenue Act of 1916—Established the estate tax.
1917
Charitable contributions granted tax deductible status. Federal
income taxes were disallowed as a tax deduction. Credit for
dependents allowed for first time.
1918
Tax preferences and exemptions established. Tax credit was
granted for foreign income taxes paid. Carryforward provisions
adopted for net operating losses. Depletion deductions for mines
and oil and gas wells were instituted. Tax-free corporate
mergers and other reorganizations permitted.
1921
Capital gains rates established. Profit-sharing and pension trusts
exempted from tax.
1924
Gift tax enacted to prevent avoidance of the estate tax.
1926
January 1, 1926—Gift tax repealed.
1932
Gift tax restored in more effective form.
1934
The personal exemption and exemption for dependents were
made deductible in determining net income for the purpose of
surtax as well as normal tax.
1935
Federal Social Security Act enacted.
1936
Mutual investment companies allowed deduction for dividends
distributed by them.
1938
LIFO adopted as an acceptable inventory method.
1939
Internal Revenue Code of 1939—Set out to codify separately
the Internal Revenue laws.

1942
Net operating losses were allowed to be carried back.
Provisions were made or changed for medical expenses,
alimony, capital gains, and a standard deduction in lieu of
itemized deductions.
1943
Current Tax Payment Act—Pay-as-you-go system adopted.
1948
Marital deduction originated for estate and gift tax. Split-
income treatment approved for married couples.
1950
Self-employment tax enacted.
1954
Internal Revenue Code of 1954—Successor to the 1939 Code.
Completely overhauled federal tax laws. Largest piece of
federal legislation enacted to date. Broad changes were made in
an attempt to codify income, estate, gift, and excise tax laws
along with administration and procedure rules into one
document.
1962
The Revenue Act of 1962—Granted a tax credit of 7 percent for
investment in Section 38 Property. Further, the concept of
“depreciation recapture” was introduced.
1964
The Revenue Act of 1964—Intended to stimulate sagging
economy. Largest corporate and individual tax rate reduction
since the Act of 1913.
The Act extended depreciation recapture to business realty.
Foreign investment income subjected to increased taxation.
1966
The Tax Adjustment Act of 1966—Suspended the 7 percent
investment credit. It was reinstituted six months later.
Graduated withholding replaced flat-rate. Corporations required
to pay estimated tax more quickly.
1969
The Tax Reform Act of 1969—Investments in commercial and

industrial buildings were significantly affected when
depreciation allowances were reduced and the recapture rules
changed. Investment tax credit repealed.
1971
The Revenue Act of 1971—Restored investment credit at 7
percent.
1974
Employee Retirement Income Security Act of 1974 (ERISA)—
Major changes to the entire private pension system.
1975
The Tax Reduction Act of 1975—Reduced taxes for both
individuals and corporations. Changed the investment tax credit
from seven to 10 percent for a two-year period.
1976
The Tax Reform Act of 1976—Established at-risk rules for tax
shelters and eliminated many tax shelters. Also, the Act made
extensive changes in the treatment of foreign income.
1977
The Tax Reduction and Simplification Act of 1977—Attempted
to simplify the system. Established zero-bracket amount
exemption deductions.
1978
The Revenue Act of 1978—Revised corporate rate structures.
New structure taxes the first $100,000 of income on a graduated
scale, ranging from 17 to 40 percent, and at a 46 percent rate on
all taxable income over $100,000. The Act made the 10 percent
investment credit permanent.
The Act also made changes to capital gains, tax shelter rules,
employee benefits, and estate and gift taxes.
1978
The Energy Tax Act of 1978—Instituted a tax credit for
residential energy savings.
1980
The Bankruptcy Act of 1980—Added a seventh type of tax-free
reorganization, the “G” type. Clarified rules for tax treatment of
bad debts.

1980
The Windfall Profit Tax Act—Excise tax levied on domestic oil.
1980
The Installment Sales Revision Act of 1980—Revised
installment sales rules.
1981
Economic Recovery Tax Act (ERTA)—Largest tax cut bill ever
passed. Top individual tax rates decreased from 70 to 50
percent. All property placed in service after December 31, 1980,
eligible for the Accelerated Cost Recovery System (ACRS).
Increased allowable contributions to Keoghs, SEPs, and other
retirement systems. Permitted two-earner married couples a
deduction to reduce the inequity of the “marriage penalty.”
Extended the investment credit to include a wider array of
investments.
1982
Tax Equity and Fiscal Responsibility Act (TEFRA)—Largest
revenue-raising bill ever passed. Tightened up on itemized
deductions. New rules on partial liquidations and for the
taxation of distributed appreciated property. Tightened up
pension rules. Corporate deductions for certain tax preferences
cut by 15 percent. Required that basis of depreciated property
must be reduced by 50 percent of investment credit. ACRS
modified for 1985 and 1986 and Federal Unemployment Tax Act
(FUTA) notes increased.
1982
Technical Corrections Act of 1982—Made changes to: ACRS,
the investment credit, targeted jobs credit, the credit for
research costs, and incentive stock options. Made changes to the
Windfall Profit Tax Act.
1982
Subchapter S Revision Act of 1982—Enacted many new
provisions for S corporations.
1983
Social Security Act Amendments of 1983—Bailed out the Social
Security System.

1984
Deficit Reduction Act of 1984—Composed of two parts: first,
the Tax Reform Act of 1984 and second, the Spending
Reduction Act of 1984. The Tax Reform Act of 1984 provided
for reducing the holding period on capital gains from more than
one year to more than six months, extending the ACRS recovery
period for 15-year real property to 18 years, taxing interest-free
loans between family members, and drastically slashing the
income-averaging provisions.
1986
The Tax Reform Act of 1986—The most significant and
complex tax revision in the history of this country. The scope of
the changes was so comprehensive that the tax law was
redesignated the Internal Revenue Code of 1986.
1987
Revenue Act of 1987—Focused primarily on business tax rules.
Areas affected included accounting for long-term contracts,
limitations on the use of the installment method, application of
corporate tax rates to master limited partnerships, and changes
in the estimated tax rules for corporations. The Act postponed
for five years the reduction to 50 percent of the top estate and
gift tax rate.
1988
Family Support Act of 1988—Provided for major reform in the
area of modifying the principal welfare program, Aid to
Families with Dependent Children (AFDC). Also included in the
Act was the modification of employee business expense
reimbursement rules. Beginning in 1989 additional amounts will
have to be deducted as miscellaneous itemized deductions.
1988
Technical and Miscellaneous Revenue Act of 1988—TAMRA
contained a number of substantive provisions. Included in the
Act were the taxpayer’s bill of rights, limitations on the
completed-contract accounting method, and extension of the
exclusions for employee-provided educational assistance and
the business energy credits.

1989
P.L. 101-140. Repealed Code Sec. 89. The nondiscrimination
and qualification rules for employee benefit plans were
repealed. Prior law nondiscrimination rules were reinstated.
1989
Medicare Catastrophic Coverage Repeal Act of 1989—Repealed
the medicare surtax retroactively.
1989
Revenue Reconciliation Act of 1989—The Act achieved a
deficit reduction of about $17.8 billion and accelerated the rate
of collection of withholding and payroll tax. The Act also
changed the partial interest exclusion on ESOPs. Modifications
were also made to the like-kind exchange rules.
1990
Revenue Reconciliation Act of 1990—The Act contained a
number of significant changes, including a deficit reduction of
about $40 billion in 1991. The Act also increased from two to
three the number of statutory rates, 15 percent, 28 percent, and
31 percent. Also, a maximum capital gain rate of 28 percent was
established.
1991
Tax Extension Act of 1991—The Act extended, for six months
only, 11 tax provisions that were to expire on December 31,
1991.
1992
Energy Policy Act of 1992—The Act greatly increased the
amount of employer-provided transportation benefits excludable
by employees.
1993
Revenue Reconciliation Act of 1993—The Act raised the tax
rates for high-income earners. Changes also were made to the
AMT, passive losses, and Section 179. Corporate tax rates
increased by 1 percent.
1994
Social Security Domestic Employment Reform Act of 1994—
The Act raised the threshold for paying Social Security and

federal unemployment taxes on domestic workers from $50 per
quarter to $1,000 annually, retroactive to the beginning of 1994.
1994
General Agreement on Tariffs and Trade (GATT)—To offset the
loss of revenue from the reduction in tariffs, Congress passed
several tax and revenue provisions. The major revenue items
were: estimated tax treatment for Code Sec. 936 and subpart F
income; increased premiums for employers with underfunded
pension plans; and reduced interest rates on large corporate tax
refunds.
1996
Taxpayer Bill of Rights 2—The Act included more than 40
separate provisions, many of which provided useful tools for tax
practitioners representing clients before the IRS.
1996
Small Business Job Protection Act—The major portion of tax
law changes passed in 1996 was contained in this Act. It also
contained many technical corrections. The balance of the Act
was divided into four major categories: small business
provisions, S corporation reform, pension simplification, and
revenue-raising offsets.
1996
Health Insurance Portability and Accountability Act—The focus
of this Act was on portability of health insurance. However, this
Act contained tax provisions that focus on a variety of health-
related issues, as well as several revenue-raising provisions
unrelated to health care.
1996
Personal Responsibility and Work Opportunity Reconciliation
Act—The tax impact of this Act was primarily limited to the
earned income tax credit.
1997
Taxpayer Relief Act of 1997—The Act provided significant tax
cuts for many taxpayers. Major features included a reduction in
capital gains tax rates, expanded IRAs, educational tax
incentives, estate tax relief, and a child tax credit.

1998
IRS Restructuring and Reform Act of 1998—The major intent of
the Act was to rein in the Internal Revenue Service. Two of the
most important provisions of the Act dealt with changing the
holding period for a capital asset to be classified as long-term
so as to receive the most favored capital gain rate from more
than 18 months down to more than 12 months. The second
important area of the Act was the “technical corrections”
section, which clarified many of the key provisions in the
Taxpayer Relief Act of 1997. There were over seventy technical
corrections contained in the Act.
1998
Tax and Trade Relief Extension Act of 1998—This Act included
extensions of several expiring tax credits through June 30,
2000. The major extensions provided for in this legislation
include the research tax credit, the work opportunity credit, and
the welfare-to-work credit.
1999
Tax Relief Extension Act of 1999—This Act extended the time
period for which tax credits and exclusions continued to be
available.
2000
FSC Repeal and Extraterritorial Income Exclusion Act of 2000;
the Consolidated Appropriations Act, 2001; the Installment Tax
Correction Act of 2000—The year 2000 saw the passage of
three important tax bills that contain many provisions impacting
taxpayers. The Community Renewal Tax Relief Act of 2000 was
contained in the Consolidated Appropriations Act, 2000. This
Act renewed provisions designed to enhance investment in low
and moderate-income, rural and urban communities. The Act
also extended for two years medical savings accounts (MSAs).
Also included was a provision expanding innocent spouse relief.
The Installment Tax Correction Act of 2000 reinstated the
availability of the installment method of accounting for accrual
basis taxpayers.
2001

Economic Growth and Tax Relief Reconciliation Act of 2001—
The largest tax cut since 1981. The Economic Growth and Tax
Relief Reconciliation Act of 2001 (P.L. 107-16) was estimated
to provide tax savings of $1.35 trillion over the next 10 years.
The Act contained over 440 Code changes and numerous phase-
in and transitional rules. The wide range of changes primarily
affected individuals, from cuts in marginal income tax rates to
changes in contribution limits for retirement plans.
2002
The Job Creation and Worker Assistance Act of 2002 was
passed in March 2002. This Act contained a number of general
business incentives, special relief for New York City, individual
incentives, extenders, and some technical corrections.
2003
Jobs and Growth Tax Relief Reconciliation Act of 2003—The
third largest tax cut in U.S. history. The purpose of the tax bill
was to jump-start the U.S. economy. The bill contained ten
major provisions. Half of the provisions accelerated tax cuts
originally scheduled not to take effect until 2006.
2004
Working Families Tax Relief Act of 2004—The primary focus
of this $146 billion package was on offering the middle class
tax relief.
2004
American Jobs Creation Act of 2004—The primary focus of this
$145 billion package was on business incentives.
2005
Energy Policy Act of 2005—The $14.5 billion energy package
contained incentives for oil, gas, electric, nuclear and
alternative fuel industries.
2005
The Safe, Accountable, Flexible, Efficient Transportation
Equity Act: A Legacy for Users—This $286.5 billion, six-year,
highway and mass transit bill authorized funds for federal -aid
highways, highway safety programs and transit programs.
2005

The Katrina Emergency Tax Relief Act of 2005 (KETRA)—
Signed into law by President Bush on September 23, 2005.
KETRA provided $6.1 billion in emergency tax relief for
victims of Hurricane Katrina. Another major provision of the
bill was that it provided tax incentives for charitable giving.
2005
Gulf Opportunity Zone Act of 2005—The hurricane relief act is
an $8.6 billion package of tax incentives primarily aimed at the
gulf region. Major provisions included creation of Gulf
Opportunity (GO) Zones, fifty percent bonus depreciation
related to rebuilding in the zones, expansion of Code Sec. 179
expensing for investments in the GO Zone, enhancements of
low-income housing and rehabilitation credits within the zones,
and expanded tax-exempt bond limits within the zones.
2006
Pension Protection Act of 2006—Provided for significant
strengthening of traditional pension plans. Specific focus was
on the funding rules for defined benefit plans and strengthening
the reporting rules for plan administrators. Further, the Act
made permanent the retirement savings enacted under the
Economic Growth and Tax Relief Act of 2001.
2006
Tax Relief and Health Care Act of 2006—The Act extended a
number of provisions including the higher education tuition
deduction, state and local sales tax deduction, welfare to work
tax credit, teacher classroom expenses and tax credits for
research and development.
2007
Small Business and Work Opportunity Tax Act of 2007—
Provided for incentives for small businesses together with an
increase in the federal minimum wage. The Act extended the
work opportunity tax credit through August 31, 2011. Further,
the Act enhanced the Section 179 deduction, extending it
through 2010 and indexing it for inflation.
2007
Mortgage Forgiveness Debt Relief Act of 2007—The Mortgage

Forgiveness Debt Relief Act was a way of giving tax relief for
debt forgiveness on mortgages and continuing the deduction for
mortgage insurance payments.
2008
Economic Stimulus Act of 2008—The Act was designed to jump
start the U.S. economy. The centerpiece of the Act provided for
rebates to individuals reaching as high as $600 and $1,200 for
married couples. Beyond the rebates to individuals, the Act also
provided for $44.8 billion in business incentives. The major
business incentive was the enhanced Code Section 179
expensing. It raised Code Section 179 expensing from $128,000
in 2008 to $250,000 and increased the threshold for reducing
the deduction from $510,000 to $800,000.
2008
Farm and Military Acts of 2008—The Food, Conservation and
Energy Act of 2008 provided benefits to farmers, ranchers and
timber producers. The Military Tax Relief Bill provided
benefits to members of the armed forces who are receiving
combat pay, saving for retirement, or purchasing a new home.
2008
Housing Assistance Act of 2008—This Act provided first-time
homebuyers with a refundable credit of 10% of the purchase of
a new home up to $7,500, subject to certain phase-out rules.
Furthermore, it provided taxpayers who claim the standard
deduction an additional deduction up to $500 or $1,000 on a
joint return for state and local property taxes. It also provided
an increase for low-income housing tax credits.
2008
Emergency Economic Stabilization Act of 2008—The
centerpiece of the legislation was the $700 billion which was
made available to stabilize the economy. The Act also included
AMT (alternative minimum tax) relief along with the extension
of numerous tax provisions that were set to expire.
2009
The American Recovery and Reinvestment Act of 2009—The
$789 billion new law contained nearly $300 billion in tax relief.

Major provisions included: Making Work Pay Credit,
enhancements to the child tax credit, a 2009 Alternative
Minimum Tax (AMT) patch, many energy incentives, and
extension of bonus depreciation and Section 179 expensing.
2009
Worker, Homeownership, and Business Assistance Act of
2009—The major provisions of the Act were that it extended
and expanded the first-time homebuyer credit, it allowed for up
to $2,400 in unemployment benefits to be tax-free in 2009, and
it allowed for enhanced credits for the years 2009 and 2010 for
the earned income credit and the child tax credit.
2010
The Patient Protection and Affordable Care Act—This Act
usually referred to as the Affordable Care Act or "Obamacare"
was signed into law on March 23, 2010. The Act has two parts,
the Patient Protection and Affordable Care Act and the Health
Care and Reconciliation Act. PPACA is a law intended to
ensure that all Americans have access to affordable health care.
2010
The Hiring Incentives to Restore Employment Act—This bill is
referred to as the HIRE Act. The HIRE Act greatly expanded
Code Section 179 expensing, COBRA premium assistance
extended through March 31, 2010, and an employer’s payroll
tax holiday and retention credit for employers hiring workers
who were unemployed.
2010
Small Business Jobs Act of 2010—The bill contained several
important tax provisions. The Act significantly increased the
maximum expensing under Section 179 to $500,000 and
increased the beginning of the phase-out range to $2 million for
tax years beginning in 2010 and 2011. Also, the Act extended
the 50 percent bonus first year depreciation for one year.
2010
Tax Relief, Unemployment Insurance Reauthorization, and Job
Creation Act of 2010—The 2010 Tax Relief Act extended for
two years the Bush-era tax cuts including the capital gains and

dividend tax cuts. Further it cut payroll taxes two percentage
points in 2011, placed a two-year patch on the alternative
minimum tax and revived the estate tax.
2012
American Taxpayer Relief Act of 2012—The Act allows all
Bush-era tax cuts to sunset after 2012 for individuals with
income over $400,000 and $450,000 for couples. Also, the Act
permanently patches the alternative minimum tax, increased
capital gains rates to 20 percent for those individuals making
over $400,000 and extended for five years the American
Opportunity Tax Credit.
2014
The Tax Increase Prevention Act of 2014 was signed into law
by President Obama on December 19, 2014. H.R. 5771 extends
temporarily over 50 expired provisions. The law also creates
Achieving a Better Life Experience (ABLE) which affords
benefits for persons with disabilities.
2015
Bipartisan Budget Act of 2015—President Obama signed into
law the Act on November 2, 2015. It contains several important
tax provisions especially with respect to partnership audit rules.
It eliminates TEFRA, after December 31, 2017, unified
partnership audit rules together with protocols for electing large
partnership rules. In its place will be a more streamlined audit
regime. The Act also makes changes to the Patient Protection
and Affordability Care Act (ACA) with respect to employers
with over 200 employees automatically enrolling full-time
employees into an employer health plan.
2015
Protecting Americans from Tax Hikes (PATH) Act of 2015—
The PATH Act of 2015 did much more than just extend the 50-
plus provisions that expired at the end of 2014. Some provisions
were made permanent, others extended for five years (through
2019) and others extended for two years (through 2016). Among
the more notable extensions for individuals are: the American
Opportunity Tax Credit, deduction for certain expenses for

elementary and secondary school teachers, increases in the
earned income credit and transit benefits parity. For businesses
the more notable extensions are: enhanced expensing under
Section 179, and the research tax credit.
2017
An Act to Provide for Reconciliation Pursuant to Titles II and V
of the Concurrent Resolution on the Budget for Fiscal 2018. The
tax act is more commonly referred to as The Tax Cuts and Jobs
Act. It is a massive tax act with as its centerpiece a drop in the
corporate tax rate from 35 percent to 21 percent. Its impact on
both business and individual taxpayers is huge. From changes in
the tax rates and thresholds to the elimination of personal
exemptions, The Tax Cuts and Jobs Act changed many items on
individuals’ tax returns. The Tax Cuts and Jobs Act is a
reconciliation bill. Therefore, the longer title and the Act had to
comply with stricter rules with respect to deficits. Many of the
changes to corporations are permanent but changes to individual
tax provisions are for 8 years only. They will sunset after 2025.
The goal of The Tax Cuts and Jobs Act was to reduce taxes on
both corporations and individuals and to stimulate economic
growth.
2018
Bipartisan Budget Act of 2018 contained several tax provisions.
The Act retroactively extended approximately thirty-three tax
provisions. Among the more notable is it excludes from gross
income discharge of qualified principal residence indebtedness.
2020
The Further Consolidated Appropriations Act, 2020 (HR 1865)
was signed into law by President Trump on December 20, 2019.
It raised the deficit ceiling by $428 billion. Tax-related
provisions in the Act include retroactive and current renewal of
the tax breaks known as “extenders” and the Setting Every
Community Up for Retirement Enhancement Act of 2019 (the
SECURE Act) which makes major changes to 401(k) plans,
IRAs, and creates a new multiple employer plan.
¶1161

FEDERAL TAX LEGISLATIVE PROCESS
When reviewing the tax acts since the mid to late 1970s, it
becomes obvious that tax reform is a yearly event. Tax bills are
passed for numerous reasons (i.e., revenue needs, incentive for
economic development, or to affect the economy). Tax bills in
this country have not followed a uniform path. Normally, major
tax legislation originates with the President sending a message
to Congress. An alternative approach is for congressional
initiative on a tax bill.
The Constitution requires that revenue legislation originate in
the House of Representatives. Therefore, the first step is for
hearings before the House of Representatives Ways and Means
Committee. Many influential bodies present recommendations
to this Committee—the Secretary of the Treasury, the Office of
Management and Budget, etc. After meeting with various
bodies, the Committee meets in executive session, and a tax bill
is transmitted by means of a Committee report to the House.
The House of Representatives debates the bill usually under a
“closed rule” procedure, which permits amendments to come
only if approved by the Ways and Means Committee. If the bill
is defeated it may be referred back to committee; if it passes, it
is sent to the Senate where it is first discussed in the Senate
Finance Committee.
Hearings are held by the Finance Committee which might result
in amendments to the House bill. The amendments may range
from insignificant to totally changing the bill. The bill is then
transmitted to the whole Senate. One significant difference
between the House and the Senate is that, in the Senate, any
Senator may offer amendments from the floor of the Senate.
After passage, if there are any differences between the House
and Senate versions of the bill, it goes to the Joint Conference
Committee, which is composed of ranking members of the
House Ways and Means Committee (seven members) and the
Senate Finance Committee (five members) for resolution. The
Conference Committee version of the bill must be accepted or
rejected—it cannot be changed by either the House or the

Senate. Assuming passage by the House and the Senate, the bill
becomes law when approved by the President. If it is vetoed,
both the Senate and the House must vote affirmatively by a two-
thirds majority to override the President’s veto.
Exhibit 1 illustrates the sequence of events whereby a tax bill is
introduced before the House Ways and Means Committee,
passes through the House of Representatives, the Senate
Finance Committee, and the Senate. As indicated in the final
portion of Exhibit 1, if approved by the President, the tax bill
will be incorporated into the Internal Revenue Code.
Exhibit 1. THE LEGISLATIVE PROCESS
¶1165
TAX REFORM
Tax reform acts are passed by Congress and signed into law by
the President quite regularly. Several tax reform acts stand out
because of the magnitude of the act. The year 1986 was a most
interesting year for tax legislation. Both political parties,
Democrats and Republicans, were “demanding” tax reform. The
Treasury Department presented to President Reagan a massive
tax reform plan that would impact the tax liability of most
individuals and corporations. President Reagan, in his 1986
budget, called for a tax system that would be “simpler, more
neutral, and more conducive to economic growth.”
Tax Reform Act of 1986
The Senate passed a bill with only two rate brackets, 15 and 27
percent (28 percent was the final figure approved). Like that of
the House of Representatives, their bill called for the removal
of many tax deductions. One new feature added in the Senate
bill was the drastic reduction in the number of people eligible
for Individual Retirement Accounts (IRAs). After much debate,
compromising, and political maneuvering, the Tax Reform Act
of 1986 was passed and signed into law by President Reagan on
October 22, 1986. The Tax Reform Act of 1986 carries the label
of the most extensive overhaul of the U.S. tax code in almost 40
years, as well as the most fundamental reform of the U.S. tax

structure. The scope of the changes was so comprehensive that
the tax code was renamed the Internal Revenue Code of 1986.
Table 5 presents comparative data for the inflation-indexed
items for 2019 and 2020.
Table 5. 2019-2020 PARTIAL COMPARISON OF TAX
CHANGES FOR INDIVIDUALS
Item
2019
2020
Filing requirements
If filing status is:
A return is required if gross income was at least:
A return is required if gross income was at least:
Single
Under 65
$12,200
$12,400
65 or older
13,850
14,050
Head of Household
Under 65
$18,350
$18,650
65 or older
20,000
20,300
Married Filing Jointly
Both under 65

$24,400
$24,800
One spouse 65 or older
25,700
26,100
Both 65 or older
26,700
27,400
Not living with spouse at end of year (or on date spouse died)
$0
0
Married Filing Separately
All
0
0
Qualifying Widow(er)
Under 65
$24,400
$24,800
65 or older
25,700
26,100
Note: Children and other dependents should see Chapter 3 for
special rules.
CHANGES FOR INDIVIDUALS—Continued
Item
2019
2020

Tax rates
Married filing jointly or surviving spouse
10%
0
$19,400
10%
0
$19,750
12%
$18,650
to $78,950
12%
$19,750
to $80,250
22%
$75,900
to $168,400
22%
$80,250
to $171,050
24%
$153,100
to $321,450
24%
$171,050
to $326,600

32%
$233,350
to $408,200
32%
$326,600
to $414,700
35%
$416,700
to $612,350
35%
$414,700
to $622,050
37%
Over
$612,350
37%
Over
$622,050
Single
10%
0
to $9,700
10%
0
to $9,875
12%
$9,325
to $39,475
12%
$9,875
to $40,125

22%
$37,950
to $84,200
22%
$40,125
to $85,525
24%
$91,900
to $160,725
24%
$85,525
to $163,300
32%
$191,650
to $204,100
32%
$163,300
to $207,350
35%
$416,700
to $510,300
35%
$207,350
to $518,400
37%
Over
$510,300
37%
Over
$518,400
Married filing separately
10%

0
to $9,700
10%
0
to $9,875
12%
$9,325
to $39,475
12%
$9,875
to $40,125
22%
$37,950
to $84,200
22%
$40,125
to $85,525
24%
$76,550
to $160,725
24%
$85,525
to $163,300
32%
$116,675
to $204,100
32%
$163,300
to $207,350
35%
$208,350

to $306,175
35%
$207,350
to $311,025
37%
Over
$306,175
37%
Over
$311,025
Head of household
10%
0
to $13,850
10%
0
to $14,100
12%
$13,350
to $52,500
12%
$14,100
to $53,700
22%
$50,800
to $84,200
22%
$53,700
to $85,500
24%
$131,200
to $160,700

24%
$85,500
to $163,300
32%
$212,500
to $204,100
32%
$163,300
to $207,350
35%
$416,700
to $510,300
35%
$203,500
to $518,400
37%
Over
$510,300
37%
Over
$518,400
Social Security wage base
The maximum amount of taxable and creditable annual earnings
subject to the Social Security and self-employment income tax
is $132,900.
The maximum amount for 2020 is $137,700.
CHANGES FOR INDIVIDUALS—Continued
Item
2019
2020

Standard deduction
Basic standard deduction
Single
$12,200
$12,400
Head of household
18,350
18,650
Married filing jointly or qualifying widow(er)
24,400
24,800
Married filing separately
12,200
12,400
Additional standard deduction for blindness or 65
Married (filing jointly or separately) or qualifying widow(er)
$1,300
$1300
Single or head of household
$1,650
$1650
Dependent’s standard deduction
Cannot exceed the greater of (A) $1,100 or (B) earned income
plus $350 (limited to $12,200).
Cannot exceed the greater of (A) $1,100 or (B) earned income
plus $350 (limited to $12,400).
Nanny Tax
Wage threshold for paying Social Security and federal
unemployment taxes on domestic workers is $2,100 annually.
Wage threshold for paying Social Security and federal

unemployment taxes on domestic workers is $2,200 annually.
American Taxpayer Relief Act of 2012
The “fiscal cliff” was averted. The Act allowed the Bush-era tax
cuts to sunset for taxpayers with incomes over $400,000 and for
couples with income over $450,000. Many tax breaks that were
to expire were extended. It permanently patches the alternative
minimum tax and provides for a maximum estate tax of 40
percent with a $5 million exclusion.
Other highlights of the Act include: raising the tax on incomes
over $400,000 (individuals) and $450,000 (filing jointly) to
39.6 percent; raising the maximum capital gains tax to 20
percent; five year extension on the American Opportunity Tax
Credit; and a two year extension on certain business tax items.
The Tax Cuts and Jobs Act
One of the measures adopted in the Tax Reform Act of 1986
was that inflation adjustments would be provided annually for
several specific items such as the standard deduction, tax
brackets, personal exemption amounts, and the earned income
credit. Indexing was designed to protect individuals from
“bracket creep”—that is, where an individual’s income
increases only by the inflationary rate but the taxpayer moves
into a higher tax bracket.
After many months of discussion both the House of
Representatives and the Senate passed tax bills. A joint House-
Senate conference committee reconciled the differences and on
December 15, 2017, the conference committee approved the tax
reform bill and it was then sent back to both the House and the
Senate for approval. On December 20, 2017, both branches of
Congress passed the tax act. The House approved the bill 227-
203. No Democrats voted for the bill. The Senate’s
parliamentarian ruled that three provisions violated the
reconciliation rules and had to be eliminated. The Senate then
passed the bill 51-48 with no Democrats voting in favor. The
President then signed the bill into law on December 22, 2017. It
is the most significant tax legislation in the past 30 years.

Opponents maintain the deficit will grow uncontrolled.
Proponents maintain economic growth will be substantial and
will pay for the tax cuts.
Tax Extenders
President Trump signed into law on December 20, 2019 a
massive appropriations bill that will fund the government
through September 30, 2020. The 1773-page document covers a
vast array of provisions. Some of the major provisions are:
retroactive and current renewal of tax extenders, repeal of ACA
taxes and retirement security. Over two dozen provisions were
extended through 2020 and two provisions were extended
through 2022. Below is a listing of the most important extenders
that we cover in this book.
Extenders retroactively renewed through 2020
· Exclusion from gross income of discharge of principle
residence acquisition indebtedness
· Mortgage insurance premiums treated as qualified residence
interest
· Deduction for qualified tuition and related expenses
· Indian employment tax credit
· Extension of empowerment zone and tax incentives
· Seven-year recovery period for motorsports entertainment
complexes
· Special expensing rules for certain film and television
productions
· Energy efficient commercial buildings deduction
· Excise tax credits and payment provisions relating to
alternative fuel
· The 7.5 percent floor on medical expense deductions
· The New Markets Tax Credits
· Work Opportunity Tax Credit
· Look-through treatment of payments between related
controlled foreign corporations
· Employer credit for paid family and medical leave
Extenders renewed through 2022
· Incentives for Biodiesel and Renewable Diesel

· The 45G railroad track maintenance credit
Underlying Rationale of the Federal Income Tax
¶1171
OBJECTIVES OF THE TAX LAW
The federal income tax is comprised of a complicated and
continually evolving blend of legislative provisions,
administrative pronouncements, and judicial decisions. The
primary purpose of the tax law is obviously to raise revenue,
but social, political, and economic objectives are also extremely
important. These various objectives, which frequently work at
cross-purposes with the revenue raising objective of the law,
must be examined and understood to gain an appreciation of the
rationale underlying the immense multipurpose body of law
known as the federal income tax.
It is easy to criticize the entire tax law for being too complex.
However, any time one law attempts to raise revenue and
achieve a variety of social, political, and economic objecti ves,
while simultaneously attempting to be equitable to all income
levels and administratively feasible for the government to
enforce, it cannot avoid being complex.
Tax loopholes are frequently attacked as being
counterproductive to the revenue raising objective of the
Treasury because they cost the U.S. government billions of
dollars in lost revenue. However, some of these so-called
loopholes can be thought of as tax incentives, enacted by
Congress to encourage certain types of investment, or to
achieve specified social, economic, or political objectives.
For example, the tax law provides that interest from municipal
bonds is generally excluded from gross income, while interest
received from all other sources, including savings accounts and
corporate obligations, is subject to taxation. The municipal
bond provision thus offers excellent tax benefits for individuals
with available resources to invest, but these bonds typically
provide a lower yield than corporate obligations.
Primarily because of this tax benefit, municipal bonds are a
popular type of investment for wealthy taxpayers. To better

evaluate the criticism that municipal bonds are a tax loophole,
the probable tax consequences of this type of investment can be
examined in the case of a taxpayer in the 37 percent marginal
tax bracket.
EXAMPLE 1.2
Cliff, a 37% bracket taxpayer, has $50,000 available to invest.
After evaluating the pros and cons of stocks, bonds, money
market certificates, and other types of investments, his decision
is limited to the following two choices:
Freemont Highway municipal bonds, rate of interest
9%
Data-Search Inc., corporate bonds, rate of interest
12%
Freemont
Data-Search
Interest income (before taxes)
$4,500
$6,000
Income taxes
0
2,220
Yield (after taxes)
$4,500
$3,780
Result. Cliff will select the Freemont municipal bonds. Even
with a lower rate of interest than the corporate obligations,
Freemont provides a larger after-tax yield.
A common but simplistic criticism of this tax provision is that
the wealthy individual has used a loophole to avoid $1,665 of
taxes ($4,500 interest × 37 percent tax rate), thereby depriving
the U.S. government of a corresponding amount of revenue.
However, this criticism must be weighed against the underlying
purpose of the municipal bond provision which is encouraging

taxpayers to invest in state and local obligations and allowing
the various municipalities to compete for resources in the bond
market at a lower rate of interest than corporate bonds.
¶1175
ECONOMIC FACTORS
Over the years, numerous provisions of the tax law have been
employed to help stimulate the economy, to encourage capital
investment, or to direct resources to selected business activities.
Perhaps the most well-known provision of the tax law, designed
to serve as a stimulus to the economy, was the investment tax
credit. This credit, which served to encourage investment in
qualified property, primarily tangible personal property used in
a trade or business, had been suspended for a period of time,
repealed, reinstated, and again repealed.
Similar to its use of the investment credit, Congress has used
depreciation write-offs as a means of controlling the economy.
Viewed as a popular stimulus for business investment is the tax
benefit resulting from the accelerated cost recovery methods of
depreciation. The Tax Cuts and Jobs Act liberalized the
expensing rules. Additionally, the related election to expense
allows the taxpayer to deduct as much as $1,040,000 (in 2020)
of the cost of qualifying property in the year of purchase.
However, where the cost of qualified property placed in service
during the year exceeds $2.59 million, the $1,040,000 ceiling is
reduced by the amount of such excess.
Various other tax provisions have been employed to help
stimulate selected industries. Thus, unique tax benefits, such as
the provisions for percentage depletion, apply to the mining of
natural resources. Correspondingly, farming activities benefit
from special elections to expense rather than capitalize soil and
water conservation expenditures under an approved
conservation plan.
Small business investment has been encouraged by various
provisions. For example, certain types of small businesses may
elect to file as an S corporation, which essentially provides the
limited liability protection of corporate status, while treating

most items of income as if the entity were a partnership.
Correspondingly, a special rule allows ordinary loss treatment
for small business stock.
For year beginning after December 31, 2017 the corporate tax is
a flat 21 percent.
¶1181
SOCIAL FACTORS
Numerous tax provisions can best be explained in light of their
underlying social objectives. For example, premiums paid by an
employer on group-term insurance plans are not treated as
additional compensation to the employees. This provision
encourages business investment in group-term insurance and
provides benefits to the family of a deceased employee. Also,
social considerations provide the rationale for excluding
employer-paid premiums on accident and health plans or the
premiums on medical benefit plans from an employee’s gross
income.
Deferred compensation plans allow an individual to defer
taxation on current income until retirement. The preferential tax
treatment is an attempt to encourage private retirement plans to
supplement the Social Security benefits. Other socially
motivated tax provisions include the deduction for charitable
contributions, the child care credit for working parents, and the
credit for the elderly.
Frequently, social considerations help to explain a tax provision
that discourages certain types of activities. For example, even
though an individual may have incurred a fine or a penalty
while engaged in a regular business activity, no deduction is
allowed for this type of expenditure. The basis underlying this
Congressional policy is that by allowing such a deduction, the
law would be implicitly condoning and encouraging such
activities. Correspondingly, bribes to government officials and
illegal kickbacks or rebates are not deductible, even if related to
the active conduct of one’s trade or business.
¶1185
POLITICAL FACTORS

Since the tax law is created by Congress, and Congress consists
of several hundred elected officials, political factors play a
major role in the development of tax legislation. Special interest
groups frequently seek to influence tax legislation, while
Congressmen themselves are often likely to introduce
legislation which would be of particular benefit to their own
district or, perhaps, to selected constituents. Of course, special
interest legislation does invite widespread criticism if it does
not also serve a useful economic or social objective.
As with the economic and social objectives, many politically
inspired provisions have been designed in a negative context to
discourage certain types of activities. Thus, provisions such as
the alternative minimum tax, which imposes an alternative tax
rate on taxable income increased by tax preference items, the
limitation on investment interest expense, or the accumulated
earnings restrictions on corporations can be explained on this
basis.
¶1187
TAX POLICY AND REFORM MEASURES
If there has been a trend through the years in tax statutes, it has
been toward reform. The word “reform” itself first appeared in
the popular name of the tax act entitled Tax Reform Act of
1969, but the concept of reform had begun to take shape long
before and the enactment of reform measures has continued
unabated through the years.
During the later part of the 1980s, various changes in the tax
law, especially the passage of the Tax Reform Act of 1986, have
resulted in the most dramatic tax modifications in tax policy
since the enactment of the Internal Revenue Code of 1913. For
the first time in 73 years, Congress attempted to address the
broad public-policy implications of the entire tax law. In
undertaking the revision of 1986, Congress sorted through a
massive panorama of loopholes, inequities, and antiquated
provisions and eliminated provisions that had lost much of their
original social, political, or economic purpose.
Clearly, the tax policy implications of the 1986 revision will be

under examination for some time to come. A major impact can
be expected on the manner in which individuals and businesses
save, invest, earn, and spend their money. For example, with the
curtailment of the deduction for contributions to individual
retirement accounts (IRAs), high-yield securities such as
dividend-paying blue chip stocks, corporate bonds, and
“municipals” might become more attractive investments than
growth stocks. In fact, many wage earners may find it
advantageous to pay taxes on their entire salary, rather than
investing in a deferred compensation plan if they anticipate
future increases in their marginal tax rates. Correspondingly,
with the elimination of the consumer interest deduction, many
individuals may shift to making cash purchases instead of
incurring nondeductible obligations. Of course, some
homeowners may be tempted to circumvent these restrictive
provisions by using home equity loans to finance consumer
purchases.
The Taxpayer Relief Act of 1997 cut taxes in a fashion that had
not been seen since 1981. The reduction of capital gains tax
rates will have a significant impact on investment strategies.
The student of tax law can anticipate frequent if not annual
changes to the way individuals and businesses are taxed. The
source of tax revenue to finance the operation of the federal
government during the next decade will be a hotly debated
issue. Some tax policymakers will promote new taxation
schemes, such as a consumption tax, while others will advocate
a tax policy that is revenue-neutral and neutral as to its impact
on various income groups.
Basic Tax Concepts
¶1195
ESSENTIAL TAX TERMS DEFINED
When studying federal income taxation, it is important to keep
in mind several basic tax concepts. By understanding these
basic concepts unique to federal taxation, the course will be
more interesting and meaningful. Because some of the terms set
out below have definitions peculiar to income taxation, it is

advisable that they be carefully examined before proceeding to
the discussion of specific topics. Refer to the Glossary of Tax
Terms in the back of the book for a comprehensive listing of tax
terms discussed throughout the text.
Accrual basis of accounting
The accrual basis is distinguished from the cash basis. On the
accrual basis, income is accounted for as and when it is earned,
whether or not it has been collected. Expenses are deducted
when they are incurred, whether or not paid in the same period.
In determining when the expenses of an accrual-basis taxpayer
are incurred, the all-events test is applied. Such test provides
that the expenses are deductible in the year in which all of the
events have occurred that determine the fact of liability and the
amount of the liability can be determined with reasonable
accuracy. Generally, all of the events that establish liability for
an amount, for the purpose of determining whether such amount
has been incurred, are treated as not occurring any earlier than
the time that economic performance occurs.
Assignment of income doctrine
The assignment of income by an individual who retains the right
of ownership to the property has generally proved ineffective as
a tax-shifting procedure. For the assignment to be effective, a
gift of the property would be necessary. For example, Ben is
preparing to attend Major State College. As a means of paying
for room and board, his father assigns to Ben his salary. This is
an invalid assignment of income and Ben’s father would be
liable for the tax. In Lucas v. Earl, 2 USTC ¶496, 281 U.S. 111-
115, 50 S.Ct. 241 (1930), the Supreme Court ruled that the
government could “tax salaries to those who earned them and
provide that the tax could not be escaped by anticipatory
arrangements and contracts however skillfully devised to
prevent the salary when paid from vesting even for a second in
the man who earned it.” Also, in this case the Court stated that
“no distinction can be taken according to the motives leading to
the arrangement by which the fruits are attributed to a different
tree from that on which they grew.”

Basis
The basis of property is the cost of such property. It usually
means the amount of cash paid for the property and the fair
market value of other property provided in the transaction.
EXAMPLE 1.3
An individual paid cash of $20,000 for an automobile and
assumed a $7,500 loan on the car; thus, the basis in the
automobile is $27,500.
EXAMPLE 1.4
An individual paid $500,000 for a tract of land and a building.
Purchase commissions, legal and recording fees, surveys,
transfer taxes, title insurance, and charges for installation of
utilities amounted to $70,000. The basis of the property would
be $570,000. Any amounts owed by the seller and assumed by
the buyer are included in the basis of the property.
The definition and the determination of “basis” are of utmost
importance because it is that figure which is usually used for
depreciation and the determination of gain or loss. If property
was acquired by gift, inheritance, or in exchange for other
property, special rules for finding its basis apply.
Business purpose
When a transaction occurs it must be grounded in a business
purpose other than tax avoidance. Tax avoidance is not a proper
motive for being in business. The concept of business purpose
was originally set forth in Gregory v. Helvering, 35-
1 USTC ¶9043, 293 U.S. 465, 55 S.Ct. 266 (1935). In this case,
the Supreme Court ruled that a transaction aiming at tax-free
status had no business purpose. Further, the Court stated that
merely transferring assets from one corporation to another
under a plan which can be associated with neither firm was
invalid. This was merely a series of legal transactions that when
viewed by the Court in its entirety had no business purpose.
Capital asset
Everything owned and used for personal purposes, pleasure, or
investment is a capital asset. Examples of capital assets are
stocks, bonds, a residence, household furnishings, a pleasure

automobile, gems and jewelry, gold, silver, etc. Capital assets
do not include inventory, accounts or notes receivable,
depreciable property, real property, works created by personal
efforts (copyrights), and U.S. publications.
Cash basis
The cash basis is one of the two principal recognized methods
of accounting. It must be used by all taxpayers who do not keep
books. As to all other taxpayers (except corporations, certain
partnerships, and tax-exempt trusts) it is elective, except that it
may not be used if inventories are necessary in order to reflect
income. On the cash basis, income is reported only as it is
received, in money or other property having a fair market value,
and expenses are deductible only in the year that they are paid.
Claim of right
The term claim of right asks whether cash or property received
by an individual to which the individual does not have full
claim and which the individual might have to return in the
future must be included in income. The question here is whether
the taxpayer must report the income when received or wait
until the taxpayer has full right to it. In North American Oil
Consolidated v. Burnet, 3 USTC ¶943, 286 U.S. 417 (1932), the
Supreme Court resolved the question by stating that amounts
received by an individual under a claim of right must be
included in gross income even though the individual might have
to refund the amount at a later time.
Conduits
Some entities are not tax paying. They pass through their
income (loss) to owners (beneficiaries). A partnership is an
example of a conduit. Partnerships do not pay taxes; they
merely report the partnership’s taxable income or losses. The
income (loss) flows directly to the partners. However,
partnerships do compute partnership taxable income. Other
types of conduits are grantor trusts and S corporations.
Constructive-receipt doctrine
When a cash-basis individual receives income, or it is credited
to an account the individual may draw upon, or it is set aside

for the individual, the courts have ruled that the individual has
constructively received the income. This concept was developed
to stop taxpayers from choosing the year in which to recognize
income. Once an individual has an absolute right to the income,
it must be recognized. A good example of the constructive
receipt doctrine is interest earned on a bank account. If interest
is credited to the taxpayer’s account, it is of no consequence
that the taxpayer does not withdraw the money. The day the
interest is credited to the account is the day the taxpayer must
include the amount in income.
Entity
Generally, for tax purposes there are four types of entities:
individuals, corporations, trusts, and estates. Each entity
determines its own tax and files its own tax return. Each tax
entity has its specific rules to follow for the determination of
taxable income. Basically the concept of “entity” answers the
question “Who is the taxpayer?” Note that partnerships were not
in the list of entities. For tax purposes, partnerships are not tax-
paying entities. The income (loss) flows directly to the partners.
Gross income
Gross income, for income tax purposes, refers to all income that
is taxable. The law enumerates specific items of income that are
not to be included in gross income and, therefore, are
nontaxable. With these exceptions, all income is includible in
gross income.
Holding period
The holding period of property is the length of time that the
property has been held by the taxpayer, or the length of time
that the taxpayer is treated for income tax purposes as having
held it. The term is most important for income tax purposes as it
relates to capital gains transactions. Whether capital gain or
loss is short or long term depends on whether the asset sold or
exchanged has been held by the taxpayer for more than 12
months.
Income
The fundamental concept of income is set forth in the Sixteenth

Amendment—”incomes, from whatever source derived.” It is
the gain derived from capital, labor, or both. For tax purposes
the term “income” is not used alone. The most common usages
are gross income, adjusted gross income, and taxable income.
Income-shifting
Income-shifting is the transfer of income from one family
member to another who is subject to a lower tax rate or the
selection of a form of business that decreases the tax liability
for its owners.
Pay-as-you-go tax system
The American tax system is often referred to as a pay-as-you-go
tax system. Much of the federal government’s tax collections
come from withholdings and estimated taxes. The various types
of taxpayers pay tax throughout the year, not just at year-end.
The United States has been on a pay-as-you-go system since
1943.
Realized v. recognized gain or loss
A gain or loss is realized when a transaction is completed.
However, not all realized gains and losses are taxed
(recognized). A recognized gain or loss occurs when a taxpayer
is obligated to pay tax on a completed transaction.
Substance v. form
Individuals should arrange their financial transactions in a
manner that will minimize their tax liability. If a transaction is
all it purports to be and not merely a transaction to avoid taxes,
then it is valid. If the transaction is solely to avoid taxes and
there is no business purpose to the transaction, then it is
invalid. The fact that a taxpayer uses one form of transaction
rather than another to minimize taxes does not invalidate the
transaction. A good example of when substance v. form is a
significant issue is in the area of leases. Payments under a lease
are tax deductible. Payments under a purchase agreement are
not tax deductible. Therefore, it is of utmost importance to
determine the true “substance” of this type of transaction.
Questions to be asked might include: Do any equity rights
transfer to the lessee at the end of the lease period? May the

lessee buy the property at a nominal purchase price? With a
lease transaction it is immaterial that the parties refer to the
transaction as a lease. The true substance of the transaction
controls over the form.
Tax benefit rule
A recovery is includible in income only to the extent that the
deduction reduced tax in any prior year by any amount.
Therefore, where a deduction reduced taxable income but did
not reduce tax, the recovery amount is excludable from income.
This rule applies to both corporate and noncorporate taxpayers.
Taxable income
Taxable income for a corporation is gross income minus all
deductions allowable, including special deductions such as the
one for dividends received. Taxable income for individuals who
itemize deductions is equal to adjusted gross income minus the
greater of itemized deductions or the standard deduction amount
and the qualified business deduction. For taxpayers who do not
itemize, taxable income is adjusted gross income minus the
standard deduction and the qualified business deduction.
Wherewithal to pay
The concept that the taxpayer should be taxed on a transaction
when he or she has the means to pay the tax. For example, a
taxpayer owns property that is increasing in value. The IRS
does not tax the increased value until the taxpayer sells the
property. At the time of sale, the taxpayer has the wherewithal
to pay.
SUMMARY
· Taxes are indeed big business. The Internal Revenue Service
collected $3,001,581,900,000 in 2018.
· Individuals contributed 52.45 percent of all taxes raised by the
IRS.
· Corporations contributed approximately 6.75 percent of all
taxes raised by the IRS.
· A basic understanding of tax terminology will help business
leaders run their corporations.

Chapter
2
Tax Research, Practice, and Procedure
OBJECTIVES
1. Identify the primary authoritative sources of the tax law and
understand the relative weight of these authorities.
2. Explain the role of the court system as a forum for both the
taxpayer and the government.
3. Develop a familiarity with the various forms of judicial
citations.
4. Understand the general organization of a loose-leaf tax
service and the importance of a citator service and other types
of secondary reference materials.
5. Describe the organization of the Internal Revenue Service
and selected rules relating to practice before the IRS.
6. Discuss the examination of returns, including correspondence
examinations, office examinations, and field examinations.
7. Explain the appeals process, both within the IRS and through
the court system.

8. Understand the possible communications between the IRS
and taxpayers, including private rulings, determination letters,
and technical advice.
9. Describe some of the more common penalties to which
taxpayers and tax preparers might be subject.
10. Understand ethics as related to the tax practitioner.
OVERVIEW
To the general public, the tax practitioner is often viewed
simply as a preparer of tax returns. However, from a broader,
more professional perspective, tax practice also involves
extensive research, creative tax planning, and effective
representation of clients before the audit or appellate divisions
of the Internal Revenue Service.
Tax research is the process whereby one systematically searches
for the answer to a tax question, using the various primary and
secondary sources of tax-related information. This involves
reviewing and evaluating appropriate Internal Revenue Code
sections, Treasury Regulations, Internal Revenue Service
Rulings, and court decisions. Research into this voluminous
material is typically facilitated by the use of one of the loos e-
leaf tax services, which are organized and cross-referenced in
such a manner as to assist the researcher in the confusing trek
through the overwhelming mass of authoritative data. Also, due
to rapid technological advances made in computer-assisted tax
research, the researcher may access the most complete and up-
to-date authoritative data with online tax research services.
The tax specialist needs to understand the organizational
structure of the IRS and its administrative procedures to provide
fully informed tax consulting services to taxpayers involved in
disputes with the IRS. Thus, this chapter includes a discussion
of the internal organization of the IRS and how its various
administrative groups function, the rules relating to practice
before the IRS, and the procedures for examination of returns,
including service center examinations, office examinations, and
field examinations.
What actions can a taxpayer take if there is an adverse decision

by the tax auditor or revenue agent? To provide an answer to
this question, this chapter details and explains the appeals
process, both within the IRS and through the court system.
Another approach available to the taxpayer is the right to
request advice from the IRS on the tax consequences of a
particular transaction. This chapter discusses the various
communications between the IRS and taxpayers, including
private letter rulings, determination letters, and technical
advice.
Some of the more common penalties to which taxpayers and tax
preparers might be subject are also discussed. Tax practitioners
should be familiar with the code of professional ethics of their
profession since a violation of these standards might mean that
“due care” has not been exercised and the practitioner might be
subject to charges of negligence.
Tax Reference Materials
¶2001
CLASSIFICATION OF MATERIALS
Tax reference materials are usually classified as primary
“authoritative” sources or secondary “reference” sources.
Primary source materials include the Internal Revenue Code
(Statutory Authority), Treasury Regulations and Internal
Revenue Service Rulings (Administrative Authority), and the
various decisions of the trial courts and the appellate courts
(Judicial Authority).
Secondary reference materials consist primarily of the various
tax reference services. Additional secondary materials include
periodicals, textbooks and treatises, published papers from tax
institutes and symposia, and newsletters.
Reminder. While the editorial opinions included in the
secondary reference materials are extremely knowledgeable and
comprehensive, neither the IRS nor the courts will afford any
authoritative weight to these opinions. One exception is
Mertens, Law of Federal Income Taxation. This tax service is
often quoted in judicial decisions.
Both primary and secondary sources can be accessed through

one of the computer-assisted research services. These electronic
data bases are updated daily and contain many source
documents not normally found in the traditional tax library.
Primary Source Materials
¶2021
STATUTORY AUTHORITY
Statutory authority is primarily the Internal Revenue Code, but
it also includes the U.S. Constitution and tax treaties. The
authority of the U.S. government to raise revenue through a
federal income tax is derived from the Sixteenth Amendme nt to
the Constitution. Following ratification of this Amendment, the
federal income tax law was enacted on October 3, 1913, and
was made retroactive to March 1, 1913. Various other revenue
acts were soon enacted. From these provisions, a loose and
disconnected body of tax law emerged, making it virtually
impossible to systematically engage in tax research.
Accordingly, to facilitate a convenient form of organization, the
various revenue acts that were enacted between 1913 and 1939
were codified into Title 26 of the United States Code, known as
the Internal Revenue Code of 1939.
In subsequent years, with the growing complexity of the tax
law, the Code was revised and rewritten as the Internal Revenue
Code of 1954. During the next thirty-two years numerous tax
laws were incorporated as amendments into the 1954 Code.
Accordingly, the Economic Recovery Tax Act of 1981 (ERTA),
the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA),
and the Tax Reform Act of 1984 were included as part of the
Internal Revenue Code of 1954, as amended. However, in 1986,
as a result of the sweeping changes made by the Tax Reform
Act of 1986, Congress changed the name of the tax law to the
Internal Revenue Code of 1986.
Organization of the Code
The Internal Revenue Code of 1986 is comprised of nine
subtitles (A-I), each consisting of individual, consecutively
numbered chapters (1-98). The subtitles most commonly
encountered by the tax practitioner that form the basis of this

book are Subtitle A, “Income Taxes,” including Chapters 1–6,
and Subtitle B, “Estate and Gift Taxes,” including Chapters 11–
15. The remaining subtitles relate to topics such as employment
taxes, excise taxes, alcohol and tobacco taxes, etc. Portions of
Subtitle F, “Procedure and Administration,” including Chapters
61–80, are also examined in this text.
The major portion of the Code dealing with federal income tax
is located in Chapter 1 of Subtitle A. This extremely important
Chapter, entitled “Normal Taxes and Surtaxes,” is further
divided into Subchapters (A–Z), and each Subchapter is then
generally divided into parts and subparts, which are then
divided into sections. These sections are typically referred to as
“Code Sections.”
The following exhibit (Exhibit 1) provides a Table of Contents
for Chapter 1 of Subtitle A of the Internal Revenue Code of
1986.
Exhibit 1. INTERNAL REVENUE CODE OF 1986—
SELECTED TABLE OF CONTENTS
Subtitle A—Income Taxes
Chapter 1—Normal Taxes and Surtaxes
Subchapter
Beginning Section Number
A
Determination of Tax Liability
1
B
Computation of Taxable Income
61
C
Corporate Distributions and Adjustments
301
D
Deferred Compensation, Etc.
401
E

Accounting Periods and Methods of Accounting
441
F
Exempt Organizations
501
G
Corporations Used to Avoid Income Tax on Shareholders
531
H
Banking Institutions
581
I
Natural Resources
611
J
Estates, Trusts, Beneficiaries, and Decedents
641
K
Partners and Partnerships
701
L
Insurance Companies
801
M
Regulated Investment Companies and Real Estate Investment
Trusts
851
N
Tax Based on Income from Sources Within or Without the
United States
861
O
Gain or Loss on Disposition of Property
1001
P
Capital Gains and Losses

1202
Q
Readjustment of Tax Between Years and Special Limitations
1301
R
Election to Determine Corporate Tax on Certain International
Shipping Activities Using Per Ton Rates
1352
S
Subchapter S: Tax Treatment of S Corporations and Their
Shareholders
1361
T
Cooperatives and Their Patrons
1381
U
Designation and Treatment of Empowerment Zones, Enterprise
Communities, and Rural Development Investment Areas
1391
V
Title 11 Cases
1398
W
District of Columbia Enterprise Zone [Stricken]
1400
X
Renewal Communities [Stricken]
1400E
Y
Short-Term Regional Benefits [Stricken]
1400L
Z
Opportunity Zones
1400Z-1
Citing the Code

Code Sections, particularly those found within Chapter 1 of
Subtitle A, are cited by detailed reference to section,
subsection, paragraph, and subparagraph. On occasion, the
reference is even broken down to inferior subdivisions, such as
a clause.
For example, Section 453(e)(3)(A)(i) might serve as an
illustration.
Throughout this text, references to Code Sections are in the
form explained above. Unless otherwise noted, references to
Code Sections relate to the Internal Revenue Code of 1986.
References to the 1939 or 1954 Code are specificall y noted.
Congressional Committee Reports
Congressional Committee Reports are the minutes or official
statements made by members of the House Ways and Means
Committee, Senate Finance Committee, and Conference
Committee on their intention in passing a specific piece of
legislation. Unlike Treasury Regulations, Revenue Rulings, and
Revenue Procedures issued by the IRS that are not binding on
the courts, congressional intent expressed in Committee Reports
very often is binding as these Committee Reports are regarded
as very high authority. Committee Reports are published in
the Cumulative Bulletin and by private publishers, including
Wolters Kluwer and Thomson Reuters. Additionally,
the Congressional Record reports floor debates in the House of
Representatives and in the Senate.
Blue Books
As stated in the House Committee Report to the Revenue
Reconciliation Act of 1989 (P.L. 101-239), “Blue Books” have
been added to the list of authorities on which taxpayers may
rely for interpretation of the tax law (see discussion at ¶2035).
Blue Books are prepared by the Staff of the Joint Committee on
Taxation for major tax acts. Although Blue Books are generally
based on Committee Reports for an act, they often contain
additional interpretative information. The IRS has used this
interpretative information in numerous rulings as the basis for a

particular position. Blue Books are published electronically by
Wolters Kluwer, CCH.
¶2035
ADMINISTRATIVE AUTHORITY
As a result of congressional authority, the Secretary of the
Treasury or a delegate, the Commissioner of Internal Revenue,
is authorized to provide administrative interpretation of the tax
law. As noted in Section 7805(a):
Except where such authority is expressly given by this title to
any person other than an officer or employee of the Treasury
Department, the Secretary or his delegate shall prescribe all
needful rules and regulations for the enforcement of this title,
including all rules and regulations as may be necessary by
reason of any alteration of law in relation to internal revenue.
Treasury Regulations
Treasury Regulations have generally been classified into three
broad categories: legislative, interpretative, and procedural.
Legislative regulations are those that are issued by the Treasury
under a specific grant of authority by Congress to prescribe the
operating rules for a statute. Generally, legislative regulations
have the force and effect of law. Interpretative regulations are
issued pursuant to the general rule-making power granted to the
Commissioner under Code Sec. 7805(a) and provide taxpayers
with guidance in order to comply with a statute. Although
interpretative regulations do not have the force and effect of
law, the courts customarily accord them substantial weight.
Procedural regulations are considered to be directive rather than
mandatory and, thus, do not have the force and effect of law.
They explain the IRS’s position and provide the mechanics for
compliance with the various federal income tax laws, as for
example the making and filing of tax elections.
The Regulations are organized in a sequential system consistent
with the Code. Additionally, the Regulations are prefixed by a
number that designates the applicable area of taxation to which
they refer. For example, following are the more important
Regulation prefixes:

Part
1.
Final income tax regulations
Part
20.
Estate Tax
Part
25.
Gift Tax
Part
31.
Withholding taxes
Part
301.
Procedure and Administration
Part
601.
Statement of Procedural Rules
Accordingly, an “Income Tax” Regulation relating to Section
453 of the Code would be cited as Reg. §1.453, followed by a
dash, then the sequential number of issue, with subparts added
for more detailed reference.
Proposed Regulations
New Regulations and changes to existing Regulations usually
are issued in proposed form before they are finalized. During
the interval between the publication of the Notice of Proposed
Rulemaking and finalization of the Regulation, taxpayers and
other interested parties are permitted to file objections or
suggestions. Proposed Regulations generally do not have the
same weight as Temporary Regulations. Tax law publishers,
such as Wolters Kluwer and Thomson Reuters, provide a
comprehensive listing of these Proposed Regulations, showing
the date of their proposal and date of adoption and also publish
the text of the Proposed Regulations.
Temporary Regulations
Sometimes Temporary Regulations are issued by the Treasury

Department. Their purpose is to provide interim guidance
regarding recent tax legislation until final Regulations are
adopted. Temporary Regulations (issued after November 20,
1988) must also be issued as Proposed Regulations and must
undergo public and administrative scrutiny during a comment
period as do Proposed Regulations. Every Temporary
Regulation issued after November 20, 1988, will expire three
years from the date of issuance. Prior to its expiration, a
Temporary Regulation has the same weight as a Final
Regulation.
Final Regulations
Finalized Regulations are published in the Federal Register as
are the Proposed Regulations and Temporary Regulations. All
tax Regulations are also published in the Internal Revenue
Bulletin. Final Regulations and Temporary Regulations are
designated as Treasury Decisions (T.D.s) and are assigned a
sequential number in order of issuance for the year. The
effective date and date of adoption are significant.
Final Regulations as well as Proposed and Temporary
Regulations are reproduced in major tax services.
Revenue Rulings and Revenue Procedures
Revenue Rulings, the official pronouncements of the IRS, are
similar to Treasury Regulations in that they represent
administrative interpretations of the internal revenue laws.
Revenue Rulings are issued with respect to a particular issue
and insure that this issue will be handled uniformly throughout
the United States, both in planning and in auditing. Revenue
Rulings, however, do not have the same authoritative weight as
regulations. Every issue of the Internal Revenue
Bulletin includes the following statement:
Rulings and procedures reported in the Bulletin do not have the
force and effect of Treasury Department Regulations, but they
may be used as precedents. Unpublished rulings will not be
relied on, used, or cited as precedents by Service personnel in
the disposition of other cases. In applying published rulings and
procedures, the effect of subsequent legislation, regulations,

court decisions, rulings, and procedures must be considered, and
Service personnel and others concerned are cautioned against
reaching the same conclusions in other cases unless the facts
and circumstances are substantially the same.
Revenue Procedures are published official statements of
procedure issued by the IRS that affect either the rights or the
duties of taxpayers or other members of the public under the
Internal Revenue Code and related statutes and regulations.
Revenue Procedures usually reflect the contents of internal
management documents. A statement of the IRS position on a
substantive tax issue will not be included in a Revenue
Procedure. Revenue Procedures are directive and not
mandatory.
Both Revenue Rulings and Revenue Procedures are originally
published in the weekly issues of the Internal Revenue
Bulletin, printed by the U.S. Government. However, through
2008, on a semiannual basis, the bulletins were compiled,
reorganized by Code section classification, and published in a
bound volume designated the Cumulative Bulletin. Once
published in the Cumulative Bulletin, a Revenue Ruling or
Revenue Procedure received a permanent citation as shown
below:
After 2008, a Revenue Ruling, such as Rev. Rul. 2014-12,
would be cited as Rev. Rul. 2014-12, 2014-15 I.R.B. 923. This
is the 12th Rev. Rul. of 2014 in the 15th weekly issue of the
Internal Revenue Bulletin on page 923. The citation for a
Revenue Procedure is identical, except the abbreviation “Rev.
Proc.” is used in place of “Rev. Rul.”
Other Administrative Pronouncements
In addition to substantive rulings (Revenue Rulings and
Revenue Procedures) published to promote a uniform
application of the tax laws, the IRS issues communications to
individual taxpayers and IRS personnel in three primary ways:
(1) Private Letter Rulings, (2) Determination Letters, and (3)
Technical Advice Memoranda. These documents are part of the

IRS rulings program, which is discussed in detail at ¶2225.
Digests of Private Letter Rulings may be found in Private Letter
Rulings (published by Thomson Reuters), Bloomberg
BNA Daily Tax Reports, and Tax Analysts Tax Notes. IRS
Letter Rulings Reports (published by Wolters Kluwer) contains
both digests and the full texts of all Private Letter Rulings.
These documents may also be accessed electronically through
Wolters Kluwer's IntelliConnect® or CCH® AnswerConnect.
Determination Letters are not published; however, the IRS is
now required to make individual rulings available for public
inspection. Technical Advice Memoranda are available similar
to Private Letter Rulings.
IRS List of Substantial Authority for Taxpayer Reliance
The IRS has provided guidance on (1) adequate disclosure of
items and positions taken on tax returns for purposes of
avoiding the accuracy related penalty for understatement of tax,
Rev. Proc. 94-36, 1994-1 CB 682, and (2) a listing of
substantial authority that may be relied on to avoid imposition
of that penalty. Reg. §1.6662-4(d)(3). In addition, the IRS
issues a list of positions for which there is not substantial
authority. This list must be issued by the Secretary of the
Treasury (and revised not less frequently than annually) and
published in the Federal Register. Code Sec. 6662(d)(3).
The purpose of the list is to assist taxpayers in determining
whether a position should be disclosed in order to avoid the
substantial understatement penalty. House Committee Report,
Revenue Reconciliation Act of 1989. Thus, a taxpayer could
choose to disclose that position to avoid the imposition of the
accuracy-related penalty. However, inclusion of a position on
this list is not conclusive as to whether or not substantial
authority exists with respect to that position.
Prior to 1990, the list of substantial authority was restricted to:
(1) the Internal Revenue Code, (2) final and temporary
regulations, (3) court cases, (4) IRS administrative
pronouncements, (5) tax treaties, and (6) congressional intent
reflected in committee reports accompanying legislation. Reg.

§1.6661-3.
The list of substantial authority now includes (1) the Joint
Committee on Taxation’s General Explanation of tax legislation
(i.e., the “Blue Book”); (2) proposed regulations; (3)
information or press releases; (4) notices, announcements, and
other similar documents published in the Internal Revenue
Bulletin; (5) private letter rulings; (6) technical advice
memoranda; (7) actions on decisions; and (8) general counsel
memoranda. Reg. §1.6662-4(d)(3)(iii). “Authority” does not
include conclusions reached in treatises, legal periodicals, and
opinions rendered by tax professionals.
With respect to the test for “substantial authority,” the IRS
continues to apply the principle that there is substantial
authority for the tax treatment of an item only if the weight of
authorities supporting such treatment is substantial in relation
to the weight of authorities supporting contrary tax treatment.
The type of document providing the authority affects the weight
to be accorded an authority. Reg. §1.6662-4(d)(3)(i) and (ii).
¶2055
JUDICIAL AUTHORITY
The ultimate test in the interpretation of the Code, in
determining the validity of Regulations, and in applying the
“law” to the facts of a given case takes place in the courts. The
court system provides the taxpayer with the opportunity to test
before a neutral forum both the position taken by the taxpayer
and that taken by the Commissioner with respect to any issue.
The courts historically have played a substantial role in the
interpretation, application, and enforcement of the tax
law. Exhibit 2 outlines the trial and appellate court alternatives
for federal tax litigation.
Trial Court System
There are three tribunals that have original jurisdiction to hear
and decide tax cases arising under the Internal Revenue Code. A
taxpayer can file a petition with the United States Tax Court, in
which event assessment and collection of the deficiency will be
stayed until the Tax Court’s decision becomes final. But, the

taxpayer may, if he or she prefers, pay the deficiency and then
sue for a refund in a U.S. District Court or the United States
Court of Federal Claims.
Exhibit 2. JUDICIAL APPEALS ALTERNATIVES
U.S. Tax Court
The U.S. Tax Court’s jurisdiction is limited to cases concerning
the Internal Revenue Code, and would include income tax law,
estate tax law, excess profits, but not employment taxes. The
Tax Court consists of 19 judges appointed by the President for
15-year terms. It is a special court whose jurisdiction is limited
almost exclusively to litigation under the Internal Revenue
Code. Prior to 1943, the Tax Court was known as the Board of
Tax Appeals. Although the Tax Court is a single court located
in Washington, D.C., hearings are held in several cities
throughout the nation, usually with only a single judge present
who submits his opinion to the chief judge. Only rarely does the
chief judge decide that a full review is necessary by all 19
judges.
Decisions of the Tax Court are issued as either “regular” or
“memorandum” decisions. “Regular” decisions are those that
require an interpretation of the law. In theory, “memorandum”
decisions concern only well-established principles of law and
require only a determination of facts. However, on occasion, the
courts have cited “memorandum” decisions. Hence, both kinds
of Tax Court decisions should be regarded as having precedent
value.
Viewing itself as a national court hearing cases from all parts of
the country, for many years the Tax Court had followed a policy
of deciding cases on what it thought the result should be. The
Tax Court has abandoned its “national law” view, under which
it applied its own rule on a nationwide basis without limitation
by rules of the circuits in which tax controversies arose. The
Tax Court has adopted the position that it will follow
precedents of the Circuit Court of Appeals of jurisdiction
(known as the Golsen rule). As a result, it is entirely possible

that the Tax Court will rule differently on identical fact patterns
for two taxpayers residing in different circuits in the event of
inconsistent holdings between the various Circuit Courts.
The Tax Court is the only court to which a taxpayer may take a
case without first paying the tax. Consequently, taxpayers resort
to it in many instances. Because it is a court of limited
jurisdiction dealing primarily with tax matters, its decisions are
accorded considerable weight. This is particularly true of
decisions in which the Commissioner of Internal Revenue has
acquiesced.
Historically, the policy of the IRS has been to announce in
the Internal Revenue Bulletin the determination of the
Commissioner to acquiesce or not acquiesce in most of the
regular decisions of the Tax Court. An announcement of
acquiescence (cited Acq.) indicates that the IRS has accepted
the conclusion reached in the case but not necessarily the
reasons given by the court in its opinion. An announcement of
nonacquiescence (cited Nonacq.) usually means that the IRS
will continue to litigate the issue if it arises again. Since 1991,
the IRS has indicated acquiescences or nonacquiescences for
memorandum decisions of the Tax Court as well as for decisions
of other courts. An announcement of acquiescence is not legally
binding on the IRS and, thus, can be retroactively withdrawn at
any time. If a case is being relied upon, it is important to
determine whether it has been acquiesced in by the
Commissioner, the extent of the acquiescence (if any), and
whether the initial acquiescence may have been withdrawn at a
later date.
Additionally, a procedure is used in the Tax Court for cases
involving disputes of $50,000 or less. The taxpayer who uses
the “small tax case” procedures should be aware that the
decision may not be appealed. The advantage to using this
procedure is the fact that the formal procedures of the Tax
Court are relaxed and made informal.
Judicial Citations—Tax Court Regular Decisions. Regular and
memorandum decisions of the Tax Court are reported

separately. The Government Printing Office publishes bound
volumes of only the regular decisions under the title United
States Tax Court Reports (cited TC).
Permanent Citation: Microsoft Corporation, 115 TC 228 (2000).
Thus, the decision appears in Volume 115 of the United States
Tax Court Reports, page 228, issued in 2000.
Because there is usually a time lag between the date a decision
is rendered and the date it appears in bound form, a temporary
citation is used until a permanent citation can be substituted.
Temporary Citation: Gilda A. Petrane v. Commissioner, 129 TC
—, No. 1 (July 2007).
Thus, the temporary citation identified that the decision
appeared in Volume 129 of the United States Tax Court
Reports, page left blank, 1st regular decision issued by the Tax
Court since Volume 128 was issued. Once Volume 129 was
issued, the permanent citation incorporating the page w as
substituted and the number of the case is not used.
Permanent Citation: Gilda A. Petrane v. Commissioner, 129 TC
1 (2007).
Judicial Citations—Tax Court Memorandum Decisions. The
government provides only photocopies of the memorandum
decisions. However, memorandum decisions are published by
both Wolters Kluwer and Thomson Reuters in bound volumes
separate from those in which they report other tax cases. The
Tax Court memorandum decisions are published by Wolters
Kluwer under the title Tax Court Memorandum Decisions (cited
TCM), while the Thomson Reuters series is called Thomson
Reuters Memorandum Decisions (cited TC Memo).
Wolters Kluwer Citation: Harvey D. Perry, Jr. v.
Commissioner, 84 TCM 1, T.C. Memo. 2002-165 (2002).
Thomson Reuters Citation: Harvey D. Perry, Jr. v.
Commissioner, 2002 TC Memo ¶2002-165.
Although presented in a different way, the reference in both
citations indicates that the memorandum decision was the 165th
memorandum decision issued by the Tax Court in 2002.
Both regular and memorandum decisions for years prior to 1943

were published by the government under the title United States
Board of Tax Appeals Reports.
Citation: J.E. Burke, 19 BTA 743 (1930).
Thus, the decision appears in Volume 19 of the United States
Board of Tax Appeals Reports, page 743, issued in 1930.
U.S. District Courts
The U.S. District Courts were the main courts of original
jurisdiction for tax cases prior to the establishment of the Board
of Tax Appeals which later became the Tax Court. A taxpayer
can take a case to the U.S. District Court for the district in
which the taxpayer resides only if the taxpayer first pays the tax
deficiency assessed by the IRS and then sues for a refund. Each
state has at least one District Court in which both tax and
nontax litigation are heard. Only in a District Court can one
obtain a jury trial, and even there a jury can decide only
questions of fact—not those of law.
Judicial Citations—U.S. District Courts Decisions. Published
decisions of the U.S. District Courts, including both tax and all
other types of litigation, are reported in the Federal
Supplement (cited F.Supp.) published by West Publishing
Company. In addition, the tax decisions of the District Courts
are also published in the two special tax reporter series, Wolters
Kluwer United States Tax Cases (cited USTC) and Thomson
Reuters American Federal Tax Reports (cited AFTR).
West Citation: Eugene B. Glick, 96 F.Supp. 2d 850 (DC Ind.,
3/14/00).
The order of citation is volume number, reporter, page number.
Wolters Kluwer Citation: Eugene B. Glick, 2000-
1 USTC ¶50,372 (DC Ind., 3/14/00).
Paragraph reference rather than a page number gives the
location of the case.
Thomson Reuters Citation: Eugene B. Glick, 86 AFTR 2d
2000-5083 (DC Ind., 3/14/00).
The prefix “2000” preceding the page number indicates the year
the case was decided.
U.S. Court of Federal Claims

The U.S. Court of Federal Claims is a single court consisting of
16 judges appointed by the President. The court resides in
Washington, D.C. and the decision to travel is made on a case-
by-case basis and is heard by the trial judge to whom the case
has been assigned. Prior to October 29, 1992, the court was
known as the U.S. Claims Court, and prior to October 1, 1982,
the court was known as the U.S. Court of Claims whose
decisions were appealed directly to the U.S. Supreme Court.
In federal tax matters, the U.S. Court of Federal Claims has
concurrent jurisdiction with the U.S. District Courts. The Court
of Federal Claims is a constitutional court and has jurisdiction
in judgment on any claim against the United States that is:
1. Based on the Constitution
2. Based on any Act of Congress
3. Based on any regulation of an executive department
Judicial Citations—U.S. Court of Federal Claims
Decisions. Since 1992, decisions of the Court of Federal Claims
have been reported by West Publishing Company in the Federal
Claims Reporter (cited FedCl). The decisions of the Claims
Court from October 1982 until 1992 were reported by West
Publishing Company in a series designated the U.S. Claims
Court Reporter (cited ClCt). Decisions of the predecessor Court
of Claims were published by the U.S. Government Printing
Office in a separate series of volumes entitled the U.S. Court of
Claims Reports (cited CtCl). The decisions of the predecessor
Court of Claims were also published by West Publishing
Company from May 1960 through September 1982 in
the Federal Reporter 2d Series (cited F.2d), while decisions
between 1932 and 1960 were reported in the Federal
Supplement (cited F.Supp.).
In addition, the tax decisions of the Court of Federal Claims
(and the predecessor Claims Court and Court of Claims) are also
published in the Wolters Kluwer United States Tax
Cases (cited USTC) and Thomson Reuters American Federal
Tax Reports (cited AFTR).
West Citation:

Katz v. U.S., 22 ClCt 714 (ClCt, 1991).
Scott v. U.S., 354 F.2d 292 (CtCl, 1965).
Betz v. U.S., 40 Fed Cl 286 (Fed Cl, 1998).
Wolters Kluwer Citation:
Katz v. U.S., 91-1 USTC ¶50,289 (ClCt, 1991).
Scott v. U.S., 66-1 USTC ¶9169 (CtCl, 1965).
Betz v. U.S., 98-1 USTC ¶50,199 (Fed Cl, 1998).
Thomson Reuters Citation:
Katz v. U.S., 67 AFTR2d 91-733 (ClCt, 1991).
Scott v. U.S., 16 AFTR2d 6087 (CtCl, 1965).
Betz v. U.S., 81 AFTR2d 98-611 (Fed Cl, 1998).
Appeals Court System
If either the taxpayer or the IRS is not satisfied with a trial
court decision, an appellate court may be asked to review that
decision. There are two levels of courts that handle appeals
from the three courts of original jurisdiction. Appeals may be
taken to the U.S. Courts of Appeals of jurisdiction or the U.S.
Court of Appeals for the Federal Circuit. As a final step, the
controversy may be appealed from the appellate courts to the
Supreme Court.
The authority of decisions of all Courts of Appeals stands above
that of the Tax Court, a District Court, or the Court of Federal
Claims. The U.S. Supreme Court is, of course, the final
authority as to what a statute means or as to any question of
federal law.
U.S. Circuit Courts of Appeals
Appeals in tax cases may be taken from the U.S. District Courts
or the Tax Court by either the IRS or the taxpayer to the U.S.
Courts of Appeals of jurisdiction. Jurisdiction is based upon the
location of the taxpayer’s residence. There are eleven numbered

circuits and additional unnumbered circuits for the Distr ict of
Columbia Circuit and the Federal Circuit. See Exhibit 3.
Normally, a Circuit Court’s review, made by a panel of three
judges is limited to the application of law—not the
determination of facts. In this process, the appellate court of
any circuit is obligated to follow the findings of the U.S.
Supreme Court but not those of the other Circuit Courts. When
conflicts develop between circuits, District Courts of each
individual circuit are required to follow any precedent set by
the appellate court of their own circuit (i.e., the Circuit Court to
which their decisions may be appealed). Also, as noted earlier,
pursuant to the Golsen rule, the Tax Court follows the policy of
observing precedent set by the appellate court of the circuit in
which the taxpayer resides. In this way, consistency in the
application of law is maintained between the Tax Court and the
District Court of jurisdiction, even though there may exist an
inconsistency in the law’s application to taxpayers residing in
various circuits.
Judicial Citations—U.S. Circuit Courts of Appeals
Decisions. All U.S. decisions, both tax and nontax, of the
various Circuit Courts are published by West Publishing
Company in the Federal Reporter including 2nd and 3rd Series
(cited F.2d and F.3d). In addition, tax decisions of the Circuit
Courts are also contained in Wolters Kluwer's United States Tax
Cases (cited USTC) and Thomson Reuters American Federal
Tax Reports (cited AFTR). Citations indicate not only the
volume and page, but also the particular court.
West Citation: Diane S. Blodgett v. Commissioner, 394 F.3d
1030 (CA-8, 2005).
Wolters Kluwer Citation: Diane S. Blodgett v.
Commissioner, 2005-1 USTC ¶50,146 (CA-8, 2005).
Thomson Reuters Citation: Diane S. Blodgett v.
Commissioner, 95 AFTR2d 2005-448 (CA-8, 2005).
U.S. Court of Appeals for the Federal Circuit
On October 1, 1982, the seven judges of the Court of Claims
and the five judges of the Court of Customs and Patent Appeals

became the 12 judges of the newly created Court of Appeals for
the Federal Circuit (CA-FC). The IRS and taxpayers appeal
decisions from the U.S. Court of Federal Claims to this court.
The court is empowered to sit in various locations around the
country and can be expected to make an effort to hold sessions
in the major cities where its business arises.
Exhibit 3. FEDERAL JUDICIAL CIRCUITS
U.S. Supreme Court
Appeals to the U.S. Supreme Court from the Circuit Courts of
Appeals and the Court of Appeals for the Federal Circuit may
be made generally by a petition for certiorari. The Supreme
Court may grant certiorari at its discretion; further, the Supreme
Court is not required to give reasons for its refusal to review.
However, past experience has shown that the Court generally
grants certiorari only if:
1. The issue has resulted in conflicting decisions in the Circuit
Court of Appeals or
2. The issue involved raises an important and continuing
problem in the administration of the tax law.
If the Supreme Court declines to review the decision, it will
formally deny the petition for certiorari.
Judicial Citations—U.S. Supreme Court Decisions. All U.S.
Supreme Court decisions are published by the U.S. Government
Printing Office in the United States Supreme Court
Reports (cited U.S.), West Publishing Co. in the Supreme Court
Reporter (cited S.Ct.), and the Lawyer’s Co-Operative
Publishing Co. in the United States Reports, Lawyer’s
Edition (cited L.Ed.). Like all other federal tax cases (except
those rendered by the U.S. Tax Court), tax-related Supreme
Court decisions are reported by Wolters Kluwer in United States
Tax Cases (cited USTC) and Thomson Reuters in American
Federal Tax Reports (cited AFTR).
GPO Citation:
Drye, Jr. v. U.S., 528 U.S. 49 (1999).
West Citation:

Drye, Jr. v. U.S., 120 S.Ct. 474 (1999).
Lawyer’s Ed. Citation:
Drye, Jr. v. U.S., 145 L.Ed.2d 466 (1999).
Wolters Kluwer Citation:
Drye, Jr. v. U.S., 99-2 USTC ¶51,006 (1999).
Thomson Reuters Citation:
Drye, Jr. v. U.S., 84 AFTR2d 99-7160 (1999).
Secondary Source Materials
¶2075
ANALYSIS OF TAX LAW SOURCES
The voluminous bulk and complexity of our tax law make it
extremely difficult to systematically research all of the statutory
and administrative provisions associated with a given set of tax
issues. The problem is further compounded when one also
attempts to analyze, evaluate, and update the leading court cases
that impact on these issues. Fortunately, secondary reference
materials provide a convenient cross-referenced and
continuously updated road map to guide the practitioner in the
complicated task of wading through a growing maze of primary
tax authority.
Tax Research Services
There are various tax research services that are published with
the specific purpose of providing comprehensive reference
information on the ever-changing tax law and on-going
developments in administrative rulings and case decisions. The
use of any particular tax research service is best described in
materials made available to users by the representatives of the
tax research services. However, there are some general points to
be made on the use of these tax research services. First, it is
important to check for the latest developments on any topic,
issue, or case being researched under a specific statute,
regulation, or ruling. Second, editorial analysis, be it a synopsis
or digest, provided by the tax research services for case
decisions or administrative rulings is an interpretative
commentary. Such editorial commentary, no matter how
knowledgeable, is not intended to be a substitute for the

authoritative primary source document.
Internet Based Research Systems
The role of electronic research systems cannot be overstated. To
say that most print materials are also available online does not
describe the increasingly integrated and comprehensive search
capabilities of online research systems. Users can access
computerized tax law data banks with their personal computers
by using various tax research publisher’s online internet-based
research systems. Whatever format the researcher uses, all data
bases are now integrated with primary and secondary source
materials from which the researcher can retrieve full text
documents or search for key words or phrases. Publishers’
computerized tax research systems can also be used to access
citation information to locate all judicial decisions that have
cited a particular decision or statute. These online citators are
more current than is possible in print format.
Wolters Kluwer Tax Products on the Internet
As examples of electronic tax research systems, Wolters
Kluwer’s CCH® AnswerConnect and CCH® IntelliConnect ®
offer a completely integrated suite of tax research materials
including primary source documents, i.e., the Internal Revenue
Code, Treasury Regulations, Revenue Rulings, tax case
decisions, administrative guidance and more. In addition to
primary source material, both AnswerConnect and
IntelliConnect include editorial analysis and content.
AnswerConnect and IntelliConnect include many tax research
resources encompassing Federal Tax, State Tax, International
Tax, Financial and Estate Planning, Accounting, etc. Within
each category, various resources and products are available for
research and practice assistance. The electronic format of the
internet-based tax research services provides an opportunity to
include automated tools and calculators, which makes the tax
research systems ideal not only for tax research, but also to find
quick answers and practice aids. Both AnswerConnect and
IntelliConnect include Smart Charts on many topics, as well as
calculators, decision tools, and more. In addition to these

features, the internet-based research systems provide an
opportunity for the most current information that can be updated
more frequently than the print resources. Both include the
Wolters Kluwer daily news service, Tax Day, current journals
and newsletters, the latest Wolters Kluwer briefings on major
tax developments, a Case Citator that is current to date and
many other electronic products including Wolters Kluwer's
well-regarded Law, Explanation and Analysis books on current
legislation. Subscribers to internet-based tax research systems
receive log in information providing access to the full array of
resources anytime and virtually anyplace.
In addition to the internet-based tax research systems, new
applications are being continuously developed by most tax
research services. Wolters Kluwer offers tax research
information specifically designed for mobile devices including
iPhones and iPads. Some of these applications include CCH
Mobile, eBooks, current journals, and newsletters.
It must be noted here that despite the encompassing nature of
electronic research and search methods, students are well
advised to have a firm understanding of the nature, basis and
authority of the documents they are using to support a tax
position and how the various sources of authority are
interrelated and linked. Therefore, following the internet screen
shots below on the Wolters Kluwer internet-based system, a
more detailed description of the organization of various tax
research products is included with the understanding that these
original research resources are still available in print format and
are now also available through the electronic research systems.
Complete, current, and reliable tax information is on the
Internet from Wolters Kluwer
at https://taxna.wolterskluwer.com. Many tax research products
are also available on mobile applications.
Researching a Topic
Using IntelliConnect, as a research illustration, in the Internet
browser’s Address bar, go to http://intelliconnect.cch.com. You

will be taken to the Log In page where you can enter your User
ID and Password where you can initiate a search.
Type your search term or phrase in the navigation bar at the top
of the screen. For purposes of illustration look for the “nanny
tax threshold for 2020” and click Go. On the left side of the
screen you can choose to Narrow Your Results. For this
example click the plus next to “by Document Type” and when
the list expands, click on Explanations.
This screen displays the results that best match your query.
Click on the first document and the screen will split so that the
document will appear at the bottom.
Review the document to see if it contains the information with
respect to the nanny tax threshold for 2020. In this example the
first item listed contains information on the nanny tax threshold
for both 2019 and 2020. The nanny tax was $2,100 for 2019. In
2020 it will be $2,200. Cash amounts paid for a nanny are not
subject to FICA taxes if less than $2,200 during 2020.
Once you have found the information you were searching for
you can choose to save the document as a pdf or text, email it to
someone, or print it using the options in the middle of the tri
screen.
Wolters Kluwer’s CCH AnswerConnect electronic search
service is available for subscribers
at: http://answerconnect.cch.com.
From the home screen, enter your search term or phrase in the
navigation bar at the top of the screen. For purposes of
illustration, look for “nanny tax” and click on the magnifying
glass icon to the right.
When you click on the first document in the list of results that
best match your query, the information appears on the screen:

In this example, the first item listed is from the Master Tax
Guide and contains information on Household Employees
(Nanny Tax). The nanny tax is $2,200 for 2020. Cash amounts
paid for a nanny are not subject to FICA taxes if less than
$2,200 during 2020.
Once you have found the information you were searching for
you can choose to print, save the file as a Word or pdf
document, or email it to someone by clicking on the
corresponding icon above the Contents box on the right side of
the page.
The only way to become proficient at using an electronic data
base is through practice and experience. The tax student is
encouraged to experiment with Wolters Kluwer's online tax
research systems, CCH® Answer Connect and CCH®
IntelliConnect, by searching for the answer to a tax question.
Once the art of electronic searching is mastered, it will be
obvious how much more comprehensive and efficient it is than a
traditional paper search. For example, what authority can you
find to justify a deduction for home office expense by a college
professor? What authority can you find that would deny the
deduction?
IRS Homepage
The IRS homepage on the World Wide Web
(http://www.irs.gov) went online on January 8, 1996. During its
first 24 hours of operation, close to one million “hits” were
recorded. Features on the IRS homepage include the following:
Do Your Taxes for Free, Get Your Refund Status, Get Your Tax
Record, Make a Payment, Get Answers to Your Tax Questions,
Forms and Instructions, News, and Help.
One very useful aspect of the IRS homepage is the ability to
retrieve the latest in tax news. In the “search” box type in
“newsroom” to access information on important topics (as
shown below). From the IRS homepage, click on News.

Across the top of the page the tabs provided are: File, Pay,
Refunds, Credits & Deductions, and Forms & Instructions.
Besides retrieving tax news from the IRS, tax forms and
instructions may be downloaded. The fifth item listed across the
top of the page is Forms and Instructionss. By clicking on
Forms and Instructions, the Forms and Instructions page
appears. All IRS tax forms may be retrieved from this site.
Please note that forms and publications from prior years are
available back to 1992.
By clicking on the “List All Current Forms & Instructions”
link, https://apps.irs.gov/app/picklist/list/formsPublications.htm
l appears. All IRS tax forms may be retrieved from this site.
Searching the Internet
A good way to search the Internet is by using search engines. A
search engine allows you to type in a term or phrase that
describes your area of interest. For example, open your Internet
browser’s search screen and type in the pxhrase “tax history.”
Once the search is complete, all of the finds are listed and
linked to millions of useful sources (sample screens shown
below).
Standard Federal Tax Reporter, Wolters Kluwer
Wolters Kluwer publishes in all major federal tax areas. These
publications are available on Wolters Kluwer’s online tax
research systems, CCH® AnswerConnect and CCH®
IntelliConnect® and in print.
The most comprehensive of these tax reference publications is
the Standard Federal Tax Reporter, frequently referred to as
the Standard or Fed. Other specialized tax services include
the Federal Excise Tax Reporter and the Federal Estate and Gift
Tax Reporter.
The Standard Reporter consists of 24 coordinated and cross-

referenced loose-leaf volumes that provide comprehensive
coverage of the income tax law. The service also provides
weekly supplements presenting current federal court decisions,
new rulings, and changes in the law or regulations, digests of
Tax Court decisions, as well as reviews of the significant
legislative changes, and editorial comments that provide tax
planning ideas related to current developments.
The major portion of the Standard, Volumes 1 through 18,
compiles the legislative, administrative, and judicial aspects of
the income tax law. The volumes are arranged in Code Section
order and reflect the current income tax law and accompanying
related regulatory texts (including proposed amendments to the
Regulations), as well as legislative Committee Reports,
followed by “Explanations” and supplemented with digests of
associated administrative rulings and judicial decisions. Volume
19, “New Matters,” is used to retain current developments, such
as digests of Tax Court decisions, full texts of rulings, current
tables of decisions and rulings, and the Supreme Court Docket.
The Standard also includes the “U.S. Tax Cases Advance
Sheets” Volume in which are reported the full texts of new
income tax decisions from the federal courts, including the U.S.
Supreme Court and the U.S. Court of Federal Claims. In the
three Internal Revenue Code Volumes may be found the current
internal revenue statutes. The Index Volume leads to the basic
contents by subject through the Topical Index and also features
a tax calendar, rate tables and tax rate schedules, tax planning
information, checklists, and special tables.
United States Tax Reporter, Thomson Reuters
United States Tax Reporter, published by Thomson Reuters,
consists of 18 coordinated loose-leaf volumes organized by
Code sections and updated on a weekly basis. The service is
similar to Wolters Kluwer’s and also includes a tw o-volume
Internal Revenue Code, a seven-volume Citator, a one-volume
Index, a one-volume Table of Cases, Rulings, and Tax Tables, a
Recent Developments volume, an Advance Sheets volume for
AFTR2d cases and a volume of proposed amendments to Federal

Tax Regulations. Thomson Reuters also publishes loose-leaf tax
services for excise taxes and for estate and gift taxes. This
service is included in the Thomson Reuters Checkpoint online
service.
Mertens, Law of Federal Income Taxation, Thomson Reuters
Merten’s Treatise on the Law of Federal Income
Taxation, published by Thomson West, is an intensive,
annotated work, providing excellent in-depth discussions of
general concepts of tax law. However, unlike services such as
those of Wolters Kluwer and Thomson Reuters, Mertens is not
generally used as a comprehensive, self-contained reference
service. Rather, it is typically regarded as a useful complement
to the traditional reference services.
Tax Management Portfolios, Bloomberg BNA
Tax Management Portfolios, published by Bloomberg BNA, is a
useful supplement to a tax library. Each portfolio ranges in
length from 50 to 200 pages and deals exclusively with a special
tax topic, covering Code, Regulations, reference to primary
authorities, and extensive editorial discussion, including
numerous tax planning ideas. Bloomberg BNA Portfolios are
available online.
Federal Tax Coordinator, Thomson Reuters
The Federal Tax Coordinator, published by Thomson Reuters, is
somewhat similar in organization to Wolters Kluwer’s Standard
Federal Tax Reporter and Thomson Reuters's United States Tax
Reporter, with compilation volumes and an elaborate cross-
reference system of indexation. However, this service is
organized by topic rather than by Code section. Popular features
of the Tax Coordinator are the editorial explanations,
illustrations, planning ideas, and warnings of potential tax
traps. This service is included in the Thomson Reuters
Checkpoint online service.
The Citator
Probably the most comprehensive method for evaluating and
updating case law is through the use of a citator. The Wolters
Kluwer Citator contains an alphabetical listing of the Tax Court

(formerly the Board of Tax Appeals) and federal court decisions
since 1913. It is updated currently online in
CCH® AnswerConnect and CCH® IntelliConnect®.
Additionally, the Wolters Kluwer Citator indicates a paragraph
reference where each case is digested in the Compilation
Volumes of the Standard Federal Tax Reporter. More than one
paragraph reference will be given if a case involves several tax
issues. The Citator is available on CCH® AnswerConnect and
CCH® IntelliConnect® and offers instant linking to the cases
cited.
Each listing outlines the judicial history of a selected case
beginning with the highest court to have ruled on that issue.
Then, in descending order, the actions of lower courts are also
cited and described. Finally, under each listing,
the Citator refers to other court cases, which helps to evaluate a
given decision as a precedent.
The Citator 2nd, published by Thomson Reuters, is a service
with monthly and annual cumulative supplements organized in a
manner somewhat consistent with that of the Wolters Kluwer
Citator. Essentially, Thomson Reuters provides an alphabetical
list of court cases followed by a descriptive legislative history
of each case. However, in those cases involving more than one
issue, the Thomson Reuters citator also cross-references its
descriptive system of judicial references according to the
various issues. Citators are included in the online servi ces of
Wolters Kluwer and Thomson Reuters.
To illustrate the usefulness of the citator to the researcher, the
Wolters Kluwer Citator will be explained in greater detail.
Refer to Exhibit 4, a sample taken from the Wolters Kluwer
Citator and locate the Atlas Life Insurance Co. case. The case
name is followed by paragraph (¶) references to the Compilation
Volumes in which the decision appears as an annotation to the
law, regulations, and other cases in point. The black dot
preceding each court action in the case permits the researcher to
quickly scan the judicial history of the case. Atlas Life
Insurance Co. was decided on appeal in the Supreme Court in

1965, which reversed the decision of the Court of Appeals for
the Tenth Circuit. The Court of Appeals decision reversed the
ruling of the District Court of Oklahoma.
Exhibit 4. WOLTERS KLUWER CITATOR—COURT CASES
SAMPLE SECTION
In addition to the historical record of the case, citations are
given for the court actions taken in a particular case which show
where the full text of the decision may be found. A citation
to U.S. Tax Cases (USTC), for example, refers to an expansive
series of volumes published by Wolters Kluwer that cover tax-
related court opinions issued since 1913. The volumes,
published twice a year, cover Supreme Court, Courts of
Appeals, District Courts, and Court of Federal Claims cases.
The Thomson Reuters citator would refer to the American
Federal Tax Reports (AFTR), the comparable Thomson Reuters
series of federal court cases. Memorandum decisions of the Tax
Court are published by Wolters Kluwer under the title Tax
Court Memorandum Decisions (cited TCM), while the Thomson
Reuters series is called TC Memorandum Decisions (cited TC
Memo).
The Citator typically gives even further research informati on
than already discussed. For each case listed in the Citator there
is given the “cited record” of that case. These “cited records”
list the names and citations of later cases which discussed and
distinguished the main case. Thus, the “cited record” permi ts
the researcher to evaluate the judicial authority of the related
case.
For the very latest developments in any case, the researcher
using the Wolters Kluwer Citator should also check the “Case
Table” (for the current year) in Volume 19, the “New Matters”
volume of the Standard. Appeals to higher courts, IRS
acquiescences or nonacquiescences, and government decisions
on whether to appeal federal court cases are shown in the “Case
Table” (for the current year) for all cases. (Where Supreme
Court action is indicated in the Case Table, more information on

the case may be obtained from the Supreme Court Docket
located in the New Matters Volume.)
Books
In addition to the loose-leaf reference services and the bound
volumes of tax-related court cases published in the special
reporter series U.S. Tax Cases (USTC) available from Wolters
Kluwer or the American Federal Tax Reports (AFTR) available
from Thomson Reuters, a well-equipped tax library should
contain numerous leading tax textbooks.
Following are selected, highly recommended tax books:
Price on Contemporary Estate Planning, John R. Price and
Samuel A. Donaldson (Wolters Kluwer)
Federal Tax Practitioner's Guide, Susan Flax Posner (Wolters
Kluwer)
Federal Income Taxation of Corporations and
Shareholders, Boris I. Bittker and James I. Eustice (Thomson
Reuters)
S Corporation Taxation, Robert W. Jamison (Wolters Kluwer)
Practical Guide to Partnerships and LLCs, Robert Ricketts and
Larry Tunnell (Wolters Kluwer)
Practical Guide to U.S. Taxation of International
Transactions, Robert J. Misey, Jr. and Michael S. Schadewald
(Wolters Kluwer)
Partnership Taxation, Arthur Willis, Philip Postlewaite, and
Jennifer Alexander (Thomson Reuters)
Tax Institutes
Current tax topics are discussed and technical papers presented
at the various tax institutes and symposia held annually at
universities and other locations throughout the United States.
The well-known tax institutes, such as New York University and
the National Tax Association—Tax Institute of America,
publish their annual proceedings. The papers presented at the
annual University of Chicago Federal Tax Conference are
published every year in the March issue of TAXES—The Tax
Magazine. The papers presented at the annual UCLA Tax
Controversy Institute and the New York University Tax

Controversy Forum are published each year in the December-
January and August-September issues of the Journal of Tax
Practice and Procedure.
Tax Periodicals
Several monthly and quarterly journals contain current articles
dealing exclusively with technical tax matters. Some of these
magazines cover a broad range of tax topics, while others
specialize in a particular area of taxation.
Following are some of the more popular tax periodicals:
Corporate Taxation (Thomson Reuters)
CPA Journal (New York State Society of Certified Public
Accountants)
Estate Planning (Thomson Reuters)
International Tax Journal (Wolters Kluwer)
Journal of the American Taxation Association (American
Taxation Association)
Journal of Tax Practice and Procedure (Wolters Kluwer)
Journal of Taxation (Thomson Reuters)
Journal of Taxation of Financial Products (Wolters Kluwer)
National Tax Journal (National Tax Association)
Practical Tax Strategies (Thomson Reuters)
Tax Adviser (American Institute of Certified Public
Accountants)
Tax Executive (Tax Executives Institute)
Tax Law Review (New York University School of Law)
Tax Lawyer (American Bar Association)
TAXES—The Tax Magazine (Wolters Kluwer)
Trusts and Estates (Penton Media, Inc.)
Newsletters
The practitioner needs to stay on top of current developments in
the tax field and for this purpose finds that weekly and even
daily updates of pertinent tax law information is needed. Daily
reporting is available both electronically through online
computer legal research systems from tax publishers and
through the mail. There is the daily Tax Day News and Federal
Tax Weekly, published by Wolters Kluwer; the Bloomberg

BNA Daily Tax Report, available from Bloomberg BNA; and
Tax Analysts’ Tax Notes Today.
Research Methodology
¶2125
TYPES OF TAX RESEARCH SITUATIONS
Essentially, there are two types of tax research cases or
situations. The “closed-fact” case, sometimes referred to as ex
post facto research, involves the legal interpretation of
historical events. In such cases, the taxable transactions have
already occurred and can no longer be altered, although various
tax elections and alternatives might still be available. Two
common examples of “closed-fact” situations are preparation of
a tax return after the taxable year is completed and
representation of a taxpayer before the Audit Division of the
IRS on the examination of a previously filed tax return.
In contrast, the “open-fact” case typically involves events that
have not yet been finalized (i.e., controllable facts). Thus, this
type of research relates primarily to future planning decisions.
However, whether the primary focus of a research engagement
is for tax compliance or tax planning, the underlying methods
and techniques should be systematic, thorough, properly
documented, and effectively communicated to the client.
¶2135
RESEARCH MODEL
The following research model presents a five-step systematic
format that can be applied to a “closed-fact” or an “open-fact”
case:
1. Gathering the facts and identifying the tax issues to be
researched.
2. Locating and studying the primary and secondary authorities
relevant to the enumerated tax issues.
3. Updating and evaluating the weight of the various authorities.
4. Reexamining various facets of the research.
5. Arriving at conclusions and communicating these conclusions
to the client.
STEP 1: Gathering the Facts and Identifying the Tax Issues to

Be Researched
During this difficult part of the research process it is necessary
to elicit a comprehensive, unbiased report from the client.
Difficulty stems from the fact that taxpayers often tend to have
a simple perspective of the tax issues related to their problem.
They fail to see the multiple issues that might be involved in
what they perceive as a single, straightforward issue.
EXAMPLE 2.1
Mary Jones, a single taxpayer, moved from New York to Miami
in 2020. Accordingly, she sold her residence in New York at a
gain well in excess of $400,000. In preparation of her 2020 tax
return, since the gain on the sale of this residence is quite
substantial, the researcher must examine the facts and explore
the tax-savings elections.
Mary is asked to provide all information related to these events,
and she supplies the real estate closing statement reflecting the
sale of the New York residence. As far as Mary is concerned,
she has supplied “all” information necessary to resolve this
issue. However, the following facts must still be ascertained:
1. What was the cost of the New York residence?
2. Should any improvements be capitalized as part of the basis
of the New York residence?
3. Were there any selling costs involved with the sale?
4. Over the years, were there any property assessments that
should be capitalized as part of the basis of the New York
residence?
5. Was any portion of the New York residence depreciated as a
home office deduction on prior tax returns?
6. Is Mary eligible for the $250,000 tax-free exclusion?
STEP 2: Locating and Studying the Secondary and Primary
Authorities Relevant to the Enumerated Tax Issues
For each issue enumerated in Step 1, the research might begin
with a thorough reading of the compilation materials found in
the tax services whether in print format (loose-leaf and books)
or electronic format. The editorial explanations and
observations provide useful insights and help direct the research

process. Additionally, the research should continue with a
review of the applicable Code sections, Regulations, and digests
of selected judicial decisions. Those cases which seem
particularly appropriate to the research should be cited to
facilitate reference for subsequent follow-up study. Finally,
before leaving the tax services, it is imperative to refer to the
“Current Developments” section to examine the impact of recent
actions.
STEP 3: Updating and Evaluating the Weight of the Various
Authorities
The statutory and administrative authorities selected in Step 2
must now be evaluated to determine relative weight.
Additionally, the relevant court cases must be assessed in terms
of their value as judicial precedent. Before relying upon a
particular decision, it is essential to refer to one of the citator
services and review the history and current status of that case.
It is not uncommon to discover conflicting interpretations of
similar issues by different courts. In place of a national law
policy, the Tax Court has adopted the position that better
judicial administration requires it to follow a Court of Appeals
decision. Nevertheless, courts at the same level of jurisdiction
may issue conflicting opinions; whereas, the Internal Revenue
Service is not obligated to adhere to either decision on a
nationwide basis. Accordingly, a District or Circuit Court
decision favorable to a taxpayer has significant precedent value
only within that district or circuit.
STEP 4: Reexamining Various Facets of the Research
After studying and evaluating the various statutory,
administrative, and judicial authorities, it often becomes
necessary to reexamine the original tax problem. It may even
become necessary to seek additional facts and modify or expand
the research process.
Additionally, if there are any authorities in conflict with the
projected conclusions, it is essential to study them carefully.
The researcher must not only be able to support his or her own
research conclusions, but also must be prepared to defend these

conclusions in light of conflicting authorities.
During this phase of the research, it may sometimes be useful to
clarify the meanings of unfamiliar or highly technical words or
terms. A standard dictionary may provide some guidance, but if
the words are not generally used in a nonlegal context, Black’s
Law Dictionary should be consulted.
STEP 5: Arriving at Conclusions and Communicating the
Conclusions to the Client
Communicating the conclusions of the tax research to the client
requires professional judgment. The client should be advised of
the potential benefits and risks associated with the
recommended actions. Since the communication will be in
writing, it is essential to determine how much or how little
detail should be noted. Additionally, the communication must
be expressed at the client’s level of sophistication. This
sometimes presents a difficult task, especially when the
research involves complex issues and highly technical
reasoning.
Essentially, the communication should be concise, well-
structured, and should follow an organized format that includes:
1. A review of the facts
2. An enumeration of the various tax issues
3. The conclusions
4. A discussion of the reasoning and authorities supporting the
conclusions
While the client might be concerned only with the section
dealing with conclusions, the professional substance of the
communication is contained in the reasoning and authority. It is
in this section of the report that the various authorities are
discussed and evaluated. Finally, it is in this section that the
client is supplied with authoritative support, should it ever
become necessary to defend against a challenge by the Internal
Revenue Service.
Tax Administration
¶2211
ORGANIZATION OF THE IRS

The administration and enforcement of federal internal revenue
taxes are required to be performed under the supervision of the
Secretary of the Treasury. Code Sec. 7801(a). The Internal
Revenue Service, a division of the Department of the Treasury,
has been delegated the operational aspects of the deter mination,
assessment, and collection of all internal revenue taxes. The
Commissioner of Internal Revenue, the official in charge, is
appointed by the President and serves under the Secretary of the
Treasury. Code Sec. 7802.
The Internal Revenue Service (IRS) consists of a National
Office, headquartered in Washington, D.C., and an extensive
field organization composed of over a hundred thousand
revenue agents, revenue officers, and support personnel. The
main task of the National Office is to develop uniform policies
for the nationwide administration of the tax law and coordinate
the various operations of the IRS.
Internal Revenue Service Restructuring and Reform Act of 1998
In accordance with the Internal Revenue Service Restructuring
and Reform Act of 1998, the IRS modified its entire structure.
The structure divides the IRS into four operating divisions.
Each operating division is responsible for serving a group of
similar taxpayers. The structure is organized to reflect specific
types of taxpayers and common issues associated with these
taxpayers. See Exhibit 5.
Exhibit 5. IRS ORGANIZATION CHART
The IRS’s mission is to:
Provide America’s taxpayers top quality service by helping
them understand and meet their tax responsibilities and by
applying the tax law with integrity and fairness to all.
The four operating divisions are supported by two agency-wide
service organizations: (1) Services and Enforcement; and (2)
Operations Support. In addition, the IRS Appeals Office, the
Taxpayer Advocate Service, the Office of the Chief Counsel and
Criminal Investigation are nationwide organizations that
provide separate specialized services.

The Operating Divisions
Wage and Investment Division (W&I)
W&I covers individual taxpayers who only receive wage and/or
investment income, which includes approximately 88 million
filers. Most of these taxpayers only deal with the IRS when
filing their tax returns each year. Compliance matters are
limited to such issues as dependency exemption, credits, filing
status, and deductions. Much of the income earned by W&I
taxpayers is reported by third parties (such as employers, banks,
brokerage firms) and the income is generally collected through
third-party withholding. Thus, this group is generally highly
compliant. Most of these taxpayers earn under $50,000 a year.
Small Business and Self-Employed Division (SB/SE)
SB/SE is comprised of fully or partially self-employed
individuals and small businesses. It includes corporations and
partnerships with assets less than or equal to $10 million. Also,
estate and gift taxpayers, fiduciary returns and all individuals
who file international returns are examined by this group, which
includes approximately 57 million filers. Typical taxpayers
from this group interact with the IRS 4 to 60 times per year .
Large Business and International Division (LB&I)
LB&I includes businesses with assets over $10 million. Many
complex matters, such as tax law interpretation, accounting and
regulation issues, are common. The largest taxpayers in this
group deal with the IRS on an almost continuous basis. The
LB&I is organized into support and practice areas. There are
five practice areas and three compliance practice areas.
Tax-Exempt Organizations and Governmental Entities Division
(TE/GE)
TE/GE includes pension plans, exempt organizations and the
governmental entities, and is comprised of about 24 million
filers.
Other Units
Criminal Investigation (CI)
CI’s mission is to the serve the public by investigating potential
criminal violations of the Internal Revenue Code and related

financial crimes. Its investigative jurisdiction includes tax,
money laundering, and Bank Secrecy Act laws. It is comprised
of three interdependent programs: Legal Source Tax Crimes;
Illegal Source Financial Crimes; and Narcotics Related and
Counterterrorism Financial Crimes.
Appeals
The IRS Appeals Office is headquartered in Washington, D.C.
and serves as the administrative forum for any taxpayer
contesting an IRS compliance action. It encompasses numerous
programs, including Alternative Dispute Resolution, Technical
Guidance-International, Art Appraisal Services, among others.
Taxpayer Advocate Service (TAS)
The TAS helps taxpayers who have problems with the IRS, and
who were not able to get them resolved through the normal
administrative process. The TAS is organized around two major
functions: (1) the casework function—to resolve all individual
taxpayer problems; and (2) the systemic analysis and the
advocacy function—to work with the operating divisions to
identify systemic problems, analyze root causes, implement
solutions, and proactively identify potential problems with new
systems and procedures. The TAS has offices in every state, the
District of Columbia, and Puerto Rico.
Office of Chief Counsel
The Chief Counsel serves as the chief legal advisor to the IRS
Commissioner regarding matters pertaining to the operation,
administration and enforcement of the internal revenue laws.
The Chief Counsel provides legal guidance and interpretative
advice to the IRS, the Treasury Department, and taxpayers
Office of Professional Responsibility
The Office of Professional Responsibility establishes and
enforces consistent standards of competence, integrity, and
conduct for tax professionals. It issues Circular 230.
Whistleblower Office
The IRS Whistleblower Office processes tips received from
individuals who spot tax problems in their workplace, while
conducting day-to-day personal business or anywhere else they

may be encountered. The Whistleblower Office is responsible
for assessing and analyzing the tips and, after determining their
degree of credibility, the case is assigned to the appropriate IRS
office for further investigation. An award worth 15 to 30
percent of the total proceeds that the IRS collects could be paid
if the IRS moves ahead based on the information provided.
Communications and Liaison
The Communications and Liaison Division attempts to ensure
that communications with customers, Congress, and
stakeholders are consistent and coordinated. The Division also
attempts to ensure that there is a quality work environment that
is operationally efficient and effective, including an emphasis
on automating business processes. It attempts to ensure that
there is appropriate collection, use, and protection of
information to accomplish IRS business objectives.
Office of Privacy, Governmental Liaison and Disclosure
This Division is intended to preserve and enhance public
confidence by advocating for the protection and proper use of
identity information. It administers the IRS’s privacy and
records policy and initiatves and coordinates privacy and
records-related actions across the IRS.
Return Preparer Office
This office’s mission is to improve compliance by providing
comprehensive oversight and support of tax professionals. Its
goal is to improve the compliance and accuracy of tax returns
prepared by tax return preparers. It oversees preparer tax
identification numbers (PTINs), enrollment programs, IRS-
approved continuing education providers, and the Annual Filing
Season Program for tax return preparers.
Office of Equity, Diversity & Inclusion (EDI)
The EDI Office oversees the Internal Revenue Service'
compliance with federal legislation, statutory requirements and
executive orders and to uphold taxpayer civil rights. It also
fosters workplace equality by ensuring that the IRS follows
Equal Employment Opportunity (EEO) principles throughout the
agency.

¶2215
REPRESENTATION OF TAXPAYERS
Rules for persons representing taxpayers before the IRS are
published in Treasury Department Circular No. 230. See 31
CFR Part 10. The phrase “practice before the IRS” includes all
matters connected with presentation to the IRS relating to a
client’s rights, privileges, or liabilities under laws or
regulations administered by the IRS. Circular No. 230, Sec.
10.2.
Neither the preparation of a return nor the appearance as a
witness for the taxpayer is considered practice before the IRS.
Attorneys or certified public accountants who are not under
suspension or disbarment may practice before the IRS, as may
any person enrolled as an agent. The latter individual, however,
must demonstrate special competence in tax matters by written
examination administered by the IRS. Treasury Department
Circular No. 230, Sec. 10.4.
In certain situations, other persons may represent taxpayers.
Individuals may appear on their own behalf, and, in addition,
Treasury Department Circular No. 230, Sec. 10.7, states a
number of situations where individuals may appear on behalf of
others without enrollment:
1. An individual may represent another individual who is his or
her full-time employer, a partnership of which he or she is a
general partner or a full-time employee, or a family member.
2. Corporations, associations, or organized groups may be
represented by bona fide officers or full-time employees.
3. Trusts, receiverships, guardianships, or estates may be
represented by their trustees, receivers, guardians,
administrators, or executors or full-time employees.
4. Governmental units, agencies, or authority may be
represented by an officer or regular employee of such
governmental unit, agency or authority.
5. An individual may represent any individual or entity that is
outside the United States before IRS personnel when such
representation takes place outside the United States.

6. An individual who prepares the taxpayer’s return as a
preparer and who has completed the Annual Filing Season
Program (AFSP) may represent the taxpayer before officers and
employees of the Examination Division of the IRS.
EXAMPLE 2.2
Sam Spaulding is being audited by the IRS for tax years 2018
and 2019. He prepared his own 2018 return, but ABC Tax
Return Preparation Service prepared his 2019 return. ABC could
represent Sam on matters relating to the 2019 return but only at
the agent or examining officer level, not at the higher level of
the Appeals Division and only if ABC meets the AFSP
requirements.
Circular No. 230, Secs. 10.20 to 10.37, states a number of rules
relative to practice before the IRS by tax preparers:
1. They shall not neglect or refuse promptly to submit records
or information requested by the IRS.
2. They shall advise the client promptly of any noncompliance,
error, or omission that may have been on any return or
document submitted to the IRS.
3. They shall exercise due diligence in preparing returns and
documents and in determining the correctness of oral or written
representations made by them to the IRS and to clients.
4. They shall not unreasonably delay the prompt disposition of
any matter before the IRS.
5. They shall not in any IRS matter knowingly and directly or
indirectly employ or accept assistance from any person who is
under disbarment or suspension from practice before the IRS.
6. They shall not charge an unconscionable fee for
representation of a client in any matter before the IRS.
7. They shall not represent clients with conflicting interests.
8. They shall not use or participate in the use of any form of
public communication containing false, fraudulent, misleading,
or unfair statements or claims.
¶2225
RULINGS PROGRAMS
Since passage of the first income tax laws, the IRS has engaged

in major publication efforts to provide taxpayers and their
advisors with the most current interpretive views of all areas of
federal income tax law. The Internal Revenue Bulletin is the
authoritative instrument of the IRS for announcing official
rulings (Revenue Rulings and Revenue Procedures) and for
publishing Treasury Decisions, Executive Orders, Tax
Conventions, legislation, and other items of general interest.
Since publication invites reliance, taxpayers must be aware of
the degree of authoritative weight that may be accorded such
documents. See detailed discussion at ¶2035.
In addition, Technical Information Releases (TIRs) and
Announcements are periodically distributed by the IRS to advise
the public of various technical matters. While these
pronouncements are published weekly in the Internal Revenue
Bulletin, they were not usually included in the Cumulative
Bulletin.
The IRS also issues communications to individual taxpayers and
IRS personnel in three primary ways: (1) letter rulings, (2)
determination letters, and (3) technical advice memoranda.
These documents are part of the IRS Rulings Program, which
includes published rulings appearing in the Internal Revenue
Bulletin, although letter rulings are not published in the Internal
Revenue Bulletin.
Letter Rulings
A letter ruling is a “written determination issued to a taxpayer
that interprets and applies the tax laws to that taxpayer’s
specific set of facts.” Rev. Proc. 2020-1, Sec. 2.01, IRB 2020-1.
Letter rulings generally are issued on uncompleted, actual
(rather than hypothetical) transactions or on transactions that
have been completed before the filing of the tax return for the
year in question. Thus, the emphasis of the letter rulings
program is upon the questions or problems of the taxpayer, in
contrast to the published rulings program, where the emphasis is
centered on uniformity of interpretation of the tax law.
It is the policy of the IRS, however, not to issue letter rulings in
a number of general areas:

1. Results of transactions that lack bona fide business purposes
or have as their principal purpose the reduction of federal taxes.
2. Matters on which a court decision adverse to the government
has been handed down and the question of following the
decision or litigating further has not yet been resolved.
3. Matters involving the prospective application of the estate
tax to the property or the estate of a living person.
4. Matters involving alternate plans of proposed transactions or
involving hypothetical situations.
5. Matters involving the federal tax consequences of any
proposed federal, state, local, or municipal legislation.
6. Whether a proposed transaction would subject the taxpayer to
a criminal penalty.
Further, it is the policy of the IRS to provide revised lists of
those areas of the Internal Revenue Code in which advanced
rulings or determination letters will not or will “not ordinarily”
be issued. (“Not ordinarily” connotes that unique and
compelling reasons must be demonstrated to justify a ruling or
determination letter.) Additions or deletions to the revised lists
are made as needed to reflect the current policy of the IRS and
are set out in several Revenue Procedures. For example, no
ruling will be issued to determine whether compensation is
reasonable in amount and therefore allowable as a deduction
under Code Sec. 162. This is but one of over 130 areas
identified by the IRS for nonissuance of letter rulings. There is
also a listing of over 60 areas in which rulings will not
ordinarily be issued. Rev. Proc. 2020-3, Sec. 3 and 4, 2020-1
IRB. Areas in international transactions for which rulings will
not be issued are also listed. Rev. Proc. 2020-7, Sec. 3, 2020-1
IRB.
The issuance of rulings serves to reduce the number of disputes
with revenue agents. A favorable ruling generally will avoid
any controversy with an agent in the event of a later audit. For
the taxpayer, rulings reduce the uncertainty of tax consequences
of a particular action. On the other hand, a ruling request has
some disadvantages. Cost is a factor since, under the IRS user

fee program, a taxpayer will have to pay fees to have a request
prepared. Code Sec. 7805. Rev. Proc. 2020-1, Appendix A,
2020-1 IRB. Also, there is often delay in obtaining a ruling,
which could be difficult for the taxpayer if time is a significant
factor.
Detailed instructions as to the information that a taxpayer
should submit in requesting a ruling are given in Rev. Proc.
2020-1, supra.
PLANNING POINTER
Although there may be advantages to obtaining a ruling, it may
not always be desirable to request a ruling. If the tax results are
uncertain but the taxpayer wants to go ahead with a proposed
transaction, it might be unwise to request a ruling. Also, if time
is a crucial factor and the proposed transaction is so complex
that a long time might pass before a response to a ruling request
would be given, it might be unwise to request a ruling.
Determination Letters
The determination letter program is part of the letter rulings
program. Determination Letters are not published; however, the
IRS is now required to make individual rulings available for
public inspection. A determination letter is a written statement
issued by a Director in response to an inquiry by an individual
or an organization. It applies to the particular facts involved
and is based upon principles and precedents previously
announced by the National Office to a specific set of facts. Rev.
Proc. 2020-1, Sec. 2.03, supra. Determination letters are issued
in response to taxpayers’ requests submitted to the Director,
whereas letter rulings are issued by the National Office. The
most important use of determination letters in prospective
transactions is in the qualification of pension plans and the
determination of the tax-exempt status of an organization.
PLANNING POINTER
It is advisable for taxpayers to request a determination letter in
connection with pension plans; otherwise, the taxpayer may
later find out that the plan does not qualify and deductions
might be disallowed.

A Director may not issue a determina tion letter in response to
an inquiry relating to a question specifically covered by statute,
regulations, rulings, etc. published in the Internal Revenue
Bulletin where (1) it appears that the taxpayer has directed a
similar inquiry to the National Office; (2) the identical issue
involving the same taxpayer is pending in a case before the
Appeals Office; (3) the determination letter is requested by an
industry, trade, or similar group; or (4) the request involves an
industry-wide problem. Reg. §601.201(c)(4). The form for a
request for a determination letter is the same as that for a
ruling. Rev. Proc. 2020-1, supra.
Technical Advice Memoranda
A technical advice memorandum is advice or guidance furnished
by the National Office upon request of a District or an Appeals
Office in response to any technical or procedural question that
develops during the examination or appeals process. Rev. Proc.
2020-2, Sec. 3, 2020-1 IRB. Both the taxpayer and the District
or Appeals Office may request technical advice. The taxpayer
may request advice where there appears to be a lack of
uniformity in the application of law or where the issue is
unusual or complex. Technical advice adverse to the taxpayer
and furnished to an Appeals Office does not preclude the
possibility of settlement. Technical advice can also be
advantageous from the IRS’s viewpoint in that it serves to
establish consistent holdings in field offices. Responses to
requests for technical advice memoranda sometimes become the
basis for a Revenue Ruling.
PLANNING POINTER
A revenue agent sometimes tends to resolve issues against the
taxpayer, even though the agent may actually believe the
taxpayer’s viewpoints are valid. Thus, the agent may actually
welcome a taxpayer’s request for technical advice because the
advice may coincide with what the agent actually believed and
yet the agent will not have to be the one who made the decision
in favor of the taxpayer.
User Fee Program

The payment of user fees is required for all requests to the IRS
for rulings, opinion letters, determination letters, and similar
requests. The IRS issues schedules of fees and procedures for
the collection of the fees along with other guidelines as
prescribed by the Revenue Act of 1987. The fee schedules range
from $275 to $181,500 (for pre-filing agreements). Rev. Proc.
2020-1, Appendix A, 2020-1 IRB.
¶2245
TAXPAYER COMPLIANCE ASSISTANCE
In order to assist taxpayers, individuals, corporations,
partnerships, and other legal entities to be in compliance with
requirements of the Internal Revenue Code and regulations, the
IRS develops and issues IRS Publications that address a variety
of general and special topics of concern to taxpayers. A typical
IRS Publication highlights changes in the tax law in a specific
area (for example, Pub. No. 970, Tax Benefits for Education),
explains the purpose of the law, defines terminology, lists
exemptions, provides several examples, and includes sample
worksheets and filled-in forms. As to taxpayer reliance, the IRS
warns in every IRS Publication that information provided covers
only the most common tax situation and is not intended to
replace the law or change its meaning. Even though IRS
Publications do not bind the IRS, the information contained in
IRS Publications provides essential guidance for tax law
compliance, particularly in technical or specialized areas.
Tax Practice and Procedure
¶2301
EXAMINATION OF RETURNS
Selection of Returns
The selection of returns for examination begins at the service
centers. Returns can be selected by computer programs or by
manual selection. The IRS uses the Discriminant Inventory
Function (DIF) system, which involves computer scoring using
mathematical formulas to select tax returns with the highest
probability of errors. Returns with the highest scores are then
manually examined by district classifiers, who determine

whether a return should be subject to examination. Internal
Revenue Manual, Sec. 4.1.5.1.1. Taxpayers are divided into
classes, including such classifications as business versus
nonbusiness; total positive income of varying amounts for
nonbusiness returns; and total gross receipts of varying amounts
for business returns. Total Positive Income (TPI) is defined as
the sum of positive income items on the return, such as wages,
interest, dividends, and other income items, with losses treated
as zero.
Returns are sometimes chosen at random for the National
Research Program (NRP). NRP is a program for measuring
taxpayer compliance through specialized audits of individual
tax returns. The principal uses of NRP data are to measure the
levels of compliance and tax administration gaps necessary for
formulation of the IRS’s long-term enforcement policies, to
determine changes in compliance levels over a period of time in
order to properly direct enforcement programs, to develop and
improve return selection procedures and changes in the DIF
scores, to identify alternative methods of operation, and to
achieve greater operating economies.
Other events that might give rise to an examination are:
1. Total positive income is above specified amounts.
2. Another IRS office or a non-IRS party might provide
information (e.g., a tip from a bitter former spouse).
3. A claim for refund may result in a closer examination of the
return.
4. A return of a related party (family member, partner) might be
examined to determine the correctness of the taxpayer’s return.
EXAMPLE 2.3
Arthur and Beverly Saunders were divorced in 2020. During
their marriage, Arthur had not reported some consulting income
he received beyond his regular salary. Beverly, still upset about
the divorce, reports Arthur to the IRS. This may result in an
audit.
EXAMPLE 2.4
In 2020, Charles Regus files an amended return with a sizeable

refund claim as a result of educational expense deductions that
he could have taken on his 2018 return, but which he failed to
take because he was uncertain as to whether they would qualify.
It is possible that close examination of his 2018 return might
occur as a result of this claim for refund. However, if Charles
believes he has a good case, he should file the amended return.
Correspondence Examinations
Correspondence examinations involve relatively simple
problems that can generally be resolved by mail. These
examinations would include mathematical errors, broadly
defined in Code Sec. 6213(g)(2) to mean (1) an error in
addition, subtraction, multiplication, or division shown on any
return; (2) an incorrect use of any IRS table if such incorrect
use is apparent from other information on the return; (3)
inconsistent entries on the return; (4) an omission of
information required to be supplied on the return to substantiate
a return item; and (5) a deduction or credit that exceeds a
statutory limit that is either a specified monetary amount or a
percentage, ratio, or fraction—if the items entering into the
application of such limit appear on the return.
EXAMPLE 2.5
James Judson, single, incorrectly determines his tax liability
because he used the joint rate schedule rather than the single
rate schedule. This correction and adjustment can be resolved
by mail.
The Service Center personnel might also question specific items
under the Unallowable Items Program. For example, a deduction
of Social Security taxes by the taxpayer would result in
notification by the Service Center. Such a contact is considered
to be an examination in contrast to a mathematical/clerical error
notification, which is not considered to be an examination. (If it
is an examination, one is entitled to a notice of deficiency and
to administrative appeal.) The IRS also matches information
returns of some taxpayers with income tax returns. If there is a
discrepancy, the return will be corrected, or the file might be
referred for examination and possibly criminal investigation.

District Office Examinations
A District Office examination of a return is conducted by a tax
auditor of the Audit Division either by correspondence or by
interview. Sometimes the matters are so simple they can be
handled by correspondence. Verification of particular itemized
deductions, such as interest, taxes, or charitable contributions
might be handled by correspondence. Internal Revenue
Manual, Sec. 4.10.2 and 3.
Returns selected for interview examinations generally require
some analysis and judgment as well as verification. Examples of
types of issues that lend themselves to interview examinations
are income items that are not subject to withholding, deductions
for travel and entertainment, items, such as casualty and theft
losses, that involve the use of fair market value, education
expenses, deductions for business-related expenses, and
determination of basis of property. Also, if the taxpayer’s
income is low in relation to financial responsibilities as
indicated on the return through the number of dependents or
interest expense, or if the taxpayer’s occupation is of the type
that required only a limited formal education, an office
interview might be deemed appropriate. Certain business
activities or occupations reported may lend themselves to office
interview examinations (e.g., auto repair shops, restaurants,
service stations, professional persons, farmers, motels, and
others).
EXAMPLE 2.6
Edward Egars, an outside salesperson, reports 2017 income of
$25,000 and takes travel and entertainment deductions before
application of the 50 percent limit on meals and entertainment
of $15,000. Edward could be called in for an office examination
to verify his travel and entertainment expenses for 2017.
EXAMPLE 2.7
Jane Judson has adjusted gross income of $15,000 and gives
$7,000 in cash contributions to her church. Since her
contributions exceed the norm for her bracket and approach the
maximum limitation for her income level, she could be called in

to verify her charitable contributions.
PLANNING POINTER
In an office examination, the taxpayer or a representative
should provide only information or support for items that are
requested of the taxpayer by the IRS; otherwise, the tax auditor
might open up other areas for investigation. Situations may
vary, but some practitioners believe that it is better for the
taxpayer, assuming there is a representative, such as a CPA or a
lawyer, not to be present because the representative can keep
better control over the interview and also maintain a less
emotional atmosphere.
When there is a disagreement after an office examination, if
practicable, the taxpayer is given an opportunity for an
interview with the tax auditor’s immediate supervisor or for a
conference with an Appeals Officer. Reg. §601.105(c)(1)(ii). If
these actions are not feasible, the taxpayer will be sent a 30-day
letter from the District Office indicating the proposed
adjustments and the courses of action. If the taxpayer agrees
with the adjustment, the taxpayer can sign the agreement form.
If the taxpayer disagrees, an Appeals Office conference may be
requested within 30 days or the taxpayer may ignore the 30-day
letter and wait for the 90-day letter, which allows the taxpayer
to file a petition in the Tax Court. Reg. §601.105(c)(1)(ii) and
(d)(1)(iv).
Field Examinations
Field examinations are conducted by revenue agents and involve
more complex issues than do office examinations. Field audits
take place in the taxpayer’s or the taxpayer’s representative’s
office or home (in the case of clear need, such as the taxpayer’s
advanced age). The revenue agent must identify items that may
need adjustment, gather the appropriate evidence, and apply the
applicable Code provisions, Regulations, and other
interpretative rulings. Techniques have been developed by the
IRS to try to ensure that revenue agents consider all areas
necessary for a proper calculation of the tax liability. An agent
has power to subpoena all books and records and to compel the

attendance of witnesses. Code Sec. 7602.
The agent completes a report called the Revenue Agent Report
(RAR). In agreed cases, a copy of the RAR is sent to the
taxpayer before review. If the taxpayer agrees with the revenue
agent’s adjustments and proposals, the taxpayer can sign Form
870 (Waiver of Restrictions on Assessment and Collection of
Deficiency in Tax and Acceptance of Overassessment). In
unagreed cases, the taxpayer does not receive the RAR until
after review by the Review Staff.
PLANNING POINTER
The revenue agent should be treated courteously and should be
promptly furnished information and substantiation relating to
applicable tax return items. Although the cooperation of the
taxpayer (or the taxpayer’s representative) is important, the
taxpayer should respond only to questions asked by the agent.
Disclosing unnecessary information could cause problems for
the taxpayer.
There are some advantages to settling with the revenue agent. In
addition to being less costly than settling at higher levels,
negotiations with the revenue agent are generally more informal
than negotiations at higher levels and less demanding on
technical aspects. Also, if questionable issues exist but were not
raised at the agent level, it may be wise to settle at that level in
order to avoid the possibility of persons at higher levels raising
those questionable issues. Similarly, there is an advantage to
the revenue agent to have an agreed case because it involves
more effort and time to write a report on an unagreed case than
on an agreed case.
Audit Reconsideration
The audit reconsideration is a procedure that is used when a
taxpayer has ignored a statutory notice of deficiency or where
there has been a breakdown in communication between the
taxpayer and the IRS. Internal Revenue Manual, Sec. 4.13.4.4.
An audit reconsideration is permitted when a new notice was
not sent to the taxpayer’s new address, the taxpayer had not
received any notification from the IRS on any assessment, and

the taxpayer had not been given an opportunity to submit any
required substantiation or necessary documentation.
¶2311
APPEALS PROCESS
Administrative Process
If the taxpayer and the agent do not agree, the taxpayer will be
sent a 30-day letter that explains the appellate procedures and
urges the taxpayer to reply within 30 days either by signing the
waiver or by requesting a conference. If the taxpayer does not
respond to the 30-day letter, a statutory notice of deficiency
(90-day letter) will be sent giving the taxpayer 90 days to file a
petition with the Tax Court. Thus, if the taxpayer and agent do
not agree, the taxpayer has several options:
1. The taxpayer may request a conference in the IRS Appeals
Office.
2. After receiving the statutory notice of deficiency, the
taxpayer may file a petition in the Tax Court within the 90-day
period.
3. The taxpayer could wait for the 90-day period to expire, pay
the assessment, and start a refund suit in the District Court or
the Court of Federal Claims.
If the IRS and the taxpayer agree, the statutory notice of
deficiency issued by the IRS (90-day letter) may be rescinded.
The rescinded notice voids the limitations regarding credits,
refunds, and assessments, and the taxpayer will have no right to
petition the Tax Court based on such notice. Rescinding the
deficiency notice will allow for resolution of the controversy
within the IRS.
IRS Appeals Office
If an appeal is made within the IRS, an appropriate request must
be made. The request must be accompanied by a written protest
unless:
1. The proposed increase or decrease in tax or claimed refund is
not more than $2,500 for any of the tax periods involved in field
examination cases.

2. The examination was conducted by a tax auditor (i.e., an
office examination) or by correspondence. (See IRS Publication
No. 5, Your Appeal Rights and How to Prepare a Protest If You
Don't Agree.)
If a protest is required, it should be sent within the 30-day
period granted in the letter containing the examination report.
The protest should contain:
1. A statement that the taxpayer wants to appeal the findings of
the examiner to the Appeals Office
2. Taxpayer’s name and address
3. The date and symbols from the letter transmitting the
proposed adjustments and findings the taxpayer is protesting
4. The tax periods or years involved
5. An itemized schedule of the adjustments with which the
taxpayer does not agree
6. A statement of facts supporting the taxpayer’s position in any
contested factual issue
7. A statement outlining the law or other authority on which the
taxpayer is relying
A taxpayer may go to the Appeals Office at two different times:
(1) if the protest is filed within the 30-day period as stated in
the 30-day letter, or (2) if the 30-day period passes and the
taxpayer files a petition in the Tax Court within 90 days after
receipt of a statutory notice of deficiency.
Exhibit 6 shows graphically the income tax appeal procedures
within the IRS (as described above) and through the court
system (as described on the following pages).
Exhibit 6. INCOME TAX APPEAL PROCEDURE
There are a number of important factors to consider in filing a
protest and going to the Appeals Office. It is less expensive
than litigation and yet the taxpayer leaves open the opportunity
to file a petition in the Tax Court or to sue for refund in a
District Court or the Court of Federal Claims. In addition, a
taxpayer is often able to gather more information about the IRS
position in the event the taxpayer needs to carry the case

further, and there may be a chance that the taxpayer can
convince the Appeals Officer that the IRS was incorrect at the
agent level. The Appeals Officer may be at some disadvantage
in that the case was not personally prepared and the Appeals
Officer is relying on the information presented by the revenue
agent, which could be an advantage to the taxpayer.
On the other hand, there may be some disadvantages to having
an Appeals Conference. New issues might be raised in an
Appeals Conference, although the IRS’s policy is to avoid
raising an issue unless the grounds for such action are
“substantial” and the potential effect upon tax liability is
“material.” Reg. §601.106(d)(1). The Appeals Officer must have
a strong reason for raising an issue.
Taxpayers may represent themselves at the Appeals Conference
or be represented by an attorney, CPA, or person enrolled to
practice before the IRS. The Appeals Officer, who actually
handles the appeals, reports to the Regional Director of Appeals
who, in turn, reports to the Regional Commissioner.
Proceedings before the Appeals Officer are informal and are
held in the District Office. The Appeals Officer may request
that the taxpayer submit additional information, which could
involve additional conferences.
The Appeals Officer may resolve controversies between the
taxpayer and the IRS by considering the “hazards of litigation.”
The Internal Revenue Manual, Sec. 8.8.6.4, states that a fair and
impartial resolution “reflects on an issue-by-issue basis the
probable result in event of litigation, or one which reflects
mutual concessions for the purpose of settlement based on the
relative strength of the opposing positions where there is a
substantial uncertainty of the result in event of litigation.” If
there is uncertainty as to the application of the law, the Appeals
Officer will consider a settlement in view of the hazards that
would exist if the case were litigated. Thus, the Appeals
Officer, in evaluating a case for settlement, will objectively
assess how a court might look at the case rather than attempt to
obtain the best results for the IRS. The Appeals Officer

considers the value of the evidence that would be presented, the
witnesses, the uncertainty as to an issue of fact and the
uncertainty as to a conclusion considering the court in which
the case might be litigated or appealed.
If a satisfactory settlement of the issue is reached after
consideration by the Appeals Office, the taxpayer will be
requested to sign Form 870-AD. By signing Form 870-AD, the
taxpayer waives restrictions on the assessment and collection of
any deficiency. Form 870-AD does not stop the running of
interest when filed. It is merely the taxpayer’s offer to waive
restrictions, and interest will run until 30 days after the IRS has
accepted the offer. If the taxpayer does not agree with the
decision at the Appeals level, a notice of deficiency will be
issued by the Appeals Office after consideration by the
Regional Counsel of the memorandum recommending a notice
of deficiency.
Taxpayer’s Rights
The Taxpayer Bill of Rights is a series of provisions that
require the Treasury Department to outline in “simple and
nontechnical terms the rights of a taxpayer and the obligations
of the IRS during an audit.” Additionally, the IRS is required to
inform taxpayers of their administrative and appeals rights in
the event of an adverse decision, as well as the procedures
related to refund claims, taxpayer complaints, collection
assessments, levies, and tax liens. The IRS has adopted a
Taxpayer Bill of Rights, as proposed by the Taxpayer Advocate
Service. See www.IRS.gov/taxpayer-bill-of-rights or IRS
Publication No. 1, Your Rights as a Taxpayer.
Most significantly, the law requires abatement of penalties
resulting from reliance on erroneous written IRS advice,
authorizes recovery of damages for failure of the IRS to remove
a lawful lien, permits the filing of an application for hardship
relief with the IRS Taxpayer Advocate, and outlines provisions
whereby a taxpayer, who substantially prevails in an
administrative or court proceeding against the IRS, may recover
reasonable administrative and litigation costs. Additionally, the

law allows a taxpayer or an IRS representative to make an audio
recording of an in-person interview regarding the determination
or collection of any tax.
Appeal Through the Court System
Within 90 days of mailing of a notice of deficiency, the
taxpayer may petition the Tax Court for redetermination of the
deficiency. Code Sec. 6213(a). If the 90-day deficiency notice
was issued by the Appeals Office, it is possible to arrange for
pretrial settlement with the Regional Counsel of the IRS, even
after the case has been docketed in the Tax Court. Taxpayers
filing a petition with the Tax Court may have their cases
handled under less formal rules applicable to “small tax cases”
if the amount of the deficiency or claimed overpayment is not
greater than $50,000. However, “small tax cases” are not
appealable and are not to be treated as precedents for any other
cases. Code Sec. 7463(a) and (b). If the taxpayer does not file a
petition with the Tax Court within 90 days, the opportunity to
appeal to the Tax Court is lost.
The taxpayer can pay the deficiency and file a claim for refund
by filing Form 1040X (Amended U.S. Individual Income Tax
Return) and mailing it to the IRS Center where the taxpayer
filed the original return. A claim for refund must be filed within
three years from the date the return was filed or within two
years from the date the tax was paid, whichever is later. Code
Sec. 6511(a). If the return was filed before the due date, the
three-year period starts to run from the date the return was due.
A suit to recover may not be started until after six months from
the date the taxpayer filed the claim for refund, unless a
decision on the claim for refund was made before then. A suit
for refund must be started before the end of two years from the
date of mailing of a notice to the taxpayer disallowing part or
all of the claim. Code Sec. 6532(a).
Federal Court System
There are three trial courts or courts of original jurisdiction: the
U.S. Tax Court, the U.S. District Courts, and the U.S. Court of
Federal Claims. Appeal from a decision of the Tax Court or the

U.S. District Court may be taken by either side to the federal
Court of Appeals for the circuit in which the taxpayer resides or
the corporation has its principal place of business. A review of
a decision of the U.S. Court of Federal Claims is taken to the
U.S. Court of Appeals for the Federal Circuit. The U.S.
Supreme Court has jurisdiction to hear appeals or review
decisions of the federal Court of Appeals and the U.S. Court of
Appeals for the Federal Circuit. (See Exhibit 2.) For a detailed
discussion of the trial court system, see ¶2055.
Choice of Tax Forum
There are a number of factors to consider in deciding whether to
litigate a case and where to litigate.
1. Jurisdiction. The Tax Court handles only income, estate, gift,
and excess profits tax cases. The District Court and the Court of
Federal Claims can litigate all areas of internal revenue taxes.
2. Payment of tax. In the Tax Court, payment of tax is not
generally allowed. Section 6213(b)(4) allows the taxpayer to
pay the tax after receiving a 90-day letter and still sue in the
Tax Court. This feature can be used by the taxpayer to stop the
accrual of interest on the deficiency while still choosing the Tax
Court forum. In the District Court and the Court of Federal
Claims, payment of tax is required. Thus, whether the taxpayer
has the money to pay the tax may be a factor in the choice of
tax forum.
3. Jury trial. A jury trial is available only in the District Court.
Often, tax cases do not make good jury cases because of their
complexity. Also, sometimes jurors may be prejudiced against a
taxpayer who is wealthier than they are.
4. Rules of evidence. The rules of evidence are most strict in
jury trials where efforts must be made to keep the jurors from
hearing inappropriate evidence. The evidence rules are more
lenient in the Tax Court.
5. Expertise of judges. Since the Tax Court hears only tax cases,
the judges are all very knowledgeable in tax law. The District
Court judges generally have the least tax expertise since the
District Court hears many types of cases.

6. Publicity. There will likely be more publicity in the District
Court since such suit is brought in the district in which the
taxpayer lives.
7. Legal precedent. The court decisions by which the particular
forum will be bound may also be a consideration. The Tax Court
is bound by Tax Court decisions (unless the Court of Appeals of
the circuit to which the case might be appealed held
differently), by the Court of Appeals to which the case might be
appealed, and by the U.S. Supreme Court. (See J.E. Golsen, 54
TC 742, Dec. 30,049 (1970), aff’d, 71-2 USTC ¶9497, 445 F.2d
985 (CA-10 1971), cert. denied, 404 U.S. 940, 92 S.Ct. 284.)
The District Court is bound by decisions of the Court of
Appeals for the circuit to which the decision would be appealed,
and by the U.S. Supreme Court. The Court of Federal Claims is
bound by decisions of the Court of Appeals for the Federal
Circuit and by U.S. Supreme Court decisions.
8. Factual precedent. In certain types of cases, one court may be
more favorable to the taxpayer than another court. For example,
regarding the characterization of voluntary payments to
employees’ widows as a gift or as compensation, the Tax Court
decisions have consistently been unfavorable to the taxpayer,
while results in the Courts of Appeals have been more balanced.
2020 CCH
STANDARD FEDERAL TAX REPORTS ¶5507.4741.
9. Statute of limitations. The statute of limitations is suspended
in a filing in the Tax Court whereas suit in the Court of Federal
Claims and the District Court does not suspend the statute of
limitations. Suspension of the statute of limitations means that
the IRS can raise new issues and claims for additional taxes.
10. Discovery. In the District Court and the Court of Federal
Claims, both parties (i.e., taxpayer and IRS) have available to
them discovery tools that allow them access to the other party’s
evidence prior to trial. In the Tax Court, the parties are
expected “to attain the objectives of discovery through informal
consultation or communication” and no depositions are
permitted (except in very limited circumstances). Tax Court

Rule 70.
PLANNING POINTER
It is important for taxpayers to be aware of the characteristics
of the courts so that an appropriate choice can be made if the
taxpayer decides to go to court. A taxpayer, having made a
decision to go to the District Court, for example, cannot later
decide to go to the Tax Court.
The taxpayer must think very seriously before taking a case to
court. Not only may the economic costs be high, but the
psychological and emotional costs may be high. The taxpayer
must consider whether the tax savings will be worth the legal
fees, time, and psychological costs.
A taxpayer, in deciding to which court to take a case, should not
look simply at the statistics on taxpayer winnings in the various
courts. Statistics like that have some value only if winnings by
taxpayers on similar issues are being examined.
KEYSTONE PROBLEM
If a taxpayer is called up for an office examination, what should
the taxpayer do? If the taxpayer and the tax auditor do not
agree, what steps should be taken? What factors would be
considered in deciding whether or not to pursue the matter?
¶2315
SETTLEMENT AGREEMENTS
Where a taxpayer and the appeals officer have reached an
agreement as to some or all of the issues in controversy,
generally the appeals officer will request that the taxpayer sign
a Form 870, the same agreement that is used at the district
level. However, when neither party with justification is willing
to concede in full the unresolved area of disagreement and a
resolution of the dispute involves concessions for the purposes
of settlement by both parties, a mutual concession settlement is
reached, and a Form 870-AD type of agreement is to be used.
Form 870 becomes effective as a waiver of restrictions and
assessment when received by the Internal Revenue Service,
whereas the Form 870-AD is effective upon acceptance by or on
behalf of the Commissioner of Internal Revenue.

¶2325
REFUNDS
Claims for refund of individual income taxes are to be made on
Form 1040X (Amended U.S. Individual Income Tax Return) and
on Form 1120X for corporate income tax refunds. The claim for
refund must be filed no later than three years from the date the
return was filed or no later than two years from the date the tax
was paid, whichever period expires later. Code Sec. 6511(a). If
the return was filed before the due date, the three-year period
starts to run from the date the return was due. There is a special
seven-year period of limitation on a claim for refund based on a
debt that became wholly worthless or on a worthless security. If
the refund claim relates to a net operating loss, capital loss, or
credit carryback, the refund claim may be filed within three
years after the time for filing the tax return for the year of the
loss (or unused credit). Code Sec. 6511(d).
Any tax deducted or withheld at the source during any calendar
year is deemed to be paid on the 15th day of the fourth month
following the close of the taxable year. Code Sec. 6513(b).
Thus, a refund for taxes withheld must be filed within three
years of the due date of the return (including extensions). Code
Sec. 6511(b).
EXAMPLE 2.8
In 2020, Joe, a college student, worked part-time during the
summer. He earned $3,000 and had income tax withheld of
$400. He did not file a 2020 tax return by April 15, 2021. If he
does not file his 2020 tax return by April 15, 2024, he cannot
obtain the refund of $400.
¶2333
INTEREST ON UNDER/OVERPAYMENTS
The interest rate that taxpayers must pay for underpayment of
taxes is equal to the federal short-term rate plus three
percentage points. In the case of overpayme nt of taxes, the
amount of interest owed by the Treasury is equal to the federal
short-term rate plus three percentage points. Code Sec. 6621(a).
These interest rates are adjusted quarterly, with the new rates

becoming effective two months after the date of each
adjustment.
Interest is also paid by the IRS on overpayments of tax.
However, if any overpayment of tax is refunded within 45 days
after the due date of the return (or filing date if later), no
interest is allowed. If any overpayment results from a carryback
(net operating loss, capital loss, or credit) through filing an
amended return, interest is paid only if the overpayment is not
refunded within the 45-day period. Code Sec. 6611(e) and (f).
¶2355
STATUTE OF LIMITATIONS
Assessment of any tax must be made within three years after the
return was filed or after the due date for filing, whichever is
later. Code Sec. 6501(a). After making an assessment of tax, the
IRS has 10 years in which to initiate collection proceedings.
Code Sec. 6502(a).
EXAMPLE 2.9
Fred Forbes filed his 2020 return on February 20, 2021. The
government may not assess any additional tax for 2020 after
April 15, 2024. If, on the other hand, he had filed his 2020
return on October 8, 2021, the statute of limitations would
expire on October 8, 2024.
There are some exceptions to the general rule:
1. There is no limitation on the period for assessment in three
cases: (1) false return, (2) willful attempt to evade tax, and (3)
no return. Code Sec. 6501(c)(1)-(3).
EXAMPLE 2.10
Linda Lord failed to file tax returns in 2009 and 2010 when she
had $20,000 gross income. If the government discovered in
2020 that the returns were not filed, it could assess 2009 and
2010 taxes against Linda.
2. If the taxpayer omits from gross income or overstates
expenses an amount that is in excess of 25 percent of the
amount of gross income stated on the return, the tax may be
assessed at any time within six years after the return is filed or
the due date for filing, if later. In computing gross income,

revenues from the sale of goods or services are not to be
reduced by cost of goods sold. Code Sec. 6501(e)(1). Gross
income also includes capital gains but is not reduced by capital
losses.
EXAMPLE 2.11
On her 2019 return filed on March 20, 2020, Vera Vaughn
reported her salary of $35,000 and taxable interest of $5,000.
She failed to report a $9,000 capital gain. Since the $9,000
omission does not exceed $10,000 (25 percent of $40,000), the
statute of limitations expires on April 15, 2023. If the omitted
capital gain had been $11,000, the statute of limitations would
expire on April 15, 2026.
EXAMPLE 2.12
As a sole proprietor, George Ganger had $50,000 sales and
$20,000 cost of goods sold, which were reported on his 2019 tax
return filed on March 14, 2020. Through an oversight he failed
to report $8,000 interest. Since $8,000 interest does not exceed
$12,500 (25 percent of $50,000), the statute of limitations
expires on April 15, 2023.
3. Where both the taxpayer and the IRS agree, the statute of
limitations may be extended for a specific period. The extension
must be executed before the expiration of the applicable
limitation period. Code Sec. 6501(c)(4).
4. Certain taxpayers may request a prompt assessment. The
period of assessment may be shortened to 18 months in the case
of a decedent, the estate of a decedent, or a corporation that is
dissolved or contemplating dissolution. Code Sec. 6501(d). The
purpose of this rule is to allow an estate or corporation to settle
its affairs early without having to make contingent plans for
later possible tax assessments.
5. If a personal holding company fails to file with its return a
schedule regarding its status as a personal holding company, the
tax may be assessed at any time within six years after the return
is filed. Code Sec. 6501(f).
6. In the case of a deficiency attributable to the application of a
carryback (capital loss, net operating loss, or credit), the statute

of limitations runs from the year of the loss rather than the
carryback year. Code Sec. 6501(h) and (j).
Code Secs. 1311 through 1314 contain provisions to mitigate
the effect of the statute of limitations where inequitable results
might occur.
¶2365
PENALTIES
Penalties are treated as additions to federal internal revenue
taxes and are, therefore, not deductible for federal income tax
purposes.
Delinquency Penalties
The penalty for failure to file a return on the due date
(determined with regard to any extension of time for filing) is 5
percent of the amount of tax due if the failure is for not more
than one month, with an additional 5 percent for each additional
month or fraction thereof, but not exceeding 25 percent in the
aggregate. Code Sec. 6651(a)(1). The penalty is imposed on the
net amount due—the difference between (1) the amount required
to be shown on the return and (2) the amount paid on or before
the due date and the amount of credit that may be claimed on
the return. In the case of a fraudulent failure to file a return, the
failure to file penalty is increased to 15 percent if the net
amount of tax due for each month the return is not filed up to a
maximum of five months or 75 percent. Code Sec. 6651(f). The
failure to file penalty is reduced by the 0.5 percent failure to
pay penalty for any month in which both apply.
The penalty for failure to pay the amount of tax due on a tax
return or for failure to pay an assessed tax within 10 days of the
date of notice is one-half of one percent of the tax for one
month or less and an additional one-half of one percent per
month or part thereof until the penalty reaches 25 percent. An
additional one-half of one percent per month is assessed if the
taxpayer fails to pay a deficiency within 10 days after a notice
is issued. Code Sec. 6651(a)(2) and (3) and (d). The penalty is
imposed on the net amount due.
Either or both of the penalties can be avoided if the taxpayer

can show that failure to file and/or pay was due to reasonable
cause and not to willful neglect. Code Sec. 6651(a)(1), (2), and
(3). The burden of establishing these facts is on the taxpayer.
The Internal Revenue Manual, Sec. 20.1.1.3.2, gives some
indication of what would be considered as reasonable cause for
purposes of the delinquency penalties:
1. A return mailed in time but returned for insufficient postage.
2. A return filed within the legal period but in the wrong
district.
3. Death or serious illness of the taxpayer or in the immediate
family.
4. Unavoidable absence of the taxpayer.
5. Destruction of the taxpayer’s business or business records by
fire or other casualty.
6. Erroneous information given the taxpayer by an IRS official,
or a request for proper blanks or returns not furnished by the
IRS in sufficient time to permit the filing of the return by the
due date.
7. The taxpayer made an effort to obtain assistance or
information necessary to complete the return by a personal
appearance at an IRS office but was unsuccessful because the
taxpayer, through no fault, was unable to see an IRS
representative.
8. The taxpayer is unable to obtain the records necessary to
determine the amount of tax due for reasons beyond the
taxpayer’s control.
9. The taxpayer contacts a competent tax adviser, furnishes the
necessary information, and then is incorrectly advised that the
filing of a return is not required.
If the cause does not fall within one of the reasonable causes
listed above, the District Director will decide whether the
taxpayer established a reasonable cause for delinquency.
Accuracy-Related and Fraud Penalties
The penalties relating to the accuracy of tax returns are
consolidated into one accuracy-related penalty equal to 20
percent of the portion of the underpayment to which the penalty

applies. The penalty applies to the portion of underpayment
attributable to one or more of the following:
1. Negligence
2. Substantial understatement of income tax
3. Substantial valuation misstatement
4. Substantial overstatement of pension liabilities
5. Substantial estate or gift tax valuation understatement
6. Understatements resulting from listed and reportable
transactions
The penalty does not apply to any portion of an underpayment
attributable to a penalty for fraud. Code Sec. 6662(a) and (b).
For purposes of the consolidated penalty, “underpayment”
means the amount by which any tax exceeds the excess of (1)
the sum of (a) the amount shown as the tax by a taxpayer on the
return, plus (b) amounts not shown as tax that were previously
assessed, over (2) the amount of rebates made. Code Sec.
6664(a).
The accuracy-related penalties will not be imposed if it is
shown that there was a reasonable cause for the underpayment
and that the taxpayer acted in good faith with respect to the
underpayment. Code Sec. 6664(c)(1).
Negligence Penalty
A 20-percent penalty is imposed for underpayment of tax due to
negligence or disregard of rules and regulations. Code Sec.
6662(a).
EXAMPLE 2.13
Due to negligence, Steven Stover underpaid his taxes for 2020
by $30,000. His penalty is $6,000 (20% × $30,000).
The term “negligence” includes any failure to make a
reasonable attempt to comply with the provisions of the Code,
and the term “disregard” includes any careless, reckless, or
intentional disregard. The definition of negligence is not limited
only to the items specified. Thus, all behavior that is considered
negligent under present law continues to be within the scope of
the negligence penalty. Also, any behavior that is considered
negligent by the courts but that is not specifically included

within the definition is subject to the penalty.
In an effort to provide guidance as to the scope of the term
“negligence,” the Internal Revenue Manual, Sec. 4.10.6.2.1,
states that it is “the omission to do something which a
reasonable person, guided by those considerations which
ordinarily regulate the conduct of human beings, would do, or
doing something which a reasonable person would not do.”
According to the Manual, Sec. 4.10.6.2.1, the following are
examples of cases in which negligence may exist:
1. Taxpayer continues year after year to make substantial errors
in reporting income and claiming deductions even though these
mistakes have been called to the taxpayer’s attention in
previous reports.
2. Taxpayer fails to maintain proper records after being advised
through inadequate record procedures to do so and subsequent
returns containing substantial errors are filed.
3. Taxpayer took careless and exaggerated deductions
unsubstantiated by facts.
4. Taxpayer failed to give any explanation for the
understatement of income and for failure to keep books and
records.
Substantial Understatement of Tax Liability
If there is a substantial understatement of income tax, an
amount equal to 20 percent of the amount of the understatement
can be assessed. A substantial understatement of income tax
occurs when the understatement exceeds the greater of 10
percent of the tax required to be shown on the return or $5,000.
Code Sec. 6662(d)(1). In the case of a corporation (except for
an S corporation or a personal holding company), the
understatement must exceed the greater of 10 percent of the tax
required to be shown on the return or $10,000. The amount of
the understatement is equal to the excess of the tax required to
be shown on the return over the amount of tax that is actually
shown on the return.
The penalty can be avoided if there was substantial authority for

the tax treatment; if relevant facts affecting the treatment are
adequately disclosed in the return or a statement attached to the
return; and in the case of tax shelter items, if the taxpayer
reasonably believed that the tax treatment of such item was
more likely than not the proper treatment. Code Sec.
6662(d)(2)(B) and (C). The penalty can be waived on showing
of reasonable cause and that the taxpayer acted in good faith.
Code Sec. 6664(c).
Substantial Valuation Misstatement Penalty
All taxpayers having an underpayment of tax attributable to a
valuation misstatement are subject to this 20-percent penalty.
Code Sec. 6662(e). There is a substantial valuation
misstatement if the value of any property (or the adjusted basis
of any property) is 150 percent or more of the amount
determined to be the correct amount of the valuation or adjusted
basis of the property. If the portion of the underpayment that is
subject to the penalty is attributable to one or more gross
valuation misstatements, the penalty will be applied at the rate
of 40 percent. A gross valuation misstatement occurs if the
value of the property (or the adjusted basis) was 200 percent or
more of the correct amount of the valuation of the adjusted
basis of the property. Code Sec. 6662(h)(2)(A). No penalty will
be imposed on a taxpayer for a substantial valuation
misstatement unless the portion of the underpayment
attributable to substantial valuation misstatements exceeds
$5,000, or $10,000 in the case of a corporation other than an S
corporation or a personal holding company.
EXAMPLE 2.14
Bert Barge gives a painting he purchased three years ago to his
alma mater and takes a charitable contribution deduction in the
amount of $50,000, the value placed on it by his art professor
friend. If the actual value was only $20,000 and if the tax
underpayment is $10,000, Bert would be subject to a $4,000
valuation misstatement penalty (40 percent of $10,000). The
valuation was more than 200 percent of the correct valuation.
Although valuation misstatements of charitable property

resulting in understatements of tax are subject to the accuracy
penalty provisions, the charitable deduction penalty waiver for
qualified appraisers is still possible. No penalty will be imposed
for an underpayment of tax resulting from a substantial or gross
misstatement of charitable deduction property if it can be shown
that there was a reasonable cause for the underpayment and that
the taxpayer acted in good faith.
Substantial Overstatement of Pension Liabilities
The 20-percent penalty for substantial overstatement of pension
liabilities applies only if the actuarial determination of pension
liabilities is 200 percent or more of the amount determined to be
correct. Code Sec. 6662(f). If a portion of the substantial
overstatement to which the penalty applies is attributable to a
gross valuation misstatement of 400 percent or more, the
penalty is doubled to 40 percent of the underpayment. Code Sec.
6662(h). No penalty is imposed if the underpayment for the tax
year attributable to substantial overstatements of pension
liabilities is $1,000 or less.
Estate or Gift Tax Valuation Understatements
A 20-percent penalty is imposed for estate or gift tax valuation
understatement if the value of any property claimed on an estate
or gift tax return is 65 percent or less of the amount determined
to be the correct amount of the valuation. Code Sec. 6662(g). If
the understatement is attributable to a gross valuation
misstatement of 40 percent or less of the correct amount, the
penalty amount is 40 percent of the underpayment. Code Sec.
6662(h)(2)(C). This penalty applies only if the underpayment
attributable to the understatement exceeds $5,000 for a tax
period with respect to gift tax (or with respect to the estate in
the case of estate tax).
Understatements Resulting from Listed and Reportable
Transactions
An accuracy-related penalty is imposed for understatements
resulting from listed and reportable transactions. Code Sec.
6662A. The penalty applies to understatements attributable to
(1) any listed transaction, and (2) any reportable transaction

with a significant tax avoidance purpose. The penalty is
generally 20 percent of the understatement if the taxpayer
disclosed the transaction, and 30 percent if the transaction was
not disclosed.
The listed and reportable transactions penalty is coordinated
with three other penalties; (1) The Code Sec. 6662 accuracy-
related penalty; (2) Code Sec. 6663 fraud penalty; and (3) the
valuation misstatement penalties under Code Sec. 6662(e) and
6662 (h). There is a “reasonable cause” exception, although it is
more demanding than the reasonable cause exception to the
accuracy-related (Code Sec. 6662) and fraud (Code Sec. 6663)
penalties.
Penalty for Aiding Understatement of Tax Liability
Any person who aids in the preparation or presentation of any
tax document in connection with matters arising under the
internal revenue laws with the knowledge that the document
will result in the understatement of tax liability of another
person is subject to a penalty of $1,000 ($10,000 for a
corporation) for a taxable period. Code Sec. 6701.
Civil Fraud Penalty
If any part of an underpayment is due to fraud, the penalty
imposed is 75 percent of the underpayment (the “civil fraud”
penalty). Code Sec. 6663(a). Once the IRS establishes that any
portion of an underpayment is due to fraud, the entire
underpayment is assumed to be attributable to fraud, unless the
taxpayer proves otherwise. Code Sec. 6663(b). The 20-percent
accuracy-related penalty does not apply to any portion of an
underpayment on which the fraud penalty is imposed. However,
the accuracy-related penalty may be applied to any portion of
the underpayment not attributable to fraud.
EXAMPLE 2.15
Beth Barrett owes a $50,000 deficiency, all due to civil fraud.
In addition to the $50,000 tax deficiency, Beth will be liable for
a $37,500 (75 percent of $50,000) civil fraud penalty.
Criminal Fraud Penalty
In addition to the civil fraud penalty, criminal fraud penalties

may be imposed. Section 7201 provides that “any person who
willfully attempts in any manner to evade or defeat any tax
imposed by this title or the payment thereof shall, in addition to
other penalties provided by law, be guilty of a felony. . . .” In
order for there to be criminal fraud, the attempt to evade or
defeat tax must be willful, which implies a “voluntary
intentional violation of a known legal duty.” C.J. Bishop, 73-
1 USTC ¶9459, 412 U.S. 346, 93 S.Ct. 2009 (1973). Thus, an
individual’s behavior could not be willful if the actions are
done through carelessness, or genuine misunderstanding of what
the law requires.
A taxpayer convicted of criminal fraud is subject to a fine of up
to $100,000 ($500,000 in the case of a corporation) or
imprisonment of up to five years, or both, together with the
costs of prosecution. Code Sec. 7201. The more important fraud
provisions include the following:
1. Any person who willfully fails to collect or pay over
withholding tax is guilty of a felony and, upon conviction, will
be fined not more than $10,000, or imprisoned not more than
five years, or both, together with the costs of prosecution. Code
Sec. 7202.
2. Any person who willfully fails, when required, to pay
estimated tax, to file a return, to keep records, or to supply
information will be guilty of a misdemeanor and, upon
conviction, will be fined not more than $25,000 ($100,000 in
the case of a corporation) or imprisoned not more than one year,
or both, together with the costs of prosecution. Code Sec. 7203.
3. Any person who willfully furnishes a false or fraudulent
statement or who willfully fails to supply an employee wi th a
statement of wages and withholdings will, if convicted, be fined
not more than $1,000 or imprisoned not more than one year, or
both. Code Sec. 7204.
4. Any person who willfully supplies false or fraudulent
information regarding exemptions will, if convicted, be fined
not more than $1,000 or imprisoned for not more than one year,
or both. Code Sec. 7205.

5. Any person who is convicted under the fraud and false
statement statute will be fined not more than $100,000
($500,000 in the case of a corporation) or imprisoned not more
than three years, or both, together with the costs of prosecution.
Code Sec. 7206. This statute includes:
a. Making a false declaration that is made under the penalties of
perjury
b. Aiding or assisting in preparation or presentatio n of returns,
claims, or other documents that are false as to any material
matter
c. Simulating or falsely executing any bond or other document
required by the internal revenue laws
d. Removing, depositing, or concealing any property with intent
to evade or defeat assessment or collection of any tax
e. Concealing property or withholding, falsifying, or destroying
records relating to the financial condition of the taxpayer in
connection with an offer in compromise or a closing agreement
6. Any person who willfully delivers or discloses any list,
return, statement or other document known to that person to be
fraudulent or false as to any material matter will be fined not
more than $10,000 ($50,000 in the case of a corporation) or
imprisoned not more than one year, or both. Code Sec. 7207.
Estimated Taxes and Underpayment Penalties
All taxpayers are generally required to make interim tax
payments of substantially all of their accrued tax liability for
the current year. For individuals, this is generally accompli shed
through withholding. Where withholding is insufficient,
however, as is frequently the case with self-employed
individuals, the taxpayer must file a declaration of estimated tax
and may have to make quarterly estimated tax payments. The
specific requirements are set forth in ¶9165.
If the total amount of tax paid through withholding and
estimated tax payments is not enough, an underpayment penalty
is imposed. The underpayment is computed on a quarterly basis
and the interest penalty is then applied to these quarterly
underpayments. Code Sec. 6654(d)(1). The charge runs until the

amount is paid or until the due date of the return, whichever is
earlier. An individual taxpayer can avoid the penalty for
underpayment if the payments of estimated tax are at least as
large as any one of the following:
1. 90 percent of the tax shown on the return or 100 percent (110
percent if adjusted gross income for 2002 and later exceeds
$150,000) of the tax shown on the return for the preceding
taxable year (assuming it showed a tax liability and covered a
taxable year of 12 months). Code Sec. 6654(d)(1)(A) and (B).
2. An amount equal to 90 percent of the tax for the taxable year
computed by annualizing the taxable income received for the
months in the taxable year ending before the month in which the
installment is required to be paid. Code Sec. 6654(d)(2).
The underpayment penalty can be waived if the underpayment is
due to casualty, disaster, or other unusual circumstances, or
occurs during the first two years after a taxpayer retired after
reaching age 62, or became disabled. Code Sec. 6654(e)(3).
A penalty is also imposed on corporations by Code Sec. 6655
for any underpayment of estimated corporate tax. However, no
penalty is imposed if the corporation pays estimated tax at least
as large as any one of the following:
1. The tax shown on the return of the corporation for the
preceding year
2. The tax based on the prior year’s income but determined
under the current year’s rates
3. The tax shown on the return of the corporation for the current
year.
4. An amount equal to at least 100 percent of the tax due on the
current year’s taxable income for specified cutoff periods and
on an annualized basis. Code Sec. 6655(d)(1)(B)(ii) and (e).
Note: Large corporations (those with taxable income of $1
million or more in any one of the three preceding tax years) do
not qualify for the first two exceptions.
Failure to Make Deposits of Taxes
Employers are liable for payment of the tax that must be
withheld. Code Sec. 3402. Unless underpayme nt is due to

reasonable cause and not due to willful neglect, a penalty of as
much as 15 percent of the amount of the underpayment may be
imposed. Code Sec. 6656(a) and (b).
Tax Preparer Penalties
If an income tax return preparer, in preparing a tax return with
an understatement of tax liability, takes a frivolous position or
one for which there is not a realistic possibility of being
sustained on its merits, the penalty is the greater of $1,000 or
50 percent of the income derived by the tax return preparer with
respect to the return. Code Sec. 6694(a). An “income tax return
preparer” is any person who prepares for compensation or who
employs one or more persons to prepare for compensation any
return of tax or any claim for refund of tax. Code Sec.
7701(a)(36). No more than one individual associated with a firm
will qualify as a preparer with respect to the same return or
refund claim. Under the “one-preparer-per-firm” rule, should
more than one member of a firm be involved in providing
advice, the individual with supervisory responsibility for the
matter will be subject to the penalty as a nonsigning preparer.
Reg. §1.6694-1. A preparer is not subject to penalty for failure
to follow a rule or regulation if the preparer in good faith and
with a reasonable basis takes the position that the rule or
regulation does not accurately reflect the Code.
A penalty of the greater of $5,000 or 75 percent of the income
derived by the tax return preparer with respect to the return
applies if any part of any understatement of liability as to a
return or claim for refund is due to a willful attempt to
understate the liability or to any reckless or any intentional
disregard of the rules or regulations. Code Sec. 6694(b).
EXAMPLE 2.16
A guarantee of a specific amount of refund by a preparer is an
example of an action that would give rise to this penalty. Or if
the preparer intentionally disregards information given by the
taxpayer in order to reduce the taxpayer’s liability, the preparer
is guilty of a willful attempt to understate tax liability.
PLANNING POINTER

This does not mean that the preparer may not rely in good faith
on the information furnished by the taxpayer. However, the
preparer must make reasonable inquiries if the information
furnished by the taxpayer appears to be incorrect or incomplete.
A $50 penalty applies each time a preparer (1) fails to furnish a
copy of the return to the taxpayer, (2) fails to sign the return, or
(3) fails to furnish an identifying number. Code Sec. 6695(a) -
(c). The maximum amount for each of these penalties is limited
to $27,000 (as adjusted for inflation). Any preparer who fails to
retain a copy of the returns prepared or a list of the returns
prepared is liable for a penalty of $50 for each such failure,
with a maximum fine of $27,000 (as adjusted for inflation)
applicable to any one return period. Code Sec. 6695(d). A
penalty of $50 applies for each failure to retain and make
available to the IRS upon request a list of the preparers
employed during a return period and $50 for each failure to set
forth a required item in the information list (to a maximum of
$27,000 (as adjusted for inflation) for any single return period).
Code Sec. 6695(e). Any preparer who endorses or otherwise
negotiates a refund check issued to a taxpayer for a return or
claim for refund prepared by the preparer is liable for a penalty
of $540 (as adjusted for inflation) with respect to each such
check. Code Sec. 6695(f).
¶2370
DISCLOSURE OF A POSITION ON A RETURN
The taxpayer may avoid the substantial-understatement penalty
and the tax return preparer may avoid the penalty for taking a
position for which there is not a realistic possibility of being
sustained on its merits by disclosing the item on Form 8275,
Disclosure Statement. To avoid the accuracy-related penalty,
the taxpayer must disclose any nonfrivolous position for which
there is not substantial authority but which has a reasonable
basis. Code Sec. 6662(d)(2)(B)(ii). Similarly, the tax return
preparer may avoid the $1,000 Code Sec. 6694(a) penalty if any
nonfrivolous position that does not have a realistic possibility
of being sustained on its merits is disclosed on Form 8275. The

“realistic possibility” standard is treated in the regulations as
being identical to the “substantial authority” standard in Code
Sec. 6662(d)(2)(B)(i). Reg. §1.6694-2(b)(1). Thus, the
requirement for disclosure in order to avoid the accuracy-
related penalty is identical for both taxpayers and tax preparers,
even though the statutory language differs somewhat. Once
adequate disclosure has been made, tax preparers are not subject
to the penalty as long as the position taken is not frivolous (i.e.,
not patently improper). Reg. §1.6694-2(c)(1) and (2). For
taxpayers, however, the position taken must have a “reasonable
basis,” in order to avoid the penalty. Code Sec.
6662(d)(2)(B)(ii)(II). The regulations treat this standard as
“significantly higher than the not frivolous standard applicable
to preparers.” Reg. §§1.6662-3(b)(3)(ii) and 1.6662-4(e)(2)(i).
¶2375
ETHICS RULES FOR PRACTITIONERS
CPAs and attorneys must practice according to the code of
professional ethics of their professions. The codes are similar to
Treasury Department Circular No. 230. The Tax Committee of
the American Institute of Certified Public Accountants (AICPA)
also issued 10 statements on selected topics between 1964 and
1977. The first two statements were withdrawn in 1982. The
eight remaining statements were revised in 1988 and in 2001.
Prior to 2001, they were advisory opinions of the Committee as
to what are appropriate standards of conduct in certain
situations. Effective October 31, 2001, the Statements are
enforceable standards for AICPA members. Effective January 1,
2010, the sixth and seventh standards were combined resulting
in seven standards. Summaries of the current seven “Statements
on Standards for Tax Services” follow.
1. With respect to tax return positions, a CPA should comply
with the following standards:
a. A CPA should not recommend to a client that a position be
taken with respect to the tax treatment of any item on a return
unless the CPA has a good faith belief that the position has a
realistic possibility of being sustained administratively or

judicially on its merits if challenged.
b. A CPA should not prepare or sign a return if the CPA knows
that the return takes a position that the CPA could not
recommend under the standard expressed in paragraph 1(a).
c. A CPA may recommend a position that the CPA concludes is
not frivolous so long as the position is adequately disclosed on
the return.
d. In recommending tax return positions and in signing returns,
a CPA should, where relevant, advise the client as to the
potential penalty consequences of the recommended tax return
position, and the opportunity, if any, to avoid such penalties
through disclosure.
The CPA should not recommend a tax return position that
exploits the Internal Revenue Service audit selection process or
serves as a mere “arguing” position solely to obtain leverage in
the bargaining process of settlement negotiation with the
Internal Revenue Service.
2. The CPA should make a reasonable effort to obtain from the
client, and provide, appropriate answers to all questions on a
tax return before signing as a preparer.
Statement No. 2 indicates that reasonable grounds may exist for
omitting an answer:
a. The information is not readily available and the answer is not
significant in terms of taxable income or loss or the tax liability
shown on the return.
b. Genuine uncertainty exists regarding the meaning of a
question in relation to the particular return.
c. The answer to the question is voluminous; in such cases,
assurance should be given on the return that the data will be
supplied upon an examination.
3. In preparing a return, the CPA may in good faith rely without
verification upon information furnished by the client. The CPA
should make reasonable inquiries if the information furnished
appears to be incorrect, incomplete, or inconsistent either on its
face or on the basis of other facts known to the CPA. The CPA

should refer to the client’s returns for proper years whenever
feasible.
Where the Internal Revenue Code or income tax regulations
impose a condition with respect to deductibility or other tax
treatment of an item, the CPA should make appropriate inquiries
to determine whether such condition has been met.
4. A CPA may prepare tax returns involving the use of the
taxpayer’s estimates if it is impracticable to obtain exact data,
and the estimated amounts are reasonable under the facts and
circumstances known to the CPA. When estimates are used, they
should be presented in a way that avoids the implication of
greater accuracy than exists. Estimated amounts should not be
presented in a manner which provides a misleading impression
as to the degree of factual accuracy.
There are unusual circumstances where disclosure that an
estimate is used is necessary to avoid misleading the Internal
Revenue Service regarding the degree of accuracy of the return.
Some examples of unusual circumstances are as follows:
a. The taxpayer has died or is ill at the time the return must be
filed.
b. The taxpayer has not received a K-1 for a flow-through entity
at the time the return must be filed.
c. There is litigation pending that bears on the return.
d. Fire, natural disaster, or computer failure destroyed relevant
records.
5. The recommendation of a position to be taken concerning the
tax treatment of an item in the preparation of a tax return should
be based upon the facts and the law as they are evaluated at the
time the return is prepared. Unless the taxpayer is bound as to
tax treatment in a later year, the disposition of an item in an
administrative proceeding does not govern the taxpayer in the
treatment of a similar item in a later year’s return. Therefore, if
the CPA follows the standards of Statement No. 1, the CPA may
recommend a tax return position, or prepare a tax return that
departs from the treatment of an item as concluded in an

administrative proceeding or a court decision regarding a prior
year’s return.
6. The CPA should inform the client promptly upon learning of
an error in a previously filed return, an error in a return that is
the subject of an administrative proceeding, or upon learning of
a client’s failure to file a required return. The CPA should
recommend the measures to be taken and such recommendation
may be given orally. The CPA should not inform the IRS, and
may not do so without the client’s permission, except where
required by law.
If the CPA is requested to prepare the current year’s return and
the client has not taken appropriate action to correct an error in
a prior year’s return, the CPA should consider whether to
withdraw from preparing the return. If the CPA does prepare the
current year’s return, the CPA should take reasonable steps to
ensure that the error is not repeated.
When the CPA is representing a client in an administrative
proceeding with respect to a return which contains an error
known to the CPA, the CPA should require the client’s
agreement to disclose the error to the IRS. Lacking such
agreement, the CPA should consider whether to withdraw from
representing the client and whether to continue a professional
relationship with the client.
7. In providing tax advice to clients, the CPA should use
professional judgment to ensure that the advice reflects
competence and appropriately serves the client’s needs. No
standard format or guidelines need be followed in
communicating written or oral advice to a client.
The CPA may communicate with a client when subsequent
developments affect advice previously provided with respect to
significant matters. However, the CPA cannot be expected to
communicate later developments except while assisting a client
in implementing procedures or plans associated with the advice
provided or unless the CPA undertakes this obligation by

specific agreement with the client.
TAX BLUNDERS
1. Laura Lerner found out that taxpayers have either partially or
completely won around 50 percent of cases brought to the Tax
Court. Therefore, she decides on litigation in the Tax Court,
where she thinks she has a fairly good chance of being
successful. However, in looking at the tax issue with which
Laura is concerned, a tax researcher discovers that the taxpayer
has never won a case like hers. Laura should not have relied on
the overall statistics.
2. Edward Enders decides to take his case to the Tax Court
because then he does not have to pay the tax before litigation.
After some time has passed, someone tells him that a jury would
probably have looked favorably on his case, and now he wants
to go to District Court. Having gone to the Tax Court, Edward
cannot now take his case to District Court.
3. Vera Vokel, known for her temper, her frugality, and her
dislike for the IRS, is requested to come in to the local IRS
office for an office examination. Although she had a CPA
prepare her return, she decides she would like to save the fees it
might cost her to have the CPA represent her and, therefore,
decides to go in alone for the examination. In the course of the
discussion, she becomes furious at the auditor and is disallowed
her items at issue. Vera should have had her CPA represent her
and she should probably not have been present herself so that
the audit could be conducted in a businesslike and unemotional
manner.
SUMMARY
· The primary authoritative sources of the law are statutory,
administrative, and judicial.
· The taxpayer can appeal within the IRS and/or decide to go to
Tax Court, a U.S. District Court, or the U.S. Court of Federal
Claims, and then attempt to appeal to a U.S. Court of Appeals
and the U.S. Supreme Court.
· A tax researcher can use tax services, a citator, other types of
secondary reference materials, or electronic tax research

systems and the internet in the research process.
· The Internal Revenue Service consists of the national office,
and an extensive organization consisting of 4 operating
divisions and other units.
· The examination of tax returns can be as simple as a
correspondence examination or a more involved office
examination or field examination.
· A tax practice can involve tax compliance and tax planning.
· Communications between the IRS and taxpayers can include
private letter rulings, determination letters, and technical
advice.
· There are numerous penalties to which taxpayers and tax
preparers may be subject.
· The knowledge and use of ethics is very important for the tax
practitioner.
Chapter
3
Individual Taxation—An Overview
OBJECTIVES
1. Understand the components of the tax formula.
2. Apply the standard deduction to each filing status.
3. Determine whether an individual qualifies as a dependent.
4. Distinguish among the five different filing statuses.
5. Apply the tax tables and the tax rate schedules to taxable
income.
OVERVIEW
This chapter discusses the components of the tax formula and
studies the implications of the standard deduction to the
taxpayer. Additionally, the qualifications for the dependency
exemption are analyzed. Finally, the basic filing statuses are
examined as well as the role of the tax tables and the tax rate
schedules.
¶3001
COMPONENTS OF THE TAX FORMULA

Taxable income is computed using one of the two overall
accounting methods, the cash method or the accrual method. It
is also possible to use a combination of the two overall
methods. Under the cash method, income is reported when it is
received and deductions are taken when the expense is paid. The
accrual method requires income to be reported when all the
events necessary to fix the right to receive payment have
occurred and there is reasonable certainty regarding the amount.
Likewise, accrual basis taxpayers usually claim a deduction in
the year in which all events that fix the liability have occurred,
provided the amount of the liability is reasonably determinable.
A basic understanding of the method used to calculate the tax
liability is a necessity in the study of federal income taxation.
That method is as follows:
Gross Income
–
Deductions for Adjusted Gross Income
=
Adjusted Gross Income
–
Greater of Itemized Deductions or Standard Deduction
–
Qualified Business Income Deduction
=
Taxable Income
×
Tax Rate
=
Tax Liability
–
Tax Credits and Prepayments
=
Net Tax Due or Refund
¶3011
GROSS INCOME

Gross income includes all items of income from whatever
source unless specifically excluded. Examples of gross income
include compensation for services, interest, rents, royalties,
dividends, and annuities. An individual’s income from business
is included in gross income after deducting the cost of goods
sold.
The receipt of income can be in different forms such as cash,
property, services, or even a forgiveness of an indebtedness.
However, income is not reported by a taxpayer until it is
realized.
Gross income and inclusions and exclusions will be discussed in
further detail in Chapters 4 and 5.
¶3015
DEDUCTIONS FOR ADJUSTED GROSS INCOME
To arrive at adjusted gross income, all deductions specifically
allowed by law are subtracted from gross income. Some of the
items allowed as deductions for adjusted gross income include:
1. Trade or business expenses, such as advertising, depreciation,
and utilities.
2. Certain reimbursed employee expenses, such as travel, and
transportation expenses.
3. Losses from sale or exchange of property.
These deductions are sometimes referred to as “deductions from
gross income” or, since almost all the allowable deductions in
this section are business expenses, the deductions are sometimes
referred to as “business deductions.” These deductions are
discussed in Chapter 6.
¶3025
ADJUSTED GROSS INCOME
In the tax formula there are deductions for adjusted gross
income and then deductions from adjusted gross income. It is
important to take these deductions in the proper categories.
Adjusted gross income is an important subtotal because certain
other items are based on the amount of adjusted gross income.
The credit for child and dependent care expenses along with
itemized deductions for medical expenses and charitable

contributions, are all based on adjusted gross income.
¶3035
ITEMIZING V. STANDARD DEDUCTION
Itemized deductions are certain expenses of a personal nature
that are specifically allowed as a deduction. Items included in
this group are: medical expenses, state and local income taxes,
property taxes, home mortgage interest, and charitable
contributions.
Taxpayers receive the benefit of a minimum amount of itemized
deductions called the standard deduction. The standard
deduction is a fixed amount used to simplify the computation of
the tax liability. It is also designed to eliminate lower -income
individuals from the tax rolls. All taxpayers subtract the larger
of their itemized deductions or the standard deduction.
The standard deduction is based on the filing status of the
taxpayer and is made up of the “basic standard deduction” plus
any “additional standard deduction.” The standard deduction is
adjusted annually, if necessary, for inflation.
Filing Status
Basic Standard Deduction 2020
Single
$12,400
24,800
12,400
Head of Household
18,650
Surviving Spouse
24,800
The standard deduction is of principal benefit to moderate and
low income level taxpayers since the amount is usually more
than the total itemized deductions, which means that such
taxpayers need not report their itemized deductions. Thus, the
need to audit such returns by the IRS is substantially reduced
since the opportunities for error or misstatement of taxable

income are lessened.
Additional Standard Deduction for Age and Blindness
An additional standard deduction is allowed for aged or blind
taxpayers. The additional standard deduction is the total of the
additional amounts allowed for age and blindness. The dollar
value of an additional amount will depend on the taxpayer’s
filing status. The extra standard deductions effective for 2020
are shown below. The amounts are adjusted for inflation.
Filing Status
Dollar Value of One Additional Filing Status Amount 2020
Single
$1,650
1,300
1,300
Head of Household
1,650
Surviving Spouse
1,300
Taxpayers can receive an additional standard deduction for
being both aged and blind. Thus, a married couple, both of
whom are aged and blind, receive an additional standard
deduction of $5,200 ($1,300 × 4).
EXAMPLE 3.1
Rebecca Greene, 55, qualifies as a head of household in 2020.
Her basic standard deduction is $18,650. She is not entitled to
an additional standard deduction.
EXAMPLE 3.2
Assume the same facts as in Example 3.1, except that Rebecca
is 67 and legally blind. Her basic standard deduction for 2020 is
$18,650. She is also entitled to an additional standard deduction
of $3,300 ($1,650 for her age and $1,650 for her blindness). Her
total standard deduction is $21,950.
EXAMPLE 3.3
Jeffrey and Donna Dirk are both 72 and file a joint return for

2020. Donna is blind. Their basic standard deduction i s
$24,800. They are entitled to an additional standard deduction
of $3,900 ($1,300 × 2 for their age plus $1,300 for Donna’s
blindness). Their total standard deduction is $28,700.
To qualify for the old-age additional standard deduction, the
taxpayer and/or spouse must be age 65 before the close of the
year. For purposes of the old-age additional standard deduction,
an individual attains the age of 65 on the day preceding the 65th
birthday. Thus, an individual whose 65th birthday falls on
January 1 in a given year attains the age of 65 on the last day of
the calendar year immediately preceding.
A person is considered blind for the extra standard deduction if
that person’s central visual acuity does not exceed 20/200 in the
better eye with correcting lenses, or if visual acuity is greater
than 20/200 but is accompanied by a limitation in the fields of
vision such that the widest diameter of the visual field subtends
an angle no greater than 20 degrees.
If the taxpayer or spouse dies during the year, the number of
additional standard deduction amounts for age or blindness is
determined as of the date of death. Thus, the additional standard
deduction for age will not be allowed for an individual who dies
before attaining the age of 65 even though the individual w ould
have been 65 before the close of the year.
The additional standard deductions for age 65 or older and
blindness apply only to taxpayers and their spouses. No
additional standard deduction amounts are allowed to taxpayers
who claim an exemption for dependents who are aged or blind.
EXAMPLE 3.4
Darren Davidson is single and fully supports his 70-year-old
father. Darren qualifies as a head of household. Darren’s regular
standard deduction is $18,650 for 2020. Darren may not claim
the additional standard deduction amount for his dependent
father.
Married Taxpayers Filing Separately
All taxpayers may not be able to take the larger of itemized
deductions or the standard deduction. Rules require both

spouses to either itemize or use the standard deduction. If one
spouse takes itemized deductions the other spouse is required to
also itemize even if itemized deductions are less than the
standard deduction for married individuals filing separately.
EXAMPLE 3.5
Joe and Mary Bloome are married but decide to file separate
returns for 2020. Joe has adjusted gross income of $50,000 and
$15,900 of itemized deductions, while Mary has $25,000 of
adjusted gross income and $9,400 of itemized deductions. Joe
and Mary can elect not to itemize, in which case they will each
use the standard deduction of $12,400. However, if they decide
to itemize, Joe will have itemized deductions of $15,900 and
Mary will have $9,400 of itemized deductions. Since Joe
itemizes, Mary is also required to itemize.
PLANNING POINTER
In situations where total itemized deductions are approximately
equal to the standard deduction, it is possible for cash basis
taxpayers to obtain a deduction for itemized deductions in one
year and to use the standard deduction the next year by proper
timing of payments. For example, an individual may pay two
years’ church pledges in one year and nothing the next year. It
may also be possible to pay real estate or city and state income
tax estimated payments prior to the end of the year.
¶3055
TAX RATES
The tax formula implies that the “Taxable Income” figure is
multiplied by the appropriate tax rate to arrive at the “Tax
Liability.” In reality, the “Tax Liability” is either derived from
the appropriate column of the tax tables or is computed from the
appropriate line in the tax rate schedules.
Prior to 1986 the maximum tax rate was 50 percent. The tax rate
schedules for 1987 ranged from 11 percent to 38.5 percent. The
tax rate schedules (reproduced in the Appendix) include seven
tax brackets for 2020: 10 percent, 12 percent, 22 percent, 24
percent, 32 percent, 35 percent, and 37 percent.
¶3065

TAX CREDITS AND PREPAYMENTS
Any tax credits are applied against the income tax. It is
significant to note the difference between a credit and a tax
deduction. A deduction reduces income to which the rate applies
and indirectly reduces the tax liability. A credit directly reduces
the tax liability.
The principal credits include the earned income credit, child tax
credit, credit for the elderly, general business credit, dependent
care credit, education credits, and foreign tax credit. These
credits will be discussed in further detail in Chapter 9.
The tax liability is further reduced by the amounts withheld on
income and by any estimated payments made during the year.
Income taxes may be withheld on the various sources of income
that a taxpayer receives during the year. Employers are required
to withhold income tax on compensation paid to their
employees. In addition, estimated payments may be necessary if
enough taxes have not been withheld.
¶3075
NET TAX DUE OR REFUND
The tax result after applying the credits and prepayments to the
“Tax Liability” is the amount that must be paid to the Internal
Revenue Service or the amount overpaid and to be refunded to
the taxpayer.
¶3085
CLASSIFICATION OF TAXPAYERS
The Internal Revenue Code defines the term “taxpayer” as any
person subject to any internal revenue act. The term “person”
includes an individual, a trust, estate, partnership, association,
company, or corporation. A “partnership” includes a syndicate,
group, pool, joint venture, or other unincorporated venture,
through or by means of which any business, financial operation,
or venture is carried on and which is not a trust or estate or a
corporation. The term “corporation” is not defined but is stated
to include associations, joint-stock companies, and insurance
companies.
A proper classification of taxpayers is essential in determining

the type of tax return to be filed. Individuals have little trouble
choosing the right tax return, but problems often arise with
artificial entities such as trusts, estates, partnerships,
corporations, and associations.
Taxpayers are usually classified according to the type of tax
return that they are required to file. Excluding most information
returns (which are not tax returns in the strict sense of the term)
and returns for organizations exempt from income tax, almost
all tax returns will fall into one of the following four
categories:
Type Of Return
Form
Filed By
Individual
1040
Every natural person with income of statutory minimums
Corporation
1120
Corporations, including organizations taxed as corporations
Fiduciary
1041
Trusts and estates with income in excess of statutory minimums
Partnership
1065
Partnerships or joint ventures (information return only)
Personal Exemptions
A deduction for personal exemptions is not taken on tax returns
for the period of 2018 through 2025. Technically, the personal
exemption amount is reduced to $0. However, the definition of
personal exemptions and dependents is still important. The
determination of head of household filing status is determined
by whether a taxpayer has a dependent or a qualifying child.
The child tax credit is determined based on the number of
qualifying children. The family credit is based on the number of
dependents other than qualifying children. The dependent care
credit is based on the number of dependents.

No personal exemption is allowed on the return of an individual
who is eligible to be claimed as a dependent on another
taxpayer's return. However, the proposed regulations provide
that a person is not considered a dependent of another
individual, if the other individual has no filing requirement.
¶3201
TAXPAYER AND SPOUSE
Two taxpayers are allowed on a joint return even though there
may be only one individual earning income. Where a joint
return is filed by the taxpayer and spouse, no other person is
allowed an exemption for the spouse even if the spouse
otherwise qualifies as a dependent of another person.
¶3225
DEPENDENTS
Taxpayers are allowed to claim a personal exemption for each
dependent.
The statutory definition of a dependent categorizes each
dependent as a qualifying child or a qualifying relative. The
definition also creates a uniform definition of child for
dependency exemption, child credit, earned income tax credit,
dependent care credit, and head of household filing status.
Qualifying Child
A child is a qualifying child of a taxpayer if the child satisfies
each of four tests:
Principal Abode. The child has the same principal place of
abode as the taxpayer for more than one half the taxable year.
Temporary absences due to special circumstances, including
absences due to illness, education, business, vacation, or
military service, are not treated as absences.
Relationship. The child has specified relationship to the
taxpayer. The child must be the taxpayer’s son, daughter,
stepson, stepdaughter, brother, sister, stepbrother, stepsister, or
a descendant of any such individual. An individual legally
adopted by the taxpayer, or an individual who is lawfully placed
with the taxpayer for adoption by the taxpayer, is treated as a
child of such taxpayer by blood. A foster child who is placed

with the taxpayer by an authorized placement agency or by
judgment, decree, or other order of any court of competent
jurisdiction is treated as the taxpayer’s child.
Age. The child has not yet attained a specified age. In general, a
child must be under age 19 (or 24 in the case of a full -time
student) in order to be a qualifying child. In general, no age
limit applies with respect to individuals who are totally and
permanently disabled at any time during the calendar year. The
prior-law requirements are retained that a child must be under
age 13 for purposes of the dependent care credit, and under age
17 for purposes of the child tax credit.
A tie-breaking rule applies if more than one taxpayer claims a
child as a qualifying child. First, if only one of the individuals
claiming the child as a qualifying child is the child’s parent, the
child is deemed the qualifying child of the parent. Second, if
both parents claim the child and the parents do not file a joint
return, then the child is deemed a qualifying child first with
respect to the parent with whom the child resides the longest
period of time, and second with respect to the parent with the
highest adjusted gross income. Third, if the child’s parents do
not claim the child, then the child is deemed a qualifying child
with respect to the claimant with the highest adjusted gross
income.
The prior-law support and gross income tests (discussed below)
for determining dependency do not apply to a child who meets
the requirements of the uniform definition of qualifying child.
Support. A child who provides over half of his or her own
support is not considered a qualifying child of another taxpayer.
Qualifying Relative
Taxpayers generally may claim an individual who does not meet
the uniform definition of qualifying child with respect to any
individual who is a qualifying relative. A qualifying relative
must meet all of the following tests:
1. Relationship or member of household
2. Gross income
3. Support

4. Not a qualifying child
Relationship or Member of the Household Test
The dependent must be a relative of the taxpayer or a member of
the taxpayer’s household. Individuals considered to be related
to the taxpayer and eligible for the dependency exemption
include: a child or a descendant of a child; a brother, sister,
stepbrother, or stepsister; the father or mother, or an ancestor of
either; a stepfather or stepmother; a son or daughter of a brother
or sister of the taxpayer; a brother or sister of the father or
mother of the taxpayer; and a son-in-law, daughter-in-law;
father-in-law, mother-in-law, brother-in-law, or sister-in-law. A
nonrelated person must be a member of the taxpayer’s
household for the entire year to qualify as a dependent. The
taxpayer must maintain and occupy the household. An
individual is not a member of the taxpayer’s household if any
time during the year the relationship between the individual and
the taxpayer is in violation of local law.
Gross Income Test
This test does not allow a dependent to have more than $4,300
of gross income for the year.
EXAMPLE 3.6
Colleen Drew, age 21, earned $4,500 working part-time while
attending school full-time. Colleen’s lives the entire year with
her friend who pays more than one-half of Colleen’s support.
Colleen’s friend will not be able to consider Colleen as a
dependent since Colleen exceeded $4,300 of gross income.
The gross income amount is determined before the deduction of
any expenses, such as materials, taxes, and depreciation. Thus,
a taxpayer would not be able to claim his grandmother for 2020
if she received $4,650 in rental income, even though her
expenses reduced the net income to less than $4,300. However,
cost of goods sold is subtracted from gross receipts to determine
gross income. Receipts which are excludable from gross income
are not counted in applying the gross income test.
Support Test
Over one-half of the support of a dependent must be furnished

by the taxpayer. In determining whether the taxpayer has
provided over half of the support, the support received from the
taxpayer as compared to the entire amount of support which the
individual receives from all sources, including support which
the individual supplies, will be taken into account.
In computing the amount which is contributed for the support of
an individual, there must be included any amount which is
contributed by the individual for his or her own support,
including receipts which are excludable from gross income,
such as benefits received under Social Security or money
withdrawn from a savings account. However, it is only the
amount actually spent on support which is taken into
consideration, not the total amount available for support.
The term “support” includes food, shelter, clothing, medical and
dental care, education, and similar items. Generally, the amount
of an item of support will be the amount of expense incurred by
the one furnishing the item. If the item of support furnished by
an individual is in the form of property or lodging, it will be
necessary to measure the amount of the item of support in terms
of its fair market value. The value of personal services is not
included in support determination. F. Markarian, 65-
2 USTC ¶10,755, 352 F.2d 870 (CA-7 1965), cert. denied, 384
U.S. 988, 86 S.Ct. 1886.
Where the taxpayer owns the home in which the dependent
lives, the fair rental value of the lodging furnished is part of the
total support. However, this does not mean an equal allocation
between taxpayers and dependents. It is recognized that an adult
has certain minimum base housing costs which cannot be treated
as equal to the minimum housing costs of minor children. In one
case, the court allocated 60 percent of the housing costs to the
mother and 40 percent to be divided equally among three
children. J.D.M. Cameron, 33 TCM 725, Dec. 32,654(M), T.C.
Memo. 1974-166. Amounts paid to others to care for children
while working are included as part of support. T. Lovett, 18 TC
477, Dec. 19,018 (1952), Acq., 1952-2 CB 2. The amount paid
may also qualify for the dependent care credit.

Some capital expenditures may qualify as items of support. The
cost of an automobile is counted in determining who furnished
over half of a dependent’s support. A television set furnished
and set apart in the child’s bedroom is also an item of support.
Rev. Rul. 77-282, 1977-2 CB 52.
Welfare payments made by a state agency to or on behalf of a
dependent are attributable to the taxpayer. Amounts expended
by a state for training and education of handicapped children
are not taken into account in determining support. This rule
applies only if the institution qualifies as an “educational
institution” and the residents qualify as “students.” Rev. Rul.
59-379, 1959-2 CB 51, clarified by Rev. Rul. 60-190, 1960-1
CB 51. Social Security Medicare benefits are disregarded in the
computation of support. Rev. Rul. 79-173, 1979-1 CB 86.
Amounts received as scholarships for study at an educational
institution are not considered in determining whether the
taxpayer furnishes more than one-half the support of the
student. Amounts received for tuition payments and allowances
by a veteran are not considered scholarships in determining the
support test.
EXAMPLE 3.7
John has a cousin who lives with John and who receives a
$5,000 scholarship to Academic University for one year. John
contributes $4,100, which constitutes the balance of the
cousin’s support for that year. John may claim the cousin as a
dependent, as the $5,000 scholarship is not counted in
determining the support of the cousin and, therefore, John is
considered as providing all the support of the cousin.
Not a Qualifying Child Test
An individual who is a qualifying child of the taxpayer or of
any other taxpayer cannot be a qualifying relative.
Special Rules Applying to Dependents
The taxpayer and the dependent will be considered as occupying
the household for the entire year notwithstanding temporary
absences from the household due to special circumstances. A
nonpermanent failure to occupy the common abode by reason of

illness, education, business, vacation, military service, or a
custody agreement under which the dependent is absent for less
than six months in the tax year, will be considered temporary
absence due to special circumstances.
The fact that the dependent dies during the year will not deprive
the taxpayer of qualifying the decreased as a dependent if he or
she lived in the household for the entire part of the year
preceding death. Similarly, the period during the year preceding
birth of an individual will not prevent the individual from
qualifying as a dependent.
A dependent cannot file a joint return with the dependent’s
spouse. However, the dependency consideration will still be
allowed where a joint return is filed by a dependent and spouse
merely as a claim for refund and where no tax liability would
exist for either spouse on the basis of separate returns. Rev.
Rul. 65-34, 1965-1 CB 86.
The term “dependent” does not include an individual who is not
a citizen or national of the United States unless such individual
is a resident of the United States or a country contiguous to the
United States. This exception does not apply to any child that
has the same principal place of abode as the taxpayer and is a
member of the taxpayer’s household and the taxpayer is a
citizen or national of the United States.
The term “student” means an individual who, during each of
five calendar months during the calendar year, is a full -time
student at an educational institution, or is pursuing a full-time
course of instructional on-farm training. A full-time student is
one who is enrolled for some part of five calendar months for
the number of hours or courses which is considered to be full -
time attendance. The five calendar months need not be
consecutive. School attendance exclusively at night does not
constitute full-time attendance. However, full-time attendance
may include some attendance at night in connection with a full -
time course of study.
An individual will not be allowed to claim exemptions for
dependents in any year they are themselves a dependent.

Social Security numbers are required for all individuals who are
claimed as dependents. Failure to include the Social Security
number or other required information can result in the loss of
the exemption.
Multiple Support Agreements
Special rules allow a taxpayer to be treated as having
contributed over half of the support of an individual where two
or more taxpayers contributed to the support of the individual if
(1) no one person contributed over half of the individual’s
support, (2) each member of the group which collectively
contributed more than half of the support of the individual
would have been entitled to claim the individual as a dependent
except for the fact that they did not contribute more than one-
half of the support, (3) the member of the group claiming the
individual as a dependent contributed more than 10 percent of
the individual’s support, and (4) each other person in the group
who contributed more than 10 percent of the support files a
written declaration that they will not claim the individual as a
dependent for the year.
EXAMPLE 3.8
Brothers Alfred, Bill, Chuck, and Don contributed the entire
support of their mother in the following percentages: Alfred, 30
percent; Bill, 20 percent; Chuck, 29 percent; and Don, 21
percent. Any one of the brothers, except for the fact that he did
not contribute more than half of her support, would have been
entitled to claim his mother as a dependent. Consequently, any
one of the brothers could consider the mother as a dependent
provided a written declaration from each of the brothers is
attached to the return of the individual considering mother as a
dependent. If, on the other hand, Don were a neighbor instead
of a brother, he would not qualify as a member of the group for
multiple support agreement purposes. He would not be eligible
to claim the mother since she was not a member of Don’s
household. Don would not be required to sign the multiple
support agreement.
Divorced or Separated Parents

When taxpayers are divorced, legally separated, or never
married, special rules apply to determine which one is entitled
to exemptions for their children. These rules may result in a
taxpayer who did not provide more than half of the support of
the child being entitled to the exemption.
To qualify, the parents must be divorced or legally separated
under a decree of divorce or separate maintenance, separated
under a written separation agreement, or lived apart at all times
during the last six months of the year. In addition, both parents
together must provide more than one-half of the child’s support.
The child must be in the custody of one or both parents for more
than one-half of the calendar year. Thus, a dependency
exemption may not be claimed by one of the parents if a person
other than the parents provides one-half or more for the support
of the child during the year or has custody of the child for one
half or more of the year.
As a general rule, a child will be treated as receiving over half
of the support from the parent having custody for the greater
number of nights for the year. If the parents of the child are
divorced or separated for only a portion of a year after having
joint custody for the prior portion of the year, the parent who
has custody for the greater number of nights of the remainder of
the year after divorce or separation will be treated as having
custody for a greater portion of the year.
EXAMPLE 3.9
Bill, a child of Jim and Cathy Durell, who were divorced on
June 1, received $5,000 for support during the year, of which
$2,200 was provided by Jim and $1,950 by Cathy. No multiple
support agreement was entered into. Prior to the divorce, Jim
and Cathy jointly had custody of Bill. For the remainder of the
year, Jim had custody of Bill for the months of October through
December, while Cathy had custody of Bill for the months of
June through September. Since Cathy had custody for four of
the seven months following the divorce, she had custody for the
greater number of nights and is the custodial parent for the year
and is allowed to consider Bill as a dependent.

Post-1984 Divorces
For divorces taking place in years after 1984, the custodial
parent is entitled to the exemption in all cases unless he or she
expressly waives the right to the exemption. This may be done
by the custodial parent signing a written declaration that he or
she will not claim the exemption. The noncustodial parent is
required to attach this declaration to his or her tax return each
year when claiming the exemption. Failure to attach Form 8332,
Release of Claim to Exemption for Child of Divorced or
Separated Parents, means that the noncustodial parent cannot
claim the exemption, regardless of the amount of support
furnished.
EXAMPLE 3.10
Mike and Jennifer are divorced. Mike pays over half of the
support of their child, Amanda. Amanda resides with Jennifer
for the greater part of the year. Mike is unable to claim Amanda
as a dependent on his return because he does not have a signed
Form 8332 from Jennifer.
The individual claiming the child as a dependent also qualifies
for the child tax credit provided other requirements are met.
KEYSTONE PROBLEM
The personal exemption qualifies the taxpayer for certain
benefits such as the child tax credit. In certain situations, such
as multiple support agreements and children of divorced
parents, it is possible to assign the personal exemption for a
dependent to one of the eligible parties. What should be taken
into consideration in determining which party should receive
the personal exemption?
Filing Status and Requirements
The tax liability of an individual not only varies with the
amount of income but also depends upon marital status.
Taxpayers must determine their income tax liability from among
five different filing statuses:
1. Married individuals filing jointly
2. Married individuals filing separate returns

3. Single individuals
4. Heads of households
5. Surviving spouses (Qualifying widow(er))
Source: Form 1040
A married taxpayer meeting the “abandoned spouse”
requirements may be considered as an unmarried person for tax
purposes. These requirements are: (1) the taxpayer must file a
separate return, (2) the taxpayer’s spouse cannot be a member
of the household during the last six months of the year, (3) the
taxpayer must furnish over half the cost of maintaining the
taxpayer’s home, and (4) the taxpayer’s home must be the
principal residence of a dependent child for more than one-half
of the year.
EXAMPLE 3.11
Melvin Moore left Esther and their two children on April 15,
2020, and has not been heard from since. Esther furnishes the
entire cost of the household and the support of the two children
for the remainder of the year. For 2020, Esther would qualify as
an abandoned spouse and thus be considered as unmarried. If
Melvin had left during the last half of the year, or if there were
no children, Esther would not qualify as unmarried under the
abandoned spouse rules. She would file as married filing
separately.
An individual qualifying as an abandoned spouse will qualify
for head of household status. Head of household status provides
the spouse with a lower rate than the tax rate for a married
person filing a separate return or a single individual.
Married persons are taxed at the lowest rate if they file jointly,
and at the highest rates if they file separately. Unmarried
taxpayers who are heads of households use a set of rates
between those for single people and those for married couples
filing jointly. Surviving spouses use the same rates as those
married filing jointly. All unmarried taxpayers who do not
qualify for another filing status must file as single taxpayers.
¶3301

MARRIED INDIVIDUALS FILING JOINTLY
A married couple may file a joint return including their
combined incomes, or each spouse may file a separate return
reflecting his or her income only. A joint return is not allowed
if either the husband or wife is a nonresident alien at any time
during the tax year, or if the husband and wife have different
tax years. However, if at the end of a tax year one spouse is a
U.S. citizen or a resident alien and the other spouse is a
nonresident alien, a special election may be made to treat the
nonresident spouse as a U.S. resident. If no election is made,
the taxpayer’s status is married filing separately unless there is
a dependent which would allow head of household status to be
used.
Joint returns were originally enacted to establish equity for
married taxpayers in common law states since in community
property states married taxpayers are able to split their income.
Therefore, the progressive rates are constructed upon the
assumption that income is earned equally by the two spouses. A
joint return may be filed and the splitting device may be used
even if one spouse has no income.
If a joint return is filed, the income and deductions of both
spouses are combined. The exemptions to which either spouse is
entitled are combined, and both spouses sign the return. In a
joint return, the general rule is that both spouses are jointly and
severally liable for any deficiency in tax, interest, and penalties.
A joint return may be made for the survivor and a deceased
spouse or for both deceased spouses. The tax year of such
spouses must begin on the same day and end on different days
only because of the death of either or both spouses. The
surviving spouse must not remarry before the close of the tax
year and the spouses must have been eligible to file a joint
return on the date of death.
The determination of whether an individual is married is made
as of the close of the tax year, unless the spouse dies during the
year, in which case the determination will be made as of the
time of death. A married couple does not have to be living

together on the last day of the tax year in order to file a joint
return, but an individual legally separated under a decree of
divorce or separate maintenance will not be considered married.
¶3315
MARRIED INDIVIDUALS FILING SEPARATELY
If a husband and wife file separate returns, they should each
report only their own income and claim only their own
exemptions and deductions on their individual returns.
Separate returns will result in approximately the same tax
liability as a joint return where both spouses have
approximately equal amounts of income. However, when the
incomes are unequal, it is generally advantageous for married
taxpayers in noncommunity property states to file a joint return
since the combined amount of tax on separate returns is higher
than the tax on a joint return.
Special circumstances may warrant the use of separate returns.
Where one spouse incurs significant medical expenses, the
smaller adjusted gross income of a separate return results in a
larger medical deduction since medical expenses are allowed
only to the extent they exceed 7.5 percent of adjusted gross
income. It may be desirable to file separate returns to protect
against a potential deficiency on the other spouse’s return where
there is some concern over the tax liability or there is a
questionable item on the return itself.
In community property states, a married couple’s income is
treated as earned equally by the two spouses. Income earned on
capital investment made from a spouse’s separate property in
most community property states remains the separate property
of that spouse. There are three community property states in
which income from separate property is treated as community
property (Texas, Idaho, and Louisiana). See discussion of the
“Texas Rule” at ¶4215. Community property income and
deductions must be accounted for on the same basis. Deductions
pertaining to the separate property of one spouse must be taken
by that spouse. However, where the income from that property
is taxable one-half to each spouse, the deductions must be

divided between the husband and wife.
The Code places numerous limitations upon deductions, credits,
etc., where married taxpayers file separately. If both husband
and wife have income, they should generally figure their tax
both jointly and separately to insure they are using the method
resulting in less tax.
If an individual has filed a separate return for a year for which a
joint return could have been filed and the time for filing the
return has expired, a joint return by the husband and wife may
still be filed. The joint return must be filed within three years of
the due date of the original return for which a change is
requested. All payments, credits, refunds, or other payments
made or allowed on the separate return of either spouse are
taken into account in determining the extent to which the tax
based on the joint return has been paid.
If a joint return has been filed for a year, the spouses may not
thereafter file separate returns for that year after the time for
filing the return for that year has expired.
¶3325
SINGLE INDIVIDUALS
A single individual for tax purposes is an unmarried person who
does not qualify as head of household. Generally, if only one of
the two individuals is working, it is advantageous from a tax
standpoint to enter into marriage. However, where the incomes
are approximately equal, the total tax may be smaller if they are
not married.
¶3345
HEADS OF HOUSEHOLDS
Unmarried individuals who maintain a household for qualifying
children or dependents are entitled to use the head of household
rates. The definition of a dependent for purposes of head of
household status is the same as the uniform definition contained
in the dependency exemption rules. The dependent must be a
qualifying child or a qualifying relation of the taxpayer. Over
one-half of the cost of maintaining the household must be
furnished by the taxpayer. The household must be the principal

abode for more than one-half of the year. A qualifying relative
must qualify as the taxpayer’s dependent. A dependent relative
who is a dependent only because of a multiple-support
agreement cannot qualify a taxpayer for head of household
status. A legally adopted child of a taxpayer is considered a
child of the taxpayer by blood. A dependent foster child is
treated like a dependent blood son or daughter, rather than as an
unrelated individual. However, the foster child must be a
dependent to enable the parent to use head of household status.
Rev. Rul. 84-89, 1984-1 CB 5. A taxpayer with a qualifying
child is not required to claim the qualifying child as a
dependent, unless the child is married, in order to qualify for
head of household status.
EXAMPLE 3.12
Sara Shuster is unmarried and maintains a household in which
she and her son reside. The son is claimed by his father as a
dependent. Since Sara is not required to claim the child as a
dependent, she may use the head-of-household tax rate
schedule. If the son is married, Sara must be able to claim him
as a dependent in order to file as head of household.
The taxpayer’s dependent parents need not live with the
taxpayer to enable the taxpayer to qualify as a head of
household. The household maintained by the taxpayer must
actually constitute the principal place of abode of the father or
mother or both of them. The father or mother must occupy the
household for the entire year. A rest home or home for the aged
qualifies as a household for this purpose.
EXAMPLE 3.13
Meg Morgan, an unmarried individual living in Baltimore,
maintains a household in Los Angeles for her dependent mother.
Meg may use the head-of-household tax rate schedule even
though her mother does not live with her.
Although generally a married couple cannot file a joint return if
one of them is a nonresident alien, the taxpayer who is a U.S.
citizen will qualify as a head of household if the taxpayer is the
one providing the maintenance of the household and if there is a

related dependent living with the taxpayer the entire year. The
law provides that, for purposes of the head of household status,
the taxpayer is treated as unmarried.
A taxpayer does not qualify for head of household status if the
only other person living in his household is a nonresident alien
spouse because the spouse does not qualify as a dependent.
However, a taxpayer having a nonresident alien spouse may
qualify if an unmarried dependent or unmarried stepchild lives
with the taxpayer. Rev. Rul. 55-711, 1955-2 CB 13, amplified
by Rev. Rul. 74-370, 1974-2 CB 7.
A physical change in the location of a home will not prevent a
taxpayer from qualifying as a head of household. The fact that
the individual qualifying the taxpayer for head of household
status is born or dies within the tax year will not block a claim
for head of household status. The household must have been the
principal place of abode of the individual for the remaining or
preceding part of the year.
A nonpermanent failure to occupy the common abode by reason
of illness, education, business, vacation, military service, or a
custody agreement under which a child or stepchild is absent for
less than six months in a year will not bar the head of household
status. However, it must be reasonable to assume that the
household member will return to the household and the taxpayer
continues to maintain the household or a substantially
equivalent household in anticipation of such return.
The costs of maintaining a household are the expenses incurred
for the mutual benefit of the occupants. They include property
taxes, mortgage interest, rent, utility charges, upkeep and
repairs, property insurance, and food consumed on the premises.
Such expenses do not include the cost of clothing, education,
medical treatment, vacations, life insurance, and transportation.
In addition, the cost of maintaining a household does not
include any amount which represents the value of services
rendered in the household by the taxpayer or by a person
qualifying the taxpayer as a head of household. The taxpayer,
for example, cannot impute a value for services provided by the

taxpayer for cooking, cleaning, and doing laundry.
It is possible for a household to be a portion of a home. The Tax
Court held that a widow and her unmarried daughter occupying
one level of a four-level house and sharing two levels
constituted a household. J.F. Fleming Est., 33 TCM 619, Dec.
32,611(M), T.C. Memo. 1974-137. Since the widow paid more
than one-half of the household maintenance expenses
attributable to her and her daughter, she qualified as a head of
household.
¶3355
SURVIVING SPOUSES
Special tax benefits are extended to a surviving spouse. In
addition to the right to file a joint return for the year in which a
spouse dies, a taxpayer whose spouse died in either of the two
years preceding the tax year, and who has not remarried, may
file as a surviving spouse provided the surviving spouse
maintains a household for a dependent child or stepchild.
Surviving spouses use the same tax rate schedules and tax tables
as married taxpayers filing joint returns. The surviving spouse
provisions do not authorize the surviving spouse to file a joint
return; they only make the joint return tax rates available.
The surviving spouse must provide over half the cost of
maintaining the household in which both the surviving spouse
and dependent live. Of course, an exemption for the deceased
spouse is available in the year of death but is not available on
the return of the surviving spouse in the two years following
death.
EXAMPLE 3.14
Albert Olm’s wife died in 2020, leaving a child who qualifies as
Albert’s dependent. In the year of death, Albert and his
deceased wife are entitled to file a joint return and claim one
dependent. If the child continues to live with Albert in a
household provided by him and be his dependent, Albert will be
allowed to file as a surviving spouse for 2021 and 2022.
¶3365
TAX RETURNS OF DEPENDENTS

For 2020, the standard deduction for an individual who can be
claimed as a dependent on the tax return of another taxpayer is
the greater of the individual’s earned income plus $350 (up to
the maximum allowable standard deduction) or $1,100.
However, an individual over 18 or a full-time student over 23
will not qualify as a dependent if they have income exceeding
$4,300.
An individual may not claim a personal exemption for themself
if the individual can be claimed as a dependent on another
taxpayer’s return unless the other individual has no filing
requirement. It does not matter whether the other taxpayer
actually claims the exemption.
EXAMPLE 3.15
Michael Turner, who is single, is claimed as a dependent on his
parents’ 2020 tax return. He receives $1,500 in interest income
from a savings account. In addition, he earns $1,800 while
working part-time after school. The standard deduction for a
single individual for 2020 is $12,400. However, Michael is
limited to a standard deduction of $2,150, the larger of his
earned income of $1,800 plus $350 or $1,100.
EXAMPLE 3.16
Sonya Ross is single and is considered as a dependent by her
parents’ in 2020. She has $1,200 in interest income and also
earns $400 from part-time employment. Her standard deduction
is limited to $1,100, the larger of her earned income of $400
plus $350 or $1,100.
EXAMPLE 3.17
Tom Moss, a 22-year-old, full-time college student, is
considered as a dependent for his parents’ in 2020. Tom is
married and files a separate return. Tom has $1,500 in interest
income and wages of $12,600. His standard deduction is
$12,400, because the greater of $1,100 or his earned income
($12,600) plus $350 is $12,950, but his standard deduction
cannot be more than the $12,400 maximum allowable standard
deduction.
Kiddie Tax

If a dependent child is subject to the kiddie tax and has more
than $2,200 of net unearned (investment) income for the year,
his or her net unearned income is taxed using the Estate and
Trusts tax rate schedule.
The kiddie tax applies in the following circumstances:
1. 17-year old or younger—subject to the kiddie tax regardless
of the amount of his or her earned income.
2. 18-year old—subject to the kiddie tax unless the child has
earned income exceeding one-half of their support.
3. 19- to 23-year old full-time student—subject to the kiddie tax
unless the child has earned income exceeding one-half of their
support.
Net unearned income is unearned income (such as interest,
dividends, capital gains, and certain trust income) less the sum
of $1,100 (referred to as the first $1,100 clause) and the greater
of: (1) $1,100 of the standard deduction or $1,100 of itemized
deductions, or (2) the amount of allowable deductions which are
directly connected with the production of unearned income.
Thus, unearned income is reduced by $2,200 unless the child
has itemized deductions connected with the production of
unearned income exceeding $1,100. The amount of net unearned
income cannot exceed taxable income for the year.
The child in each of the following examples is subject to the
kiddie tax.
EXAMPLE 3.18
Amy Acorn has $300 of unearned income and no earned income.
Amy will have no tax liability since her standard deduction of
$1,100 will reduce taxable income to zero.
EXAMPLE 3.19
Bill Barnes has $1,350 of unearned income and no earned
income. Bill will have $250 of taxable income ($1,350 gross
income – $1,100 standard deduction). His net unearned income
is reduced to zero by the first $1,100 clause and the $1,100
standard deduction. The $250 taxable income is taxed at Bill’s
tax rate.
EXAMPLE 3.20

Charles Clewis has $2,400 of unearned income and no earned
income. His $1,100 standard deduction reduces taxable income
to $1,300. The $2,400 of unearned income is reduced by (1) the
first $1,100 clause and (2) the $1,100 standard deduction,
leaving $200 of net unearned income. The $200 of net unearned
income is taxed using the parents’ marginal tax rate schedule
while the remaining $1,100 of taxable income is taxed at
Charles’s rate.
EXAMPLE 3.21
Dave Drummer has $800 of earned income and $400 of
unearned income. Dave’s standard deduction is $1,150 (the
amount of earned income plus $350). His taxable income is $50
($1,200 gross income – $1,150 standard deduction). Since the
unearned income is less than $2,200, there is no net unearned
income. The taxable income is taxed at Dave’s tax rate.
EXAMPLE 3.22
Frank Fisher has $450 of earned income and $2,300 of unearned
income. His taxable income is $1,650 ($2,750 gross income –
$1,100 standard deduction). Frank’s $2,300 unearned income is
reduced by $2,200 (the first $1,100 clause + the $1,100 standard
deduction), leaving $100 of net unearned income. The $100 of
net unearned income is taxed using the parents’ marginal tax
rate. Frank is taxed at his rate on the remaining $1,550 taxable
income ($1,650 taxable income – $100 taxed at the Estate and
Trusts rate).
EXAMPLE 3.23
Gene Gambol has $1,200 of earned income plus $3,100 of
unearned income. He has $1,150 of itemized deductions which
are directly connected with the production of the unearned
income. Gene has $450 of other itemized deductions. His
taxable income is $2,700 ($4,300 gross income – $1,600 of
itemized deductions). Gene’s net unearned income of $850 is
taxed using the parents’ marginal tax rate. The unearned income
is reduced by $2,250 (the first $1,100 clause + the entire $1,150
of deductions relating to the production of unearned income
since it exceeds $1,100). Gene is taxed at his rate on $1,850

($2,700 taxable income – $850 taxed at the Estate and Trusts
rate).
PLANNING POINTER
Parents can avoid having a dependent’s income taxed at parents’
marginal tax rate by making gifts to children of assets that will
not generate income until after the child’s income no longer
qualifies for the kiddie tax. The tax on the income would then
be taxed at the child’s tax rate. Examples of such assets include
single premium ordinary life insurance policies, Series EE
savings bonds, and property expected to appreciate over time.
A parent may elect to include on his or her return the unearned
income of a child whose income is between $1,100 and $11,000.
The child’s income must consist solely of interest and
dividends. The child is treated as having no gross income and
does not have to file a tax return if the election is made.
The electing parent must include the gross income of the child
in excess of $2,200 on the parent’s tax return for the year,
resulting in the taxation of that income at the parent’s highest
marginal rate. There is an additional tax liability equal to the
lesser of (1) $110 or (2) 10 percent of the child’s income
exceeding $1,100. This liability reflects the child’s unearned
income from $1,100 to $2,200 that would otherwise be taxed to
the child at the 10 percent tax rate.
¶3375
FILING REQUIREMENTS
The obligation to file a return depends on the amount of gross
income, marital status during the year, and age. Only income
which is taxable is included in the computation of gross income
in order to determine whether or not a return must be filed.
With certain exceptions, the gross income level at which
taxpayers must file returns is determined by the standard
deduction. Because married individuals filing separately must
both itemize or both use the standard deduction, the standard
deduction amount is not used to determine the gross income
filing figure. The old-age additional standard deduction entitles
an individual to increase the gross income level filing

requirement by $1,300 or $1,650. However, no increase is
permitted for blindness or for exemptions for dependents.
For 2020, Code Sec. 6012 requires a tax return to be filed if
gross income for the year is at least as much as the amount
shown for the categories in the following table.
Filing Status
Gross Income
Single
Under 65 and not blind
$12,400
Under 65 and blind
12,400
65 or older
14,050
Dependent with unearned income
1,100
Dependent with no unearned income
12,400
Married Filing Joint Return
Both spouses under 65 and neither blind
$24,800
Both spouses under 65 and one or both spouses blind
24,800
One spouse 65 or older
26,100
Both spouses 65 or older
27,400
Married Filing Separate Return
All—whether 65 or older or blind
5
Head of Household

$18,650
Under 65 and blind
18,650
65 or older
20,300
Surviving Spouse
$24,800
Under 65 and blind
24,800
65 or older
26,100
Even if the aforementioned gross income requirements are not
met, a return nevertheless must be filed if an individual had net
earnings from self-employment of $400 or more.
A return should be filed by any taxpayer eligible for the earned
income credit even though the taxpayer does not meet any of the
above filing requirements. A refund can result even if no
income tax has been withheld.
Taxpayers must record their identifying number (Social Security
number) on their returns. Returns filed by taxpayers claiming
exemptions for dependents must include the dependents’ Social
Security numbers.
¶3385
TAX TABLES
The tables are based on taxable income. The tables apply to
taxpayers with taxable income of less than $100,000. Separate
tables are provided for single taxpayers, married taxpayers
filing jointly and surviving spouses, married taxpayers filing
separately, and heads of households.
Each line of the tax tables represents an interval of taxable
incomes. Under $3,050 the intervals are $25 and above $3,050
the intervals are $50. The tax given in the tables is based on the
midpoint taxable income of each interval. Thus, the tax from the
tables for the interval $40,000—$40,050 is the same as the tax

determined from the tax rate schedules for $40,025.
The tax tables may not be used by the following taxpayers:
1. Estates or trusts
2. Taxpayers claiming the exclusion for foreign earned income
3. Taxpayers who file a short period return
4. Taxpayers whose income exceeds the ceiling amount
It is expected that 95 percent of all individual taxpayers will be
able to determine their tax liability from the tables.
To find the income tax from the tax tables, the taxpayer must
(1) find the line that includes the taxable income and (2) read
down the column until the taxable income line is reached. For a
married couple filing jointly with taxable income of $72,623,
the income tax would be $8,320.
Sample Tax Table For 2019
At Least
But Less Than
Single
Head of a Household
$72,600
$72,650
$11,768
$8,320
$11,768
$10,326
72,650
72,700
11,779
8,326
11,779
10,337
72,700
72,750
11,790
8,332

11,790
10,348
72,750
72,800
11,801
8,338
11,801
10,359
The 2019 Tax Tables are provided in the Appendix.
¶3395
TAX RATE SCHEDULES
Taxpayers using the tax rate schedules must compute their tax
based on taxable income. The tax rate schedules are used by
those not eligible to use the tax tables. The tax rate schedules
are presented in the Appendix and inside the front cover.
¶3405
SELF-EMPLOYMENT TAX AND MEDICARE SURTAXES
The tax on net self-employment income is levied to provide the
self-employed with the same benefits that employees receive
through their payment of the Social Security tax (FICA). In
general, the tax is levied, assessed, and collected as part of the
regular income tax.
The tax is imposed for the purposes of insuring the self-
employed individual for old-age, survivors, and disability
benefits and for hospitalization benefits under the Social
Security program. For 2020, the tax rate is 15.3 percent, made
up of two parts: (1) an old-age, survivors, and disability
insurance (OASDI) rate of 12.4 percent and (2) a Medicare
hospital insurance (HI) rate of 2.9 percent. The self-employed
individual is considered both the employer and the employee.
In general, net self-employment income equals the gross income
derived by an individual from a trade or business carried on as a
sole proprietor, less any allowable deductions, plus the
distributive share of a partnership’s net income. If a self-
employed individual has more than one business, the net self-
employment income is the total of the net earnings of all

businesses. A loss in one business is deductible from the
earnings of the other businesses.
Not all self-employment income is subject to tax. Remuneration
paid for the services of a newsboy under age 18 is exempt from
the tax. Dividends are included only by a dealer in stock and
securities. Interest is included only if on business loans. Rental
income is included only by a real estate dealer or in cases in
which services are rendered to the occupants. Generally, self-
employment income does not include any item that is excluded
from gross income. Wages received by a child under 18 from a
parent are not subject to the self-employment tax.
The self-employment tax is imposed on “net earnings from self-
employment.” Net earnings from self-employment is net self-
employment income less a special deduction. The actual
deduction, however, is not subtracted from a taxpayer’s net self-
employment income in computing net earnings from self-
employment. Instead, a taxpayer reduces net self-employment
income by an amount (termed a “deemed deduction”) equal to
net self-employment income multiplied by one-half of the self-
employment tax rate, or 7.65 percent. This deduction is
incorporated into Schedule SE by multiplying the net self-
employment income by .9235. (This gives the same deduction as
multiplying net self-employment income by .0765 and then
subtracting the result.)
A taxpayer is allowed a deduction for the employer's portion of
the self-employment tax (currently one-half) as a deduction
from gross income.
EXAMPLE 3.24
In 2020, Pierre Painter, a self-employed artist, had $45,000 in
self-employment income. His deductible business expenses
amounted to $15,000. Pierre’s self-employment tax is computed
as follows:
Gross income from self-employment
$45,000
Less: Business expense deductions
15,000

Net self-employment income
$30,000
Less: Deemed deduction ($30,000 × 7.65%)
2,295
Net earnings from self-employment
$27,705
Self-employment tax ($27,705 × 15.3%)
$ 4,239
On Form 1040, Schedule SE, Pierre would simply multiply his
net self-employment income of $30,000 by .9235.
The cap on wages and self-employment income that is taken
into account in calculating the portion of the FICA tax
applicable to old-age, survivors, and disability insurance
(OASDI) is $137,700 for 2020. This also applies to wages, self-
employment income, and income derived under the Railroad
Retirement Act. There is no longer a cap on wages and self-
employment income that is taken into account in calculating the
Medicare hospital insurance (HI) portion of the self-
employment tax.
EXAMPLE 3.25
Katie Adams has $150,000 in self-employment income for the
year. Her net earnings from self-employment is $138,525
($150,000 × .9235). She will be subject to an OASDI tax of
$17,075 ($137,700 × 12.4%) and an HI tax of $4,017 ($138,525
× 2.9%). Thus, her total self-employment tax is $21,092.
Thus, self-employment and Social Security (FICA) tax rate
parity is achieved between self-employed persons and
employees. Both employees and their employers are liable for
Social Security tax and the employer must contribute 6.2 cents
per dollar earned by the employee up to the cap limitation
($137,700 for 2020) for OASDI and another 1.45 cents per
dollar without a cap for HI.
The net earnings from self-employment subject to the OASDI
portion of the self-employment tax are limited to the self-
employment base ($137,700 for OASDI and unlimited for HI in
2020) less any wages from which Social Security tax was

withheld during the year. Thus, the tax is applied to the lesser
of (1) the self-employment base ($137,700) minus income
subject to Social Security taxes or (2) the net earnings from
self-employment.
EXAMPLE 3.26
In 2020, Margaret Moore has $139,700 in income from self-
employment and receives $8,900 in wages that are subject to
Social Security taxes. Margaret’s net earnings from self-
employment are $129,013 ($13139,700 × .9235). Her net
earnings from self-employment subject to OASDI self-
employment tax for the year are $128,800 ($137,700 – $8,900,
the wages on which Social Security tax was withheld), which is
less than net earnings from self-employment. Her net earnings
from self-employment subject to the HI self-employment tax are
$129,013, the full amount of the net earnings from self-
employment. Thus, her total self-employment tax is $19,713
($128,800 × 12.4% + $129,013 × 2.9%).
The employer portion of the self-employment tax liability for
the year is allowed as a deduction on the tax return. This
deduction is taken as a deduction from gross income on the
front of Form 1040.
EXAMPLE 3.27
Jim Jergens has $40,000 in self-employment income. His net
earnings from self-employment are $36,940 ($40,000 × .9235).
The self-employment tax is $5,652 ($36,940 × 15.3%). The
employer portion of this amount, $2,826 ($36,940 × 7.65%), i s
allowed as a deduction from gross income.
If the net earnings from self-employment are less than $400,
there is no self-employment tax. However, this does not mean
that the first $400 of net earnings from self-employment is not
subject to the self-employment tax.
EXAMPLE 3.28
Sylvia Knight’s only source of income for 2019 is $433.14 from
self-employment. The net earnings from self-employment are
$400 ($433.14 × .9235). The self-employment tax is $61.20
($400 × 15.3%). Sylvia has a deduction from gross income for

the employer portion of the self-employment tax, or $30.60
($400 × 7.65%). If Sylvia had managed to earn less than
$433.14, there would have been no self-employment tax.
An optional method of computing self-employment income may
be used by persons whose net income from a trade or business is
relatively low. The details are omitted, but the method enables
taxpayers to obtain greater credit for Social Security benefits
than their income would normally allow.
Additional Medicare Tax on Earned Income
A 0.9% Additional Medicare Tax applies to wages and net self-
employment income for tax years after 2012. The tax applies to
wages exceeding $200,000 for single, head-of-household, or
surviving spouse; $250,000 for married filing jointly; $125,000
for married filing separately. The applicable thresholds are not
adjusted for inflation.
The tax applies to the employee's share of wages. The tax does
not apply to the employer's employment taxes. Box 5 of the W-2
is used for determining the Additional Medicare Tax and
withholding.
There are no special rules for nonresident aliens and U.S.
citizens living abroad for purposes of the Additional Medicare
Tax. Wages, other compensation, and self-employment income
that are subject to Medicare tax will also be subject to the
Additional Medicare Tax if in excess of the applicable
threshold.
The threshold amount for the Additional Medicare Tax applies
separately to the FICA and the Railroad Retirement Tax Act
(RRTA). Therefore, the amount of RRTA compensation taken
into account in determining the Additional Medicare Tax under
the RRTA will not reduce the threshold amounts under Section
1401(b)(2)(A) for determining the Additional Medicare Tax
under the SECA.
The Additional Medicare Tax on earned income is part of the
employer's overall withholding. The employee reconciles the
final total of any Additional Medicare Tax when they file their
Form 1040 for the tax year.

Employers are required to apply the additional withholding at
$200,000 of wages, including taxable fringe benefits, bonuses,
tips, commissions, or other supplemental payments, the total
amount of taxable Box 5. It does not matter what filing status is
shown on Form W-4. The employer applies the $200,000
threshold to each spouse in applying the Additional Medicare
Tax. In effect the employer disregards the amount of wages
received by the other spouse in computing the Additional
Medicare Tax for each spouse.
EXAMPLE 3.29
One spouse received $210,000 of wages, while the other spouse
earns $35,000 of either W-2 wages or net self-employment
income. The employer of the first spouse is required to withhold
an additional 0.9% Additional Medicare Tax on the last $10,000
of taxable wages (i.e., $90) even though the couple will not owe
the 0.9% Additional Medicare Tax when they file their 2020
Form 1040. They will receive a tax credit against any other type
of tax that may be owed.
If an employer fails to withhold the 0.9% Additional Medicare
tax, and the tax is subsequently paid by the employee, the IRS
will not collect the tax from the employer. The employer will
remain subject to any applicable penalties on additions to tax
for failure to withhold the 0.9% Additional Medicare tax as
required. Code Sec. 3102(f)(3). The employee is personally
responsible if the employer fails to withhold the 0.9%
additional Medicare tax. Code Sec. 3102(f)(2).
The self-employed does not receive an income tax deduction for
one-half of the 0.9% Additional Medicare Tax on earned
income. Any deduction comes from the employer’s portion of
employment taxes.
EXAMPLE 3.30
A husband and wife each have "Box 5 Medicare wages" of
$150,000 listed on their respective W-2s. The combined
$300,000 "earned income" will be shown on Form 8959 for
calculating the 0.9% Additional Medicare Tax. The couple will
owe a 0.9% Additional Medicare Tax of $450 (($300,000 −

$250,000 threshold) x 0.9%) which will be included as "Other
Taxes" on page 2 of Form 1040.
EXAMPLE 3.31
A husband has $150,000 of "Box 5 Medicare wages" listed on
his W-2. His wife has a K-1 from her law firm listing Box 14
net earnings from self-employment of $162,426 ($150,000 net
self-employment income). The couple will owe $450 of
Additional Medicare Tax on their collective earned income.
EXAMPLE 3.32
A husband has $150,000 of "Box 5 Medicare wages" listed on
his W-2. His wife has a K-1 from her law firm with net earnings
from self-employment of $150,000. The wife also has a $50,000
loss from the start-up of a new Schedule C business. Since the
self-employment income of the wife would now be only
$100,000, when it is added to the $150,000 in W-2 wages of the
husband, the couple is not above the "applicable threshold" of
$250,000 for married filing jointly. Therefore, no Additional
Medicare Tax on their collective earned income would be due..
EXAMPLE 3.33
A husband and wife each have "Box 5 Medicare wages" of
$150,000 listed on their respective W-2s. The wife also has a
$50,000 loss from the start-up of a new Schedule C business.
The couple would still owe $450 of Additional Medicare Tax.
The self-employment loss is not permitted to offset W-2 wages.
EXAMPLE 3.34
The husband has $190,000 in wages subject to Medicare tax and
the wife has $150,000 in compensation subject to RRTA taxes.
The husband and wife do not combine their wages and RRTA
compensation to determine whether they are in excess of the
$250,000 threshold for a joint return. The husband and wife are
not liable to pay Additional Medicare Tax because the
husband’s wages are not in excess of the $250,000 threshold
and the wife’s RRTA compensation is not in excess of the
$250,000 threshold.
EXAMPLE 3.35
C, a single filer, has $130,000 in wages and $145,000 in net

earnings from self-employment. C’s wages are not in excess of
the $200,000 threshold for single filers, so C is not liable for
the Additional Medicare Tax on these wages. Before calculating
the Additional Medicare Tax on self-employment income, the
$200,000 threshold for single filers is reduced by C’s $130,000
in wages, resulting in a reduced self-employment income
threshold of $70,000. C is liable to pay the Additional Medicare
Tax on $75,000 of self-employment income; $145,000 in self-
employment income minus the reduced threshold of $70,000.
Net Investment Income Tax
After 2012, a 3.8% "Net Investment Income Tax" is imposed on
individuals and estate and trusts. Code Sec. 1411. The Net
Investment Income Tax will be calculated on Form 8960 and
shown as "Other Taxes" on page 2 of Form 1040.
For individuals, the tax is imposed on the lesser of:
a. An individual's "net investment income" for the tax year , or
b. Any excess of "modified adjusted gross income" (MAGI) for
the tax year over a threshold amount. Code Sec.1411(a)(1).
The "threshold amount" is $200,000 for single taxpayers and
heads-of-households; $250,000 for married filing jointly and
surviving spouses; $125,000 for married filing separately. Code
Sec. 1411(b). MAGI means an individual's adjusted gross
income for the tax year increased by otherwise excludable
foreign earned income or foreign housing costs under Sec. 911
as reduced by any deduction, exclusion, or credits properly
allocable to or chargeable against such foreign earned income.
Code Sec. 1411(d).
EXAMPLE 3.36
Elmer, a single individual, earns $190,000 in wages and/or net
self-employment income and also has $40,000 of "net
investment income" for the year. Assuming a $230,000 MAGI,
he will have to pay a 3.8% Net Investment Income Tax on the
lesser of his (1) $40,000 of net investment income, or (2)
$30,000 ($230,000 MAGI − $200,000 threshold). Elmer will pay
a $1,140 ($30,000 × 3.8%) Net Investment Income Tax for the
year.

EXAMPLE 3.37
During the year, an unmarried taxpayer received no wages or
self-employment income, but lives strictly off of her $1 million
in "net investment income" from a stock and bond portfolio.
Assuming a $1 million MAGI, she will have to pay a 3.8% Net
Investment Income Tax on the lesser of her (1) $1 million net
investment income or (2) $800,000 ($1 million − $200,000
threshold). As a result, she will pay a $30,400 ($800,000 x
3.8%) Net Investment Income Tax for the year.
The Net Investment Income Tax does not apply to a non-
resident alien or to a trust "all the unexpired interests in which
are devoted to charitable purposes." The tax does not apply to a
trust that is exempt under Sec. 501 or a charitable remainder
trust exempt from tax under Sec. 664.
"Net investment income" is defined as: [Code Sec. 1411(c)(1)
and (c)(2)]
1. Gross income from interest, dividends, annuities, royalties,
and rents (unless such income is "derived in the ordinary course
of any trade or business”);
2. Other gross income from any passive trade or business; or
3. Net gain included in computing taxable income that is
attributable to the disposition of property other than property
held in any trade or business that is not a "passive trade or
business."
"Income derived in the ordinary course of a trade or business"
does not include any trade or business that is either a passive
activity of the taxpayer, or involves trading in financial
instruments and commodities. The passive activity and tradi ng
in financial instruments and commodities are defined as
"passive business investment income" for purposes of the 3.8%
Medicare tax.
Financial Instruments include: Equity interest such as stock,
Proof of indebtedness, Options, Notional principal contracts,
Other derivatives, and Other evidence of an interest in one of
the foregoing items.
A passive investor's share of Form 1065 or Form 1120S from

Box 1 on Schedule K-1 would be "other gross income from any
passive trade or business.”
A Sec. 1231 gain reported on a K-1 from the sale of assets used
in a trade or business that the taxpayer "materially participates"
would not be treated as "net investment income" subject to the
3.8% Net Investment Income Tax. However, it would be "net
investment income" to a passive investor.
"Net investment income" includes any income, gain, or loss that
is attributable to an investment of working capital. Income or
gain from investment in working capital is treated as not
derived in the ordinary course of a trade or business. Code Sec.
1411(c)(3). For example, a business puts some of its excess
working capital into an income-producing investment such as a
certificate of deposit or interest-bearing account, or stocks that
pay dividends or result in capital gains or losses when sold.
Net investment income does not include: Code Sec. 1411(c)(6).
1. Any distribution from qualified employee benefit plan or
retirement arrangements;
2. Any distributions from a regular IRA or Roth IRA;
3. Social security benefits;
4. Any item excluded from gross income.
5. Any item taken into account in determining self-employment
income for the tax year on which an individual pays self-
employment tax under Sec. 1401(b).
The K-1 profits reported in Box 1 of a materially participating
shareholder are not considered "unearned income" for purposes
of the 3.8% Medicare tax.
EXAMPLE 3.38
John is an owner of a business that rents equipment and
machinery. He also materially participates in that business.
Regardless of the business being operated as an S corporation,
LLC/partnership, or a sole proprietorship, any net income or
loss therefrom would not be considered for purposes of the
3.8% Net Investment Income Tax calculation. However, a
Schedule C sole proprietor or the K-1 recipient of "Box 1—
Trades or Business Income” from an LLC/partnership would

still have the potential for the 0.9% Medicare tax on earned
income.
EXAMPLE 3.39
John leases a building to his rental business. This is a self-
rental situation and self-rentals are not classified as passive
income. The gross rental income will be deemed to be derived
in the ordinary course of a trade or business and, therefore,
exempt from the Net Investment Income Tax. Gain or loss from
the property will also be treated as gain or loss from the
disposition of property held in a nonpassive trade or business.
If a taxpayer is a "real estate professional" and they also
"materially participate" in their rental activities, then Sec. 469
passive loss rules do not apply. Any rental income or loss
derived from such rental activities will not factor into the
taxpayer's calculation of the 3.8% Net Investment Income Tax if
they meet the definition of trades or business for Section 162.
The IRS has provided a safe harbor for the trades or business
definition: If a taxpayer qualifies as a real estate professional
and also spends more than 500 hours participating in either a
separate or grouped rental activity, the IRS will treat those
rental activities as trades or businesses. Reg. §1.1411-
4(g)(7)(i).
EXAMPLE 3.40
John is a "real estate professional" for purposes of the passive
loss rules. He also "materially participates" in the rental
activities that he owns. The Net Investment Income Tax would
not apply to the rental activities if his "rental activities" are
treated as "trades or business" under Sec. 162. The income
would not be subject to any self-employment tax under Sec.
1402. However, assume the rental activities are not “trades or
business" for Sec. 162. As a result, any net rental income or
loss would be part of his 3.8% Net Investment Income Tax
calculation.
For purposes of the Net Investment Income Tax, the definition
allows the reduction for any otherwise allowable deductions
"properly allocable to such income or gain."

1. Deductions under Sec. 62 related to gross income
2. Itemized deductions under Sec. 63
3. Loss deductions under Sec. 165
A large capital loss in excess of any capital gain for a particular
tax year can only offset up to $3,000 of other "net investment
income." Investment interest expense can only be used to offset
"net investment income" to the extent otherwise allowed on
Form 4952. Any state or local tax attributable to the sources of
net investment income may be deducted in computing net
investment income. Any otherwise allowable deductions must
also be reduced by the itemized deduction phaseout.
Employment Taxes for Household Employers
If a taxpayer hires someone to do household work and was able
to control what work he or she did and how he or she did it, the
taxpayer has a household employee. The taxpayer has to have an
employer identification number (EIN) and pay employment
taxes.
A Form W-2, Wage and Tax Statement, must be filed for each
household employee paid $2,200 or more in cash wages in 2020
that are subject to social security and Medicare taxes. If the
wages were not subject to these taxes but the employee wishes
to have federal income taxes withheld, a W-2 must be filed for
that employee. A Form W-3, Transmittal of Wage and Tax
Statements, must also be filed if one or more W-2s are required
to be filed.
If cash wages are paid of $1,000 or more in any calendar quarter
of 2019 or 2020 to household employees for 2020, the taxpayer
may also be subject to federal and state unemployment taxes.
In the case of persons performing domestic services in a pri vate
home of the employer and person performing agricultural labor,
if the employer pays the employee’s liability for FICA taxes or
state unemployment taxes without deduction from the
employee’s wages, those payments are not wages for FICA
purposes. Code Sec. 3121(a)(6).
TAX BLUNDERS
1. Sara Michaels and Tommy Tooks marry on December 31.

Sara earned $400,000 for the year, and Tommy earned
$100,000. If Sara and Tommy had waited until the beginning of
the following year to marry they would have realized a
significant tax savings. Each filing as single taxpayers will
result in less total tax than filing jointly.
2. Assume Sara earned $95,000 and Tommy earned $5,000
because he attended school most of the year and they marry at
the beginning of the next year. There would be a significant tax
savings in marrying at the end of the first year and filing jointly
over each filing as single taxpayers.
3. Sara and Tommy decide to file as married filing separately.
Sara has $12,500 in itemized deductions and Tommy has
$10,000 in itemized deductions. Since Sara itemized on her
return Tommy is required to itemize. They may be better off to
have both take the standard deduction since the total standard
deductions would be $24,800 while itemizing only results in a
$22,500 total deduction.
SUMMARY
· The standard deduction eliminates low- to moderate-level
taxpayers from the tax rolls. The standard deduction is made up
of two parts: the basic standard deduction and the additional
standard deduction. Both of these parts are adjusted each year
for inflation. The standard deduction differs depending upon
filing status.
· Taxpayers are allowed a personal exemption for themselves
and their spouse, plus an exemption for each qualified
dependent. Taxpayers who are dependents are not allowed a
personal exemption for themselves.
· Taxpayers must determine their tax liability from among five
different filing statuses.
· Special taxation rules are imposed on returns filed by
individuals that are dependents of other taxpayers.
· In general, filing requirements are based on a taxpayer’s gross
income, filing status, and age.
· Self-employed individuals are required to pay a self-
employment tax that is equivalent to the Social Security taxes

paid by employees.
· Taxpayers could potentially be subject to a 0.9% Additional
Medicare Tax and the Net Investment Income Tax.
1W. Please submit your answers to the following questions and
problems in a Word document. You should include a cover page
and a references page for this assignment. Your qualitative
answers should be written in full sentences with depth to your
responses when needed. For questions and problems requiring
computations, you need to share your supporting calculations.
These questions and problems are located in your 2021 CCH
Federal Taxation Comprehensive Topics textbook by Smith,
Harmelink, and Hasselback.
· Question 11 Chapter#1
Why is income-shifting considered such a major tax planning
concept?
Jim files his return one month after the due date and pays the
remaining $8,000 of tax owed by him. What are his delinquency
penalties?
Olivia is being audited by the IRS. The revenue agent
determines that certain expenses that were deducted on her
return are not valid, and he accordingly makes adjustments to
her tax liability. Upon receipt of her 30-day letter, she phones
you, a CPA, for advice regarding possible future action on the
matter. What options would you discuss with Olivia?
· Problem 33 Capter#3
Which of the following taxpayers should itemize? Explain.
Robert is a single taxpayer. He has itemized deductions of
$12,600.
Jane qualifies as head of household. Her itemized deductions

total $17,850.
Brian is married and files a separate return. He has itemized
deductions of $12,600.
Lisa is a surviving spouse. Her itemized deductions are
$24,500.
· Problem 34 Chapter#3
Duke and Pat Collins have adjusted gross income of $358,000.
They have itemized deductions of $20,000 consisting of $8,000
in medical expenses that exceed 10% of adjusted gross income,
$3,000 in property taxes, $4,000 in housing interest, and $5,000
in miscellaneous itemized deductions. What is the amount of
their itemized deductions?

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