Chapters 1

Introduction to Taxation
I. Tax Terminology
A. What is a tax?
1. In summary
a. an enforced contribution that is not punitive, but is compulsory in nature -that is, it is required (it is not
voluntary);
b. Imposed by a government agency (federal, state or local); and
c. Cash-Not tied directly to the benefit received by the taxpayer.
B. Why do we have taxes?
1. Who cares about taxes?
a. Individuals - Investing decisions, purchasing home, retirement, child education.
b. Businesses - Type of legal entity, Which state to form headquarters, compensate owners, Debt vs. equity
financing, purchase business property.
c. Politicians
C. How to calculate a tax:
1. At its simplest form, tax is calculated as follows:
Tax Base
×Tax Rate
Tax
a. Tax Base = what is taxed, usually expressed in monetary terms. Taxation is mostly complicated due to the
ambiguity and complexity in computing the tax base.
b. Tax Rate = level of taxes imposed on the tax base, usually expressed as a percentage
2. Basic Federal Income Tax Formula
Gross income
- Deductions_______
= Taxable Income
× Tax Rate_________
= Income Tax
+ Other Taxes (e.g., self-employment taxes, net investment income tax)
= Total Tax
- Credits
- Prepayments
= Tax due or (refund if calculation ends up negative)
D. What are the types of tax rate systems?
1. Proportional or Flat Tax. A proportional or flat tax is one where the tax rate remains the same regardless of the tax
base. (State and local sales taxes)
a. A sales tax is flat or proportional. However, the sales tax does have a regressive effect on low-income
taxpayers because they pay a higher percent of their income in sales tax than do higher-income taxpayers.
b. The corporate income tax is a proportional or flat tax. C-Corporations pay a flat tax of 21% on all taxable
income.
2. Progressive Tax: as the tax base increases, the tax rate also increases. (The individual federal income tax system)
3. Regressive Tax: as the tax base increases, the tax rate decreases.
E. Different Ways to Measure Tax Rates:
1. Marginal tax rate - tax rate that applies to the next additional increment of a taxpayer’s taxable income (or
deductions). The marginal rate is used for tax planning and decision-making.
2. Average tax rate – measures a taxpayer’s average level of taxation on each dollar of taxable income. The average
tax rate is represented as follows:
Total Tax
Average Tax Rate=
Taxable Income
3. Effective Tax Rate – measures the taxpayer’s average rate of taxation on each dollar of income, regardless if that
income is taxable or not. When compared to the average tax rate, the effective tax rate is viewed to provide a better
depiction of a taxpayer’s tax burden. The effective tax rate is calculated as follows:

Total Tax
Effective Tax Rate=
Total Income
II. Types of taxes
 A. Income taxes. The federal government raises the most revenue by using an income tax. The individual and corporate
income tax accounts for roughly 56% of the federal government revenues. When you add employment taxes, an
additional 36% of revenue is added bringing the total revenue earned by the federal government based on “income of
Americans” to 92%.
B. Excise tax. The federal government, states, and local governments assess and collect excise taxes on such items as
gasoline, alcohol, cigarettes, and hotel rooms. Excise taxes differ from other transaction-based taxes because excises
taxes are generally based on the quantity purchased as opposed to the transaction price. Some excise taxes are
referred to as Sin Taxes because they are imposed to discourage behavior. (High taxes on alcohol and tobacco
products.)
C. Wealth transfer taxes. The federal government and most states tax the transfer of wealth. This is in the form of an
Estate Tax and/or a Gift Tax where the value of the large enough estates or gifts are taxed upon transfer to the
recipient of the estate or gift. (In addition, some states have an estate tax imposed on the estate at death, or an
inheritance tax imposed on the beneficiaries of the estate)
D. Property taxes: tax on wealth or property a taxpayer owns at a particular time. The tax is typically paid on the property's
assessed value, which is supposed to approximate fair market value.
E. Consumption taxes (sales, use, excise, value added, and turnover).
a. Sales tax. At present there is no national sales tax. State and local governments collect sales tax on certain
types of tangible personal property. Sales taxes are typically imposed on sales of personal property, but not on
sales of intangible property or the providing of services.
b. Use tax. A use tax is imposed by a state when a taxpayer brings a personal property item into the state from
another state on which sales tax has not been paid.
c. Value added tax (VAT). Most countries, except for the United States, use a value-added tax, which is a
consumption tax. The VAT is assessed on the value each taxpayer adds to goods as they move through the
production process.
2. Tariffs and duties. Tariffs and duties are levied on goods brought into a country to equalize pricing between foreign
and domestic businesses.
III. What are the characteristics of a good tax?
A. A good starting point for discussion is to look at Adam Smith's four canons of taxation: equity (or equality), economy
(or efficiency) certainty, and convenience.
1. Equity. Taxpayers should contribute toward the support of the government in proportion to their ability to pay (make
more, pay more). The concept of equality brings up the notions of vertical and horizontal equity.
a. Horizontal equity. two taxpayers with equal abilities to pay tax should pay the same amount of tax to the
government. Should taxpayers with equal abilities to pay tax pay the same amount of tax?
i. The question becomes what is equal ability? Is it measured by taxable income? If one family has more
dependents than another, should this be considered? Some say no because it was their choice whether to
have children. If you support this idea, then the idea of a special rate on capital gains should offend you
because taxpayers with equal abilities to pay are paying different amounts.
b. Vertical equity is the notion that if one taxpayer has a greater ability to pay than another taxpayer, they should
pay more. Should taxpayers with a greater ability to pay more do so?
i. They do under our current system. If you agree with this notion, then you support the concept of a
progressive tax rate structure. Many, however, say that a progressive rate structure punishes taxpayers
who work hard and are successful. If you support the concept of a flat tax, then you oppose the concept of
vertical equity. People who support a flat tax believe that everyone, regardless of their ability to pay,
should pay tax at the same rate. Most flat tax proposals exempt income from tax up to the poverty level
and tax any income more than what is needed for base necessities at the flat tax rate.
2. Economy or efficiency. Economy is the notion that the costs of assessing and collecting taxes (administrative
costs of collection) from taxpayers should be kept to a minimum. The problem is the cost of complying with the tax
law that taxpayers personally must bear. Over 50% of all taxpayers have their tax returns prepared by someone
else. Those taxpayers pay a fee to have their tax returns prepared.
3. Certainty. taxpayers should be able to calculate the amount of their tax liability and know how much tax they will
owe. It seems clear our current tax system falls short of meeting this goal.
a. The complexity of our current tax system means that many taxpayers have no clue what their tax liability will be
in any one year.
b. "Compromise is the root of all complexity." That statement alone sums up our current tax system. Although no
one could disagree with the goal of certainty, no one could say that our current tax system accomplishes the
goal of certainty.
4. Convenience is the notion that tax should be due at a time the taxpayer has the money to pay the tax and should
be paid in a manner convenient to the taxpayer. For the most part, I think our current tax system does a pretty good
job of achieving this goal. The system of withholding taxes from our pay and having employers remit seems to work
as does our system of making estimated tax payments.
 IV. Federal Income Tax
A. Persons subject to income tax.
1. Individuals. Individual taxpayers fill out Form 1040 and pay a substantial portion of the federal income tax.
2. C corporations. corporations that are validly organized under state law that are taxed under Subchapter C of the
Internal Revenue Code (IRC). The income of a C corporation is taxed first to the corporation and then, if the C
corporation pays a dividend to its shareholders, the shareholders of the corporation are taxed a second time on the
dividends (double taxation). A C corporation files Form 1120.
3. Estates and trusts. File form 1041
a. Estate. An estate is created on the death of an individual. The purpose of an estate is to manage the assets of
the decedent until they are distributed to the decedent’s beneficiaries or heirs. Note that income is generally
taxed once, either to the estate or to the beneficiary.
b. Trust. A trust is established for a specific purpose by a grantor who transfers assets to a trustee for the benefit
of one or more beneficiaries. A trust is irrevocable when the grantor gives up all future control of the trust assets,
and revocable if the grantor does not give up control of the trust or its assets. A trust can be created during the
grantor's life (inter vivo) or on the grantor's death (testamentary). Generally taxed once. The trust is taxed if the
income is retained by the trust, and the beneficiary is taxed if the income is distributed to a beneficiary.
Chapter 2
Tax Compliance, the IRS, and Tax Authorities
I. Tax Compliance is the process of self-assessing and paying income tax liability by the annual filing of income tax
returns.
A. Filing Requirement:
1. Individual Taxpayers:
a) Individual taxpayers file form 1040.
b) The filing deadline is the fifteenth day of the fourth month following the end of the tax year. (April
15th for calendar year)
c) The requirement to file a return is based on filing status. If an individual's gross income is less
than the standard deduction, an individual taxpayer is not required to file a tax return. an
individual taxpayer may still want to file a return if a refund is expected.

Filling Status and Age 2024

Explanation
(In 2024) Gross Income
Single $14,600 $14,600 standard deduction
$14,600 standard deduction + $1,950 additional
Single, 65 or older $16,550
deduction
Married, filing a joint return $29,200 $29,200 standard deduction
Married, filing a joint return, one spouse 65 or $29,200 standard deduction + $1,550 additional
$30,750
older deduction
Married, filing a joint return, both spouses 65 or $29,200 standard deduction + $3,100 additional
$32,300
older deductions (2 x $1,550)
Married filing separately $5
Head of household $21,900 $21,900 standard deduction
$21,900 standard deduction + $1,950 additional
Head of household, 65 or older $23,850
deduction
Surviving spouse with a dependent child $29,200 $29,200 standard deduction
Surviving spouse, 65 or older, with a dependent $29,200 standard deduction + $1,550 additional
$30,750
child deduction

2. C-Corporations (tax-paying entity)

a) C-Corporations file form 1120
b) All C-Corporations must file a tax return regardless of income.
 c) C-Corporations filing the fifteenth day of the fourth month following the end of the tax year.
(Calendar year, April 15th, June 30th year-end).
3. Flow-through entities (partnerships & S-Corporations)
a) Partnerships file form 1065 and S-Corporations file form 1120S.
b) must file a tax return regardless of income level.
c) fifteenth day of the third month following the entity’s year-end. (calendar-year March 15th)
B. Extensions to file
1. All taxpayers can request an automatic extension of time to file their returns, but not to pay any tax due
2. Individuals, partnerships, and S-Corporations can request an automatic 6-month extension to file. C-
Corporation too but can do a 7-month extension if June 30 deadline.
3. Individuals file for an extension on form 4868
4. Business entities file for an extension on form 7004.
5. Note: extension to file is not an extension to pay.
C. Statutes of Limitations
1. The statute of limitations is the period beyond which no legal action or changes to a tax return may be
made by the IRS or taxpayers.
2. The general statute of limitations is 3 years from the later of (1) the date the return is filed or (2) its due
date.
3. The statute of limitations increases to 6 years from the later of the date the return is filed or its due date
if the taxpayer omits gross income more than 25% of the gross income reported.
4. The statute of limitations never runs if the taxpayer files a fraudulent return. The IRS can pursue the
taxpayer at any time.
5. The statute of limitations does not begin to run until the taxpayer files a complete return.
6. The statute of limitation can be extended to allow sufficient time to resolve issues with the IRS if both
parties agree.
II. IRS Audit Selection and Examination Process
A. Selecting Returns to Audit - a taxpayer’s return is selected because the IRS believes the tax return has a high
probability of being incorrect.
1. computer programs to identify tax returns that might have an understated liability
a) Discriminant Function (DIF) system (scoring system) – example for high DIF score: unusually
high expenses relative to income, sale of business.
b) Document perfection program (checks for math errors)
c) Information matching programs (compares tax return data with other IRS information)
d) Other Methods (large corporations, certain transactions engaged by taxpayers, certain items of
income/deduction, media reports).
B. Types of Audits (examinations)
1. Correspondence audits (most common, less comprehensive) often begin with a computer-generated
notice that an error has been made. Correspondence audits are generally handled by mail through the
appropriate IRS service center. The IRS uses the document perfection program when it initially
processes returns to check for mathematical and tax calculation errors. Also, the IRS uses information
matching contained on W-2s, 1099s, etc. to the taxpayers' returns to ensure proper reporting of income
by
2. Office audits are handled at the local IRS district office. The return is selected for audit based on the
Discriminant Function System (DIF) Program. Once the returns are selected, they are sent to the
local IRS office to determine whether the high DIF score can be explained by reviewing the return. If the
decides that the return is worth auditing, a notice will be sent to the taxpayer requesting information and
scheduling a time for the office audit.
3. Field audits are also handled by the local IRS district office. Although the selection process is the same
as for an office audit, field audits are more comprehensive than office audits and they are generally
conducted at the taxpayer's place of business and usually involve a business return.
C. Examination/Appeals/Litigation Process
1. The revenue agent then issues a Revenue Agent Report (RAR), which describes each issue and the
resolution of it and sends the RAR and a FORM 870 (which asks the taxpayer to agree to the
assessment and collection of any additional tax due) to the taxpayer. The cover letter in this
correspondence is known as the 30-day letter.
2. If the 30-day letter is issued to the taxpayer and the taxpayer disagrees with the conclusions of the IRS
revenue agent in the RAR, the taxpayer has 30 days to request an appeals conference with the
appeals division of the IRS. The request must be in writing and is called a Formal Written Protest.
3. If disagrees with the conclusion of the appeals division, the taxpayer does not request an appeals
conference with IRS, does not opt for fast-track mediation, and/or does not pay the tax deficiency, the
 taxpayer will then receive a statutory notice of deficiency (the 90-day letter), meaning the taxpayer has
90 days to file a petition in tax court. Otherwise, after 90 days the IRS can begin proceedings to collect
the tax deficiency.
4. If the taxpayer receives the statutory notice of deficiency, and the taxpayer disagrees with IRS, the
taxpayer can either file a petition in tax court asking the court to hear the case or pay the tax and file a
claim for refund in U.S. District Court or U.S. Court of Federal Claims.
5. If the taxpayer is unhappy with the trial court decision (Tax Court, U.S. District Court, or U.S. Court of
Federal Claims) the taxpayer may appeal the decision to the U.S. Court of Appeals for the Circuit in
which the taxpayer resides. The U.S. Court of Appeals must hear all cases appealed to it. If the
taxpayer is unhappy with the Court of Appeals decision, the taxpayer may appeal to the United States
Supreme Court by filing a writ of certiorari. The U.S. Supreme Court chooses the cases it wants to hear
(usually 1 or 2 per year)

D. IRS Collections
1. The IRS collects unpaid taxes that have been assessed against taxpayers including imposing liens and
seizing assets of taxpayers. The IRS also may accept less than the full amount of tax due from a
taxpayer by agreeing to an Offer in Compromise.

E. After Audit (U.S. Court System)

F. Trial Courts - There are three trial courts for federal tax cases.
1. U.S. Tax Court - The U.S. Tax Court hears only tax cases. Taxpayers are entitled to sue in tax court
without paying the tax deficiency assessed by the IRS and have no right to jury trials. The tax court
judges will follow the existing precedent of the Court of Appeals for the federal circuit (This is known as
 the Golsen rule.) The tax court judges must follow U.S. Supreme Court opinions. The tax court issues
two types of decisions:
a) Regular decisions represent important cases having precedential value because of their
uniqueness. These are published by the federal government in the Tax Court Reports. For
some regular opinions, the IRS will announce either an "acquiescence" or "nonacquiescence"
which means the IRS either publicly agrees or disagrees with the tax court’s decision.
b) Memorandum decisions involve well-established issues. These are published by private
publishers such as RIA as Tax Court Memorandum Decisions.
2. Federal District Court - Federal district courts are the trial courts of the federal court system. Tax
cases will be heard if taxpayers pay the tax deficiency assessed and sue the government for a refund.
Taxpayers can request jury trials. Taxpayers and IRS have an automatic right of appeal to the Court of
Appeals for the circuit in which the taxpayer resides. Judges must follow the existing precedent of the
Court of Appeals for that circuit and the U.S. Supreme Court
3. U.S. Court of Federal Claims - U.S. Court of Federal Claims hears all monetary claims against the
United States. Tax cases will be heard if taxpayers pay the tax deficiency assessed and sue the
government for a refund. Taxpayers have no right to jury trials. Taxpayers and the IRS have an
automatic right of appeal to the U.S. Court of Appeals for the Federal Circuit. Judges must follow the
existing precedent of the Court of Appeals for the Federal Circuit and the U.S. Supreme Court.
G. U.S. Federal Court of Appeals.
1. The court of appeal for federal tax cases is the U.S. Federal Court of Appeals. Taxpayers and IRS
both have an automatic right of appeal from Tax Court decisions or Federal District Court decisions, or
U.S. Court of Federal Claims decisions. Appeals are made to the Federal Court of Appeals for the circuit
in which the taxpayer resides unless the case was tried by the U.S. Court of Federal Claims. Taxpayer
and IRS appeals from the U.S. Court of Federal Claims are made to the Court of Appeals for the
Federal Circuit. Decisions of the Federal Courts of Appeal are binding on taxpayers and IRS in that
circuit but are not binding on taxpayers and IRS outside that circuit.
H. U.S. Supreme Court - If either party is unhappy with the decision of the Federal Court of Appeals, either may
petition the U.S. Supreme Court to hear their case. U.S. Supreme Court decisions are binding on all taxpayers
and the IRS. Writs of Certiorari are rarely granted in tax cases unless there is a conflict in the circuits, the issue
is unique, or the issue is of great importance.
III. Tax Law (Authority) Sources
A. Primary Sources - The primary sources of tax law come from the three branches of government. The
legislative branch (Congress) passes the Internal Revenue Code. The Treasury Department through the Internal
Revenue Service administers the tax law by promulgating rules and regulations, and the judicial branch
interprets tax law through judicial cases.
1. Legislative (aka Statutory) Authority
a) U.S. Constitution - 16th amendment - The Congress shall have power to lay and collect taxes
on incomes, from whatever source derived
b) Internal Revenue Code (I.R.C. or “the Code”)
enacting federal tax legislation is as follows:
- House of Representatives. All federal tax bills must be introduced in the House of Representatives. The
bill is immediately referred to the House Ways and Means Committee. The Ways and Means Committee holds
hearings, which are published. The Ways and Means Committees prepares a committee report, which is also
published. The committee reports contain the most useful pieces of information and are often cited for legislative
intent. If the House and Ways Committee approves a bill, it goes to the House floor for consideration. Debate on
the bill is recorded in the Congressional Record. If the bill passes the entire House, it goes to the Senate for
consideration
- Senate. In the Senate, the bill is referred to the Senate Finance Committee. The Senate Finance Committee
holds hearings and prepares a Committee report, which is also published. The committee reports contain the
most useful pieces of information and are often cited for legislative intent. If the Senate Finance Committee
approves a bill, it goes to the Senate floor for consideration. Debate on the bill is recorded in the Congressional
Record. Once the Senate version passes the Senate, the differences between the House version and the Senate
version must be worked out by a Joint Conference Committee.
- Joint Conference Committee. The Joint Conference Committee is made up of members of the House Ways and
Means Committee and the Senate Finance Committee. Once the Joint Conference Committee has worked out
the House and Senate differences, the final version of the bill is then voted on by both the House and Senate. If
approved, it goes to the President for signature (or veto). If the bill is signed into law by the President, it is codified
as part of the 1986 Internal Revenue Code. The IRC is a primary source of tax law.
 - The IRC is organized into the subtitles, chapters, and subchapters.

2. Administrative Authority – promulgated by Treasury Department/IRS

a) Treasury Regulations are promulgated by the Treasury Department and carry the highest
authoritative weight under administrative authority. Three forms of treasury regulations. (ranked
weakest to final)
(1) Proposed regulations - are published by the Treasury Department for taxpayer
comment in the Federal Register as a Notice of Proposed Rulemaking and in the
Internal Revenue Bulletin. Because they are proposed and not final, they cannot
be relied upon by taxpayers
(2) Temporary regulations - published by the Treasury Department in the Federal
Register to provide interim guidance to taxpayers until final regulations are issued.
Temporary regulations have a limited life. The Treasury Department may issue
regulations as both proposed and temporary.
(3) Final regulations - are published by the Treasury Department in the Federal Register
after comments on the proposed regulations have been evaluated. Final regulations
carry more weight with courts than temporary or proposed regulations. These
represent treasury’s interpretations of the code until revoked.
Three types of treasury regulations: ranked highest to lowest
(1) Legislative regulations promulgated by the Treasury Department under this
Congressional grant of authority carry the same weight as the IRC section the
legislative regulation was promulgated under.
(2) Interpretative regulations – Delegated authority to interpret the IRC and are given the
same weight as expert opinions by most courts.
(3) Procedural regulations which explain treasury department procedures
b) Revenue Rulings (second highest administrative authority) are issued by IRS and
represent the official position of IRS. They apply the law to particular proposed factual situation
presented by a taxpayer. The Treasury Department determines which rulings are of sufficient
general interest to be published by IRS. Revenue Rulings can be revoked or modified by
IRS. Revenue rulings are binding on the IRS, but courts need not follow and may have
alternative interpretation of the Code. Revenue ruling to NOT have the force and effect of
“law.”
c) Revenue Procedures are issued by IRS and represent the official position of IRS with respect
to its administrative practices and procedures. For example, the first Revenue Procedure each
year deals with the process a taxpayer must use to request a private letter ruling. Revenue
Procedures can be revoked or modified by IRS.
d) Letter Rulings:
 (1) Private Letter Rulings (PLRs) are issued by IRS at the request of a taxpayer. IRS
applies the law to a particular proposed factual situation presented by a taxpayer and
generally involves high dollar tax implications. IRS charges a fee for any PLR issued.
IRS is not bound by PLRs in dealing with other taxpayers and carry no precedential
value. Can be used by taxpayers receiving letter ruling to avoid the substantial
understatement penalty. IRS does not publish PLRs and TAMs, but private publishers
such as CCH and RIA do.
(2) Technical Advice Memoranda (TAMs) are similar to PLRs except they are request
on completed transactions. Normally requested by IRS examining agent during
the course of an audit.
3. Judicial Authority
a) Tasked with the ultimate authority to interpret the Internal Revenue Code and settle disputes
between taxpayers and the IRS. Court opinions ranked from most authoritative to least
authoritative:
(1) Supreme Court: the highest judicial authority; same authority level as the Internal
Revenue Code.
(2) Courts of Appeals: 13 circuit courts; the next level of judicial authority.
(3) Trial-level courts: last levels of judicial
(a) U.S. District Courts
(b)U.S. Court of Federal Claims
(c) U.S. Tax Court
b) All courts apply the judicial doctrine of stare decisis, which means that a court will rule
consistently with its previous rulings and the rulings of higher courts with appellate jurisdiction.
The tax court applies the Golsen rule.
B. Secondary Authority - Locating relevant primary authority requires a tax researcher to use secondary sources
of authority. Secondary sources cannot be cited in tax research to support tax position. Secondary
sources of authority help a tax researcher locate relevant primary authority. They are arranged either in IRC
Section order or topically.
1. Examples of Secondary Authority
a) Tax Research Services:
(1) BNA Tax Management Portfolios
(2) CCH Standard Federal Tax Reporter
(3) RIA Federal Tax Coordinator
(4) RIA United States Tax Reporter
b) Newsletters:
(1) Daily Tax Report
(2) Federal Tax Weekly Alert
(3) Tax Notes
c) Law Reviews:
(1) Tax Law Review (New York University School of Law)
(2) Virginia Tax Review
d) Professional Journals:
(1) Journal of Accountancy
(2) Journal of Taxation
(3) Practical Tax Strategies
(4) Tax Adviser
e) Quick Reference Sources:
(1) IRS Publications
(2) CCH Master Tax Guide
(3) RIA Federal Tax Handbook
IV. Introduction to Tax Practice
A. Tax Practitioners
1. work in tax planning, research, compliance, or some combination
2. public accounting, private industry, or for the government.
3. CPAs, accountants, attorneys, enrolled agents, or others
V. Tax Planning (Chapter 3 – pp. 3-2, 3-18 to 3-20)
 A. Tax planning is the investigation of business alternatives that will achieve business goals while at the
same time minimize tax costs.
B. Tax avoidance VS tax evasion
1. Tax avoidance is the lawful or legitimate minimizing of tax liability.
2. Tax evasion is the unlawful and illegal minimizing of tax liability. Tax evasion is a criminal offense
which may subject a taxpayer to fines and/or jail.
C. General Tax Planning Strategies
1. Timing – deferring taxable income and accelerating tax deductions.
2. Income shifting –from high to low tax rate taxpayers.
3. Conversion – converting income from high to low tax activities.
D. Legal doctrines that may affect tax planning strategies
1. Business purpose doctrine - only recognize a transaction if it is entered into for some business
purpose other than to avoid taxes.
2. Substance over form doctrine - the taxability of a transaction by the substance of the transaction
rather than by its form.
3. Step transaction doctrine - collapse a series of transactions into one transaction to determine its tax
consequences.
VI. Tax Research
A. Objectives of tax research
1. Tax research objectives will depends on purpose of research.
a) Tax Planning - the objective should be to achieve the taxpayer's business objectives at the
lowest possible tax cost. The tax planner should look at the risk associated with taking a
position for tax purposes and decide whether that risk is worth assuming. Risk is measured in
terms of relevant tax authority and penalties.
b) Defending Tax position – the researcher should find all relevant authorities which support
taxpayer's position as well as any contrary authority.
2. Steps in Conducting Tax Research
o Step 1 – Understand Facts - The facts must be gathered. Either the proposed course of
action must be clearly delineated (open facts, e.g. tax planning) or the facts that happened
must be clearly understood by the researcher (closed facts, e.g. defending tax position).
o Step 2 – Identify Issue – identifying tax issues is the most critical step. The more specifical the
easier it is to locate an answer. Numerous issues to be resolved in research project.
o Step 3 – Locate Relevant Authority - The sources of tax authority are discussed below.
o Step 4 – Analyze Tax Authorities - The researcher must determine if the tax authority located
applies to the facts at issue and the researcher must analyze the strengths and weaknesses of
the authority. The conclusions of the IRS carry the most weight with IRS. Appellate judicial
decisions may carry more weight to a court than an IRS position
o Step 5 - The recommendation must be communicated. Communication is a Tax
Memorandum to the file and a client letter to the person requesting the recommendation.
VII. Taxpayer and Tax practitioner Penalties (See exhibit 2-12 on p. 2-27)
A. Failure to file return: 5% per month of the amount of correct tax due, up to 25%. The minimum penalty for
failure to file a tax return within 60 days of the due date is the lesser of $485 or 100% of the tax required. If no
tax is due on the return, there is no penalty assessed.
B. Failure to pay tax due: 1/2% (.5%) per month of the tax shown on the return, up to 25%.
C. Accuracy-related penalties:
1. Negligence penalty: 20% of the underpayment of tax due.
2. Substantial understatement penalty: A 20% penalty on the understatement may be imposed unless
the taxpayer has: (1) substantial authority; or (2) a reasonable basis for the tax treatment of the item
creating the understatement and it is disclosed on Form 8275 or Form 8275R.
3. Substantial valuation misstatements penalty: If a taxpayer overvalues property, which is deducted
on his tax return, and the overvaluation is 150% or more, a 20% penalty is imposed on the
underpayment. Penalty increases to 40% if the over valuation is 200% or more.
D. Fraud penalty: 75% of the underpayment of tax due to fraud.
VIII. Tax Professional Responsibilities
A. IRC § 6694 - IRC Section 6694 imposes a requirement on tax return preparers to not take unreasonable
positions.
1. A tax return preparer is obligated to not take a position that is unreasonable because there is no
substantial authority (40%) for the position and the tax return preparer knew of the unreasonable
 position. Substantial authority exists if the weight of authorities supporting the position is substantial in
relation to the weight of those that take a contrary. Substantial authority includes all primary authority,
including administrative pronouncements.
2. If a tax return preparer's position on a tax return is not supported by substantial authority, the preparer
may face a penalty equal to the greater of $1,000 or 50% of the income from preparing the return,
unless the tax return preparer can show there was a reasonable basis for the position taken and it was
adequately disclosed.
3. If a tax return preparer takes an unreasonable position due to willful or reckless conduct the penalty
increases to the greater of $5,000 or 75% of the income derived from preparing the return.
4. IRS can also impose many other civil and criminal penalties against tax practitioners who violate their
legal obligations.
B. Circular 230
1. All CPAS, attorneys, enrolled agents, and registered tax return preparers who practice before the IRS
are subject to Circular 230, which provides that a tax practitioner may not willfully, recklessly, or through
gross incompetence prepare a tax return that the tax practitioner knows or reasonably should know
contains a position that: (1) lacks a reasonable basis; (2) is an unreasonable position under IRC Section
6694; or (3) is a willful attempt by the tax practitioner to understate liability for tax or is a reckless or
intentional disregard of IRS rules and regulation.
2. If tax practitioners violate Circular 230, they may be suspended or disbarred from practice before the
IRS.
C. Statements on Standards for Tax Services (SSTS) - AICPA
1. SSTS 1: General Standards for Members Providing Tax Services
1.1 Advising on tax positions: A member should comply with the standards imposed by the applicable
taxing authority with respect to recommending a tax return position or preparing or signing a tax return
(IRC Section 6694). If the taxing authority has no promulgated standards, a member should not
advise a taxpayer to take a tax position unless the member has a good faith belief that the position
has a realistic possibility of being sustained (realistic possibility of success 33%), or the member
concludes that there is reasonable basis (~20%) for the position and advises the taxpayer to
adequately disclose the position to the taxing authorities.
1.2 Knowledge of Error: A member should promptly inform a taxpayer of any error. The member should
advise the taxpayer of the potential consequences of the error and advise on corrective measures to
be taken. The member is not allowed to inform the taxing authority of an error without the taxpayer’s
permission, except when required by law.
1.3 Data Protection: make reasonable efforts to safeguard taxpayer data and should consider applicable
privacy laws when collecting and storing taxpayer data.
1.4 Reliance on Tools: A taxpayer should exercise appropriate professional judgement and professional
care when relying on a tool.
2. SSTS 2: Standards for Members Providing Tax Compliance Service, including Tax Return
Positions
2.1 Tax Return positions: A member should comply with all the standards.
2.2 Tax Return Questions: A member should make a reasonable effort to obtain sufficient information to
provide appropriate answers to all questions on a return before signing as preparer.
2.3 Reliance on Information from Others: When preparing or signing a tax return a member may, in good
faith, rely on information furnished, without verification, by the taxpayer or third parties. However, a
member should not ignore the implications if the information appears to be incorrect.
2.4 Use of estimates: unless prohibited by statute, administrative rule, or a judicial holding, a member may
use reasonable estimates, if it is not practical to obtain exact data.
3. SSTS 3: Standards for Members Providing Tax Consulting Services
A member should use professional judgement to ensure that tax advice is competent and based on
applicable standards. A member has no obligation to communicate the impact of subsequent
developments that affect advice previously provided to taxpayers.
4. SSTS 4: Standards for Members Providing Tax Representation Services
The member should take steps to obtain competence in the subject matter involved and act with
integrity and professionalism in dealings with the tax authority. In connection with the completion of
taxing authority’s examination, the member should review any documents or computations detailing the
 results of the examination for consistency and discuss with the taxpayer the consequences of agreeing
to the conclusions pursuant to the terms of the engagement.

Chapter 4:

Individual Income Tax Overview, Dependents, and Filing Status

I. Individual Income Tax Formula

Taxable Income is the tax base for computing the individual income tax. The following is a simplified presentation of the
individual income tax formula:

Gross Income

- For AGI (above the line) deductions

= Adjusted Gross Income (AGI)

- From AGI (below the line) deductions:

(1) Greater of:

(a) Standard Deduction

(b) Itemized Deductions

(2) Qualified Business Income Deduction (QBID)

= Taxable Income

x Tax Rate_________

= Income Tax Liability

+ Other Taxes______

= Total Tax

- Credits

- Prepayments (withholding, estimated payments, etc.)

= Tax due or (refund)

A. Gross Income

1. For income to be taxable it must be realized. A realization event for tax purposes generally occurs when there is
a change in the form of the taxpayer's property. Unrealized appreciation of property is not recognized as income for
tax purposes until the property is sold or exchanged.

2. Income does not need to be in the form of cash. Reg. §1.61-1(a) states gross income "includes income realized
in any form, whether in money, property, or services."

3. Common types of income:

Chapter with More

Income Item Character Detail

Compensation Ordinary Chapter 5

Business Income Ordinary Chapter 9

Gains from property Ordinary or Capital Chapter 7 & 11

Interest Ordinary Chapter 5

 Dividends Ordinary or Qualified Div. Chapter 7

Rents and Royalties Ordinary Chapter 14

Alimony received (pre-2019 decree) Ordinary Chapter 5

Annuities Ordinary Chapter 5

Discharge or Indebtedness Ordinary Chapter 5

Stock compensation Ordinary or Capital Chapter 13

4. Exclusions from gross income are items or realized income which are permanently excluded from taxation. The
doctrine known as "legislative grace" any item excluded from income must be specifically set forth in the IRC.
Congress typically chooses to exclude certain items from gross income to achieve administrative efficiency, to
provide relief from double taxation, and to achieve social objectives.

5. Deferrals are items of realized income that are nontaxable in the current year but will be recognized in a future
year.

6. The following table is a partial list of common exclusion and deferral items and the chapter we will discuss:

Chapter with More

Income Item Exclusion or Deferral Detail

Muni interest Exclusion Chapter 5

Gifts and inheritance Exclusion Chapter 5

Alimony received (post-2018 decree) Exclusion Chapter 5

Gain on sale of personal residence Exclusion Chapter 5

Life-insurance proceeds Exclusion Chapter 5

Installment sale Deferral Chapter 11

Like-kind exchange Deferral Chapter 11

§351 – Corporate formation Deferral ACCT 5236

§721 – Partnership formation Deferral ACCT 5236

B. Character of Income

Character of income refers to the type of income recognized by a taxpayer. It should be noted that all income sources increase
gross income dollar-for-dollar. However, the character of income will dictate the rates applied to separate tranches of income
recognized by the taxpayer. The following are common characters of income.

1. Ordinary – any income that is not from the sale of capital asset or a §1231(b) asset resulting in a gain.
Accordingly, all sources of income are presumed ordinary unless meeting these definitions. Sources of ordinary
income are taxed at a taxpayer’s ordinary tax rate schedule found in Appendix C.

2. Capital – A capital gain or loss results from the sale or other taxable disposition of a capital asset. However, to
provide a based understanding for purposes of character of income, what is a capital asset?

(a) Capital assets are defined as any assets other than:

(i) inventory and other assets held for sale in the ordinary course of business.
 (ii) receivables (accounts or notes) for the performance of services or the sale of inventory in the
ordinary course of business.

(iii)real or depreciable property used in a trade or business

b) In general, capital assets include (1) nonbusiness assets, personal use (2) investment property. The tax
consequences of capital gains and losses depend on (1) the type of and (2) how long the asset was held prior to
disposition.

(1) Long-term capital gain (loss) = Held for more than one year. Long-term capital gains of individuals are
taxed at preferential rates of 0%, 15%, or 20% (or 25% or 28%) depending on the taxpayer’s filing status and
income levels.

(2) Short-term capital gain (loss) = Held for one year or less. Net short-term capital gains are taxed at
ordinary tax rates.

c) When a taxpayer has multiple long-term and short-term capital gains and losses, a netting process
needs to be conducted to determine the appropriate tax treatment of the end resulting net gains or losses.

d) Individuals are allowed to deduct $3,000 ($1,500 if married filing separate) of net capital losses per year.
If a taxpayer’s net capital loss exceeds $3,000 for a tax year, the excess is carried forward and added to the
capital loss netting process the subsequent tax year.

3. Qualified Dividend – Dividends from domestic corporations and qualifying foreign corporations receive a
preferential rate of 0%, 15%, or 20%, depending on the taxpayer's income level.

(1) To be qualified, the stock must have been held for 60 days during the 121-day period starting 60 days
before the ex-dividend date. If the dividend is not qualified, it is an ordinary dividend taxed at the individual's
marginal rates. While a qualifying dividend receives the same preferential rates as long-term capital gains, it is
separate character of income from capital assets.

C. Deductions

Deductions are expenses incurred by the taxpayer which are subtracted from income in computing taxable income. In contrast to
Section 61, which defined gross income very broadly, deductions are defined very narrowly by Congress in the IRC. Nothing is
deductible unless Congress says it is deductible. If an expense does not fall within a specific deduction established by Congress,
then it is not deductible.

1. For AGI Deductions – “above the line deduction,” with adjusted gross income being the line, for AGI deductions
tend to deal with business, investing, and specifically subsidized activities. The following is a partial list of for AGI
deductions and the chapter we will discuss each further:

For AGI Deduction Chapter with More Detail

Alimony paid (pre-2019 decree) Chapter 6

Self-employed health insurance premiums Chapter 6

Rental and royalty expense Chapter 6 & 14

Net capital loss ($3,000 limit, $1,500 for MFS) Chapter 7

½ Self-employment taxes Chapter 8

Business expenses Chapter 9

Losses on disposition of assets used in a trade or Chapter 11

business

Contributions to health savings account (HSA) Chapter 6

Contribution to certain retirement accounts (e.g., Chapter 13

 traditional individual retirement account)

Student loan interest Chapter 6

Out of pocket K-12 educator expenses Chapter 6

2. From AGI Deduction – Referred to as “below the line deduction.” From AGI deductions include Itemized
Deductions, the Standard Deduction, and the Qualified Business Income Deduction (QBID).

a) Itemized Deductions or Standard Deduction – individual taxpayers are entitled to either itemize their
qualifying below the line deductions or elect to deduct the standard deduction. A taxpayer will choose to take the
greater of the two amounts.

(1) The following are the primary itemized deductions (can google ex.)

(2) The standard deduction is a flat amount that an individual taxpayer elects to take each year. The
amount is indexed to inflation and is dependent on the taxpayer’s filing status. In 2024, the standard deduction
amount by filing status is as follows:

Filing Status 2024

Married filing jointly $29,200

Qualifying surviving spouse $29,200

Head of household $21,900

Single $14,600

Married filing separately $14,600

Taxpayers who are 65 or older and/or blind are entitled to an additional standard deduction of $1,950 or $1,550 depending on
filing status (discussed more in Chapter 6).

b) Qualified Business Income Deduction (QBID) The Tax Cut and Jobs Act lowered the corporate rate from
35% to 21%. QBI is generally defined as ordinary business income from a flow-through entity and is subject to
limitations. It does not include investment income, such as dividends, capital gains, etc.

D. Tax Calculation

To determine a taxpayer’s income tax liability, taxable income is applied to the progressive tax rate schedule based on their filing
status (See Appendix C). However, if taxable income consists of multiple characters of income, such as ordinary income and
long-term capital gains, the calculation becomes a bit more complicated. Tax on ordinary income computed using the tax rate
schedule and tax on income subject to preferential rates using the preferential rate schedule. This is accomplished as follows:

a) Step 1: split the income into the portion that is subject to the preferential rate and the portion tax at
ordinary rates

b) Step 2: Compute the tax separately on each type of income. Note that preferential rate is subject to the
graduated scale based on total taxable income.

c) Step 3: Add together the two tax calculations = total regular income tax liability.

E. Other Taxes

In addition to the “regular” income tax liability discussed so far, individuals may be subject to other taxes such as:

a) Alternative minimum tax (AMT)

b) Self-employment taxes
 c) Net investment income tax

d) Medicare surtax

F. Tax Credits

A tax credit is a dollar-for-dollar reduction of a taxpayer’s Total tax. By comparison, a deduction indirectly reduces a taxpayer’s
tax liability by the deduction value times the taxpayer’s marginal tax rate. Tax credits are specifically defined by Congress and
are narrowly defined. common tax credits include:

a) Child tax credit ($2,000 per qualifying child under the age of 17)

b) Other qualifying dependent credit ($500)

c) Education tax credits

d) Earned income tax credit (EITC)

e) Child and dependent care credit

f) Saver’s credit

g) Residential energy tax credit

h) Foreign tax credit

i) Business tax credits (e.g., research and development tax credit)

j) Healthcare premium tax credit

G. Tax Payments

a) The federal income tax system is a pay-as-you-go system. These payments of tax take the form of
withholding in the case of wages. If a taxpayer’s withholdings are insufficient to meet their tax liability, estimated
tax payments are required. Taxpayers are subject to underpayment penalties if are insufficient to meet their tax
liability for the year. However, there are safe-harbor provisions to avoid such penalties that we will explore in
more detail in Chapter 8.

b) When a taxpayer files their return, tax payments are subtracted from their total tax less credits and will
result in either a refund or an amount due.

Chapter 4

Individual Income Tax Overview, Dependents, and Filing Status

I. Dependent of the Taxpayer

In 2024, no personal or dependent exemption deduction is allowed. It should be noted, the elimination of the dependency
deduction under §151 is a temporary provision, and absent action by congress, is set to expire after 2025. Nonetheless,
dependent status remains relevant in determining taxpayer filing status, certain tax credits, and other tax computations.

A. Dependency Requirements: To qualify as a dependent of another taxpayer, an individual:

1. Must be a citizen of the United States, or a resident of the United States, Canada or Mexico.
2. NOT file a joint return with spouse unless there’s no tax liability
3. Must be considered a qualifying child or qualifying relative.
B. Qualifying Child: Four tests required to be a dependent a qualifying child:
1. Relationship Test: eligible relatives include either (a) or (b) below:
a) Child or descendent of a child (e.g., grandchild). The definition of a child includes a taxpayer’s adopted child,
stepchild, and eligible foster child.
(1) “Eligible foster child” means an individual who is placed with the taxpayer by an authorized
placement agency or by judgment, decree, or other order of any court of competent jurisdiction.
b) Sibling, stepsibling, halfsibling, or descendant of any of these relatives (e.g., niece or nephew).
2. Age Test:
 a) A qualifying child must be either:
(1) Under the age of 19 at the end of the tax year, or
(2) Under the age of 24 and a full-time student.
b) There is no age limit for a qualifying child who is totally and permanently disabled.
3. Resident Test: a qualifying child must have the same principal residence as the taxpayer for more than
half the year.
a) Exception: For purposes of determining residency, time spent asway for temporary purposes is considered
living with the taxpayer if temporary absence if for the following reasons:
(1) Pursuing education (e.g., away at college)
(2) Illness (e.g., time spent in a hospital)
(3) Other special circumstances (e.g., missing child)
4. Support Test:
a) A qualifying child must not provide over one-half of such their own support (living expenses) for the tax year.
Support generally includes the following expenses:
o Food, school lunches, toilet articles, haircuts; Clothing; Recreation – including toys, summer camp,
entertainment, and vacation expenses; Medical and dental expenses; Childcare expenses;
Allowances and gifts; Lodging; Education.
5. Tiebreaking rules:
a) Only one taxpayer can claim a person as a qualifying child. However, there are situations where a person may
be a qualifying child for more than one taxpayer. Under such situations, tiebreaking rules are in place to determine
who can claim the person as a qualifying child:
b) Parent over nonparent.
c) If a person is a qualifying child for bother parents, the parent whom the child resides with the longest period
during the tax year has priority for claiming the person as a qualifying child. If a qualifying child lives with each parent
an equal amount of time during the tax year, the parent with the highest AGI has priority.
(1) Exception: the noncustodial parent of a person of divorced parents may claim the qualifying
child if the custodial parent agrees to not claim the person by filing Form 8332: Release/Revocation of
Release of Claim to Exemption for Child by Custodial Parent.
d) If a qualifying child has more than one nonparent, the nonparent with the higher AGI has priority.
(1) If parents may claim an individual as a qualifying child, but fail to do so, a nonparent may claim
the qualifying child if their AGI is higher than the highest AGI parent of the child. §152(c)(4)(C).

C. Qualifying Relative

A qualifying relative is an individual who is NOT a qualifying child of the taxpayer and meets the following three tests:

1. Relationship Test: is more inclusive than that for qualifying child.

a) Qualifying family relationship: descendant, sibling, child, aunt or uncle, an-law, “member of the household”

2. Support Test: The support test differs from the support test for a qualifying child. The support test for qualifying relative
requires the taxpayer to provide more than half of the support for the person to be a qualifying relative.

a) Multiple Support Agreement Exception: Often multiple taxpayers will support a relative. This is often the case when
multiple children care for elderly parents. Under such a circumstance no single taxpayer may provide more than half of the
support for a potential qualifying relative. Under a multiple support agreement, a taxpayer who doesn’t pay more than half of the
support may still claim the person as a dependent qualifying relative if the following apply:

- no one person contributed over one-half of the support,

- Over one-half of such support was provided by two or more persons each of whom, but for the fact that any such person
alone did not contribute over one-half of such support, would have been entitled to claim such individual as a dependent
for a taxable year beginning in such calendar year,
- the taxpayer contributed over 10 percent of such support, and
- each person described in subparagraph (3) above who contributed over 10 percent of such support files a written
declaration that such person will not claim such individual as a dependent beginning in such calendar year.

3.Gross Income Test: the qualifying relative’s gross income must for the tax year must be less than $5,050 (2024).
Filing Status - Filing status is determined based on a taxpayer’s marital status at the end of the tax year. Filing status is
important for determining the following:

1. Tax rate schedule.

2. Standard deduction amount.
3. The AGI threshold for limitations of certain deductions and credits.

There are five filing statuses for federal income tax purposes:

1. Married filing jointly

2. Married filing separately
3. Qualified surviving spouse
4. Single
5. Head of household

A. Married Filing Jointly (MFJ) and Married Filing Separately (MFS):

1. Taxpayer’s legally married on the last day of the tax year (December 31st for calendar year taxpayers) can choose to file a
joint return, which combines the income and deductions for each partner, or file their returns separately. If a spouse dies during
the year, the surviving spouse is considered married to the spouse who died at the end of the tax year, unless they remarry.

2. If filing separately, the income and deductions of each spouse is filed on their respective returns. In general, it is often less
advantageous to file separate returns. Some instances where it may make sense:

a) When filing MFJ, each spouse is severely and jointly responsible for the married couples’ taxes. To mitigate exposure
to the other spouse’s activities, a couple may decide to MFS.

b) One spouse may have high medical expenses for a particular tax year. Since medical expense deductions are limited
to 7.5% of AGI, a married couple may benefit from filing separately to increase the amount of deductible medical expenses.
(Note: If married filing separately, and one spouse elects to itemize their deductions, the other spouse must also itemize.)

3. Abandon Spouse – If a taxpayer is legally married at the end of the year, but lives apart from their spouse, the taxpayer
may be entitled to file as unmarried. To provide relief in such situations, the taxpayer may file as unmarried if the following
conditions exist:

a. The taxpayer is married at the end of the year (or not legally separated).
b. The taxpayer does not file a joint return with the other spouse.
c. The taxpayer pays more than half the costs of maintaining a household that serves as the principal residence for a
qualifying child for more than half the year.
d. The taxpayer Lived apart from the other spouse for the last six months of the year (other than temporary absences, such
as school or hospital).

B. Qualifying Surviving Spouse

The years after the death of spouse, a taxpayer is no longer married. To provide tax relief to recently widowed taxpayers with a
dependent child(ren), Congress allows Qualifying Surviving Spouse filing status for the two years following the year of the
taxpayer’s spouse’s death. To qualify, the taxpayer must

1. Remain unmarried, and

2. Pay more than half the cost of maintaining a home for a qualifying child dependent of the taxpayer who lived in the home
for the entire tax year (except for temporary absences). §2(a).

The benefit of qualifying surviving spouse status is the taxpayer is treated as MFJ with respect to tax rates, standard deduction,
etc.

C. Single: Any taxpayer who is unmarried as of the last day of the tax year and does not qualify for head of household
status, files as single.

D. Head of Household:

Congress recognized unmarried individuals responsible for certain dependents should be allowed a tax relief relative to
unmarried individuals without dependents. The following requirements must be met to claim head of household:
 1. Be unmarried or considered unmarried at the end of the year.
2. Not be a qualifying surviving spouse.
3. Pay more than half the cost of maintaining a home during the year.
4. Have a “qualifying person” live in the taxpayer’s home more than half the year.
a. If the qualifying person is the taxpayer’s dependent parent(s), the parent not required to live with the
taxpayer.

Qualifying person is defined as follows:

1. Qualifying child
2. Qualifying relative is taxpayer’s parent(s):
a. Parent need not live with taxpayer.
b. Taxpayer must pay more than half cost of maintaining separate household for
taxpayer’s mother or father.
c. Parent must qualify as taxpayer’s dependent.
3. Qualifying relative, NOT taxpayer’s parent:
a. Person must have lived with taxpayer for more than half the year.
b. Must qualify as taxpayer’s dependent.
c. Must be related to taxpayer through qualified family relationship.
d. “Member of household” does not qualify as qualifying person for head of household
status.

Other rules for head of household status:

1. A qualifying person may not qualify more than one person for head of household status.
2. If a taxpayer can claim a person as a dependent only because of a multiple support agreement, that person is NOT a
qualifying person.
3. If a custodial parent agrees to under a divorce decree to allow the noncustodial parent to claim the person as a
dependent, the agreement is ignored for head of household determination of qualified person. That is, for purposes of
head of household determination, the dependent is a qualifying person for custodial parent.

Chapter 5 Lecture Notes

Gross Income and Exclusions

I. What Is Income?
A. Introduction - income is derived from labor and capital.
1. Economists measure income by looking at all increases to the wealth of an individual.
2. Accountants measure income using GAAP or IFRS. Under GAAP, income is realized when a transaction is
completed, which includes the receipt of an asset that can be reliably measured. Accountants require a
realization event before income can be accurately measured.
3. The tax law combines the approach of economists and accountants. The starting point to measure income in
tax law is to look at all increases to wealth (economic benefit). These increases are derived primarily from
labor or capital.
a. before an increase to capital is taxable, the tax law requires a realization event to occur.
B. Taxable income and gross income: starting point to calculate taxable income is gross income.
C. Gross Income - "all income from whatever source derived." In other words, everything of value received by a
taxpayer is generally income unless it is specifically excluded. "Includes income realized in any form, whether in
money, property, or services."
1. Taxpayers report realized and recognized income on their tax returns for the year:
a. They receive an economic benefit;
b. They realize the income, and
c. The tax law does not provide for exclusion or deferral.
2. Income that is excluded or deferred is not included in gross income.
a. Excluded income is never taxed.
b. Deferred income is taxed when recognized in a subsequent year.
D. Return of capital principle (§1001)
1. When measuring gross income derived from capital, the tax law excludes from gross income the
amount invested by the taxpayer. §1001. In tax law, the taxpayer's initial investment in an asset is called
 basis and it is adjusted during the life cycle of the asset to keep track of the investment amount that is
not subject to tax.
2. Another way of saying the same thing is to use a formula to calculate the realized gain or loss on an
investment. The formula is:
Sales Process
- Selling Expenses
Amount realized (The sum total of what is received by the taxpayer)
- Adjusted basis (The taxpayer's cost in an asset +/- adjustments)
Realized Gain
3. Remember a return of capital is not taxable but a return on capital is taxable.
E. Tax benefit rule (§111)
Since each tax year must stand on its own, the tax benefit rule allows any item of income reported in a prior year
that is lost in a subsequent year to be deducted in the later year. Conversely, any item of deduction reported in the
prior year that is recovered in a later year is included in income.

o That is, refunds of expenditures deducted in a prior year are included in gross income to the extent
that the refunded expenditure reduced taxes in year of the deduction. For example, a taxpayer who
operates a trade or business deducted $1,000 business expense in 2023. If the taxpayer is
refunded $200 of the business expense in 2024, the taxpayer must recognize $200 in gross income
in 2024 under the tax benefit rule.

II. When do taxpayers recognize income?

When income is recognized matters to taxpayers because from year-to-year marginal rates may change, the tax law
may change, and taxpayers generally prefer to defer paying income tax as long as possible due to the time value of
money.
A. Tax year
1. Individuals – calendar year
2. C-Corporations – calendar year or fiscal year
B. Accounting method (§446)
1. Cash method – recognize income in period it is received. Claim deductions when expenditure is made. Almost
all individual taxpayers use the cash method. A cash-basis taxpayer will recognize income when the
taxpayer receives cash or reduces what is received to cash.
2. Accrual method – income is generally recognized when earned, and expenses are generally deducted in the
period when liabilities are incurred.
C. Constructive Receipt Doctrine (§451) - Income is reported in the year the taxpayer actually or constructively
receives the income and expenses are deducted when they are paid. Under the doctrine of constructive receipt,
income is constructively received by a taxpayer when:
1. income is credited to the taxpayer's account or when the income is unconditionally available to the taxpayer;
2. the taxpayer is aware of the income’s availability; and
3. there are no restrictions on the taxpayer’s control over the income.
D. Claim of Right Doctrine - the taxpayer is required to recognize income if the taxpayer has the unrestricted right to
the income. This doctrine requires income recognition even if it is later determined that the payment must be
returned by the taxpayer.
1. a taxpayer who is required to return income recognized under the claim of right doctrine may claim a
deduction in the year the income is returned for the income returned. If the amount returned is exceeds
$3,000, the taxpayer’s relief is the greater of:
a. The tax computed in the year the income is returned with deduction (taken as a deduction current
year return), or
b. The tax paid on the income for the year of income inclusions (taken as a credit for taxes paid on the
current year return).
If the repayment relates to wages and is under $3,000 it is a miscellaneous itemized deduction which is no
longer allowed under the TCJA. However, if it’s over $3,000, it can be claimed as another itemized
deduction.
E. Who Recognizes the Income?
1. Assignment of Income: The assignment of income doctrine requires the taxpayer who earned the income to
be taxed on it. Income from property, such as dividends and interest, is taxable to the person who owns the
income-producing property.
a. The doctrine precludes the taxpayer from shifting income to another taxpayer unless the income is from
property (not from services), and the underlying property is also transferred by the taxpayer.
III. Types of Income
Gross income includes all income realized from whatever source derived, unless Congress specifically excludes it.
While there are many similarities in determining gross income for tax and financial accounting purposes, this discussion
focuses on items that may create differences.
A. Earned Income - Earned income is income received by a taxpayer in return for labor (personal services). The form
the income takes is irrelevant. The taxpayer may receive cash, property, services or other property. The taxpayer
may receive the income as an employee or a business owner. A taxpayer who participates in a barter club has
income. Under the assignment of income doctrine, income is taxed to the taxpayer who earned it, regardless of who
is paid the income or receives the benefit.
B. Unearned Income (income from property)
1. Includes gains or losses from sale of property, dividends, interest, rents, royalties, and annuities.
2. Dividends are distributions from a C corporation out of its earnings and profits. Dividends are included in gross
income of the recipient.
a. Tax consequences to dividend recipient
i. C Corporation: Includes dividend in gross income, but corporation may be eligible for a dividend
received deduction. Dividends are taxed at a corporation's marginal rate.
ii. Individual: Includes dividend in gross income. If the dividend is a qualified dividend, it will be taxed at a
preferential rate of 0%, 15%, or 20%, depending on the taxpayer's income level. To be qualified, the
stock must have been held for 60 days during the 121-day period starting 60 days before the ex-
dividend date. If the dividend is not qualified, it is an ordinary dividend taxed at the individual's marginal
rates.
iii. Stock dividend with no option to receive cash is nontaxable. Allocate stock basis among all shares
owned after the dividend.
2. Annuities (§72)
a. A taxpayer who purchases an annuity contract is purchasing a future stream of income. The annuity
purchase price is the taxpayer's investment or basis in the contract. When a taxpayer begins receiving
annuity payments, a portion of each payment is a return of the taxpayer's investment (nontaxable) and a
portion of the payment is income earned on the investment (taxable). The 3.8% NII surtax applies to
commercial annuities.
b. The formula for calculating the nontaxable portion of an annuity payment is:
Original Investment x Annuity = Nontaxable
Expected Value of Annuity Payment portion of payment
3. Property Dispositions:
a. Taxpayers usually realize a gain or loss when disposing of an asset. Taxpayers are allowed to recover their
investment in property (tax basis) before they realize any gain
b. Formula for Calculating Gain (Loss) from Sale of an Asset:
Sales proceeds
Less: selling expenses
Amount realized
Less: Basis (investment) in property sold
Gain (loss) on sale
4. Income from pass-through entities
a. Individuals may invest in various business entities
b. The legal form of the business affects how the income is taxed.
c. If the entity is a flow-through entity (partnership or S corporation) the income and deductions of the entity
"flow through" to the owners of the entity (partners or shareholders).
d. Income and deductions from flow-through entities maintain character. For example, if a S-corporation
generates a long-term capital gain ("LTCG"), each shareholder will report their allocable share of the LTCG
on their respective tax return.
5. Unemployment compensation (§85) is generally taxable to the recipient.
6. Alimony
a. Alimony is a transfer of cash from one former spouse to the other for support and is included in the gross
income of the recipient and is deductible by the payor for divorces or settlement agreements executed prior
to January 1, 2019. Alimony is not included in income by recipient and not deductible by payor for
divorces or settlements executed after December 31, 2018.
b. Alimony for tax purposes alimony is defined as:
1. A transfer of cash made under a written separation agreement or divorce decree.
2. The separation or divorce decree does not designate the payment as nonalimony.
3. In the case of legally separated (or divorced) taxpayers under a separation or divorce decree, the
spouses do not live together when the payment is made.
 4. The payments cannot continue after the death of the recipient.
c. Property settlements between former spouses are not alimony and are not a taxable transfer. Child support
payments are not alimony and are not in included in the gross income of the recipient and are not deductible
by the payor. If the amount of alimony decreases due to a child reaching a certain age, the difference
between the original alimony amount and the decreased amount is presumed to child support.
7. Prizes, awards, and gambling winnings (§74) are generally taxable to the recipient.
a. Exception:
i. For scientific, literary, or charitable achievement and transferred to a qualified charity:
 Selected without any action on his or her part to enter the contest,
 The recipient is not required to render substantial future services, and
 Payor transfers prize to federal, state, or local government or charitable organization designated by
the recipient.
ii. For employee length of service or safety achievement ($400 tangible property limit per employee per
year)
iii. To Team USA athletes from U.S. Olympic Committee on account of their competition in Olympic and
Paralympic games
8. Social security benefits (§86) may be taxable to the recipient depending upon the recipient's modified adjusted
gross income. A maximum of 85% of social security benefits may be included in the gross income of the
recipient.
9. Imputed interest
a. General rule: On loans where no interest or a below market rate of interest is charged, interest is imputed
at the current applicable federal rate with the following consequences:
1. The lender has imputed interest income.
2. The borrower has imputed interest expense (which may or may not be deductible)
3. The lender is deemed to have:
** made a gift if the loan is to a relative or friend.
** paid compensation if the loan is to an employee.
** paid a dividend if the loan is to a shareholder.
4. Exceptions:
** Imputed interest rules do not apply to aggregate loans of $10,000 or less between the lender and
borrower
** No interest is imputed when a 1loan is between individuals, the loan is for $100,000 or less, and the
borrower's net investment income for the year does not exceed $1,000. If interest is imputed, the
imputed interest cannot exceed the borrower's net investment income for the year, unless the loan
is made for a tax avoidance purpose
10. Loans and discharge of indebtedness
a. Loan proceeds are not included in the gross income of a taxpayer because of the repayment obligation.
b. Similarly, repayment of a loan has no tax consequences to the borrower.
c. However, if a portion of the debt is forgiven by the lender, the general rule is that the borrower must include
the amount of the debt discharged in gross income.
i. Exception: If, however, the borrower is insolvent before and after the forgiveness of the debt, the debt
relief is not included in the gross income of the borrower. Insolvent means liabilities exceed fair market
value of assets. If the discharge of indebtedness makes the taxpayer solvent, the taxpayer recognizes
taxable income to the extent of his solvency.
11. Treasure trove is included in gross income of the finder.
12. Illegal income is taxable and should be reported in the taxpayer's gross income.
IV. Exclusions from gross income
A. Introduction
1. Under the doctrine known as "legislative grace" any item excluded from income must be specifically set forth in
the IRC. Exclusions from gross income can be found in IRC Sections 101-139.
2. Congress typically chooses to exclude certain items from gross income to achieve administrative efficiency to
provide relief from double taxation, and to achieve social objectives.
B. Exclusions
1. Municipal bond interest (§103)
Municipal bond interest is excluded from the gross income of the taxpayer. However, any gain or loss on the
sale of a municipal bond is included in the gross income of the taxpayer.
2. Gain on sale of Principle Residence (§121)
1. Qualifying taxpayers who sell a principal residence may elect to exclude up to $250,000 ($500,000 for
married filing joint taxpayers) of the realized gain. Any gain in excess of the allowable exclusion is
 subject to tax at capital gains rates. Losses on principal residences are nondeductible because a personal
residence is a personal use asset.
2. To qualify for the exclusion, a taxpayer must have owned and used the premises as a principal residence
for at least 2 years during the 5-year period ending on the date of the sale.
i. For a married couple filing jointly to qualify for the $500,000, they both must meet the use test, but only
one of them must meet the ownership test.
ii. Note the special rules for vacation homes converted to principal residences.
3. Employee Fringe Benefits (§132)
1. The value of these benefits is included in the employee's gross income as compensation for services.
2. Certain fringe benefits, called "qualified" fringe benefits, are excluded from gross income.
i. Common qualified fringe benefits are medical and dental health insurance coverage, life insurance
coverage, and de minimis (small) benefits.
3. Employee expense reimbursement – Employer’s often reimburse employees for business expenses
incurred on behalf of the employer. If an employee is required to submit documentation supporting
expenses to receive reimbursement and the employer reimburses only legitimate business expenses, the
employer’s reimbursement plan qualifies as an accountable plan. Under an accountable plan, employees
exclude expense reimbursements from gross income.
4. Health and accident insurance (§106)
Health and accident insurance premiums paid by an employer on behalf of an employee are generally excluded
from the employee's gross income. Payments received from employer-provided policies for medical care are
also excluded from the employee's gross income. However, amounts received as disability payments (sick pay
or wage continuation plans) from an employer-provided policy are included in gross income of the employee.
If the employee pays for the disability insurance, none of the payments collected are taxable to the employee.
5. Scholarships (§117)
A college student pursuing a degree may exclude a scholarship from income provided: the scholarship does not
require the performance of services by the recipient and is used to pay for college. If a scholarship is used to
pay personal expenses, it is taxable to the student. 1If a recipient receives the scholarship in one year and does
not pay the educational expenses until the following year, the transaction is held open until the expenses are
paid.
6. Gifts (§102)
The value of property acquired by gift from the donor is excluded from the donee's gross income. Generally, the
adjusted basis of the property in the donee's hands is the same basis the donor had in the property increased by
any gift tax paid by the donor as a result of appreciation in the property gifted.
7. Inheritances (§102)
The value of property received from the estate of a decedent is excluded from the beneficiary's gross income.
Generally, the adjusted basis of the property in the beneficiary's hands is the fair market value of the property on
the date of the decedent's death.
8. Life insurance proceeds (§101)
Life insurance proceeds received on account of the death of the insured are generally excluded from the gross
income of the beneficiary
1. If the proceeds are paid over a period rather than in a lump sum, a portion of the payments represents
interest and must be included in gross income.
9. Foreign-Earned Income (§911)
a. A maximum of $126,500 (2024) of foreign-earned income can be excluded from gross income for qualifying
individuals.
b. To be eligible for the foreign-earned income and housing exclusions, the taxpayer must have her tax home
in a foreign country and (1) be considered a resident of the foreign country or (2) live in the foreign country
for 330 days in a consecutive 12-month period.
c. Taxpayers meeting the requirement for the foreign-earned income exclusion may also exclude from income
reasonable housing costs that exceed 16 percent of the statutory foreign-earned income exclusion amount
for the year (exceed 16 percent × $126,500 = $20,240 in 2024). The exclusion, however, is limited to a
maximum of 14 percent of the statutory exclusion amount (14 percent × $126,500 = $17,710 in 2024).
10. Workers' Compensation - Payments are excluded from a taxpayer's gross income.
11. Compensatory damages for personal physical injury or sickness (§104) A taxpayer can exclude from gross
income compensatory damage payments received on account of a personal physical injury or sickness.
Damages received for property damage or damage to reputation are taxable. Furthermore, all punitive
damages or damages for lost income received are included in the gross income of the taxpayer.
EXAMPLE PROBLEMS:
Marc, a single taxpayer, earns $60,000 in taxable income and $5,000 in interest from an investment in city of Birmingham bonds.
Using the U.S. tax rate schedule for 2024, how much federal tax will he owe?
$8,253 = $5,426 + 0.22($60,000 - $47,150)

Mike received the following interest payments this year. What amount must Mike include in his gross income (for federal tax
purposes)?

Bond Interest

General
$ 1,450
Motors

City of New
$ 900
York

State of
$ 1,200
New Jersey

U.S.
$ 850
Treasury

$2,300 = 1,450 + 850. because interest on bonds by state and local governments is excluded from gross income.

Shaun is a student who has received an academic scholarship to State University. The scholarship paid $14,000 for tuition,
$2,500 for fees, and $1,000 for books. In addition, Shaun's dormitory fees of $8,500 were paid by the university when he agreed
to counsel freshman on campus living. What amount must Shaun include in his gross income?

- 8,500. College students seeking a degree are allowed to exclude from gross income scholarships that pay for tuition,
fees, books, supplies, and other equipment required for the student's courses. Any excess scholarship amounts (such
as for room or meals) are fully taxable. The scholarship exclusion applies only if the recipient is not required to perform
services in exchange for receiving the scholarship.

Irene's husband passed away this year. After his death, Irene received $250,000 of proceeds from life insurance on her
husband, and she inherited her husband's stock portfolio, worth $750,000. What amount must Irene include in her gross
income?

$0 - none of these benefits are included in gross income. Taxpayers exclude inheritances and life insurance proceeds

Which of the following is a true statement about the first payment received from a purchased annuity?

- A portion of the first payment from a purchased annuity will be a return of capital depending upon the amount paid for
the investment and the expected number of payments to be received.

Hal Gore won a $1 million prize for special contributions to environmental research. This prize is awarded for public
achievement, Hal did not enter to be considered for the prize, and Hal is not required to perform any services after receiving the
prize. Hal directed the awarding organization to transfer $400,000 of the award to the Environmental Protection Agency. How
much of the prize should Hal include in his gross income?

- $600,000 = 1M – 400,000. Awards for scientific or public achievement are excluded only if the payer of the award
transfers the award to a governmental unit (e.g., EPA) or a public charity, the award requires no additional services, and
the taxpayer didn't solicit entry for the award. Since Hal meets these requirements for the $400,000, he is only required
to include $600,000 in gross income.

Joanna received $62,400 compensation from her employer, the value of her stock in ABC company appreciated by $12,000
during the year (but she did not sell any of the stock), and she received $48,800 of life insurance proceeds from the death of her
spouse. What is the amount of Joanna's gross income from these items?

- $62,400 compensation is included in gross income, the increase in the value of her stock is not realized income so it is
not included in gross income, and the life insurance proceeds are excluded from gross income.
Jamison's gross tax liability is $9,500. Jamison had $2,400 of available credits and he had $6,150 of taxes withheld by his
employer. What are Jamison's taxes due (or taxes refunded) with his tax return?

$950 taxes due = 9,500 – 2,400 – 6,150. Gross tax liability minus credits minus payments equals taxes due