TAXATION FOR DECISION MAKERS 2008 EDITION pdf

TAXATION FOR
DECISION MAKERS
2008
EDITION
Shirley Dennis-Escoffier
Karen A. Fortin
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Taxation for Decision Makers, 2008 Edition
Shirley Dennis-Escoffier and Karen A. Fortin
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iii
Brief Table of Contents
iii
Preface xii
part IINTRODUCTION TO TAXATION AND ITS ENVIRONMENT 1
1 An Introduction to Taxation 2
2 The Tax Practice Environment 41
part II INCOME AND EXPENSE DETERMINATION 86
3 Determining Gross Income 87
4 Employee Compensation 131
5 Business Expenses 182
part III PROPERTY CONCEPTS AND TRANSACTIONS 227
6 Property Acquisitions and Cost Recovery Deductions 228
7 Property Dispositions 263
8 Tax-Deferred Exchanges 308
part IV BUSINESS TAXATION 349
9 Taxation of Corporations 350

10 Sole Proprietorships and Flow-Through Entities 394
part VTAXATION OF INDIVIDUALS 435
11 Income Taxation of Individuals 436
12 Wealth Transfer Taxes 488
Appendix A Tax Research Using RIA Checkpoint® 523
Appendix B Present Value and Future Value Tables 543
Appendix C Sample Filled-in Tax Returns 545
Appendix D Tax Return Problems 569
Index 577
iv
Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .xii
part
IINTRODUCTION TO TAXATION
AND ITS ENVIRONMENT 1
1 An Introduction to Taxation . . . . . . . . . . . . . . . . . . . 2
Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Setting the Stage—An Introductory Case . . . . . . . . . . . 3
An Introduction to Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . 3
What Is a Tax? 3
A Brief History of Income Taxation in the
United States 3
Objectives of Taxation 4
Current Influences on the Tax Law 5
The Taxing Units and the Basic
Income Tax Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
The Individual and Corporate Tax Models 7
Gross Income 8 • Property Transactions 10 • Deductions 11 •
Determining the Gross Tax Liability 14 • Tax Losses 15 •
Additions to the Tax Liability 16 • Tax Prepayments
and Credits 16

Other Entities 17
Choice of Business Entity . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Sole Proprietorships 19
Partnerships 20
Partner’s Basis Account 20
Corporations 21
S Corporations 22
Comparing Business Entity Attributes 23
Other Types of Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Wealth Taxes 23
Wealth Transfer Taxes 25
Consumption Taxes 26
Tariffs and Duties 27
Types of Tax Rate Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
The Progressive Tax Rate System 28
Proportional “Flat” Tax Rate 30
Regressive Taxes 30
Characteristics of a Good Tax
. . . . . . . . . . . . . . . . . . . . . . . 31
Equity 31
Economy 32
Certainty 33
Convenience 33
Revisiting the Introductory Case . . . . . . . . . . . . . . . . . . . . 33
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Test Yourself . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Problem Assignments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Check Your Understanding 35
Crunch the Numbers 36

Think Outside the Text 38
Identify the Issues 39
Search the Internet 39
Develop Planning Skills 40
Answers to Test Yourself . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
2 The Tax Practice Environment . . . . . . . . . . . . . . . 41
Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
Setting the Stage—An Introductory Case . . . . . . . . . . 42
An Introduction to Tax Practice . . . . . . . . . . . . . . . . . . . . . 42
Taxes and Cash Flow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
Cash Flows and Present Value 43
Significance of the Marginal Tax Rate 44
Tax Planning Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
Timing Income and Deductions 45
Income Shifting 46
Changing the Character of Income 47
Other Factors Affecting Tax Planning 48
Cash Flow 48 • Nontax Considerations and Judicial
Doctrines 49
Sources of Authority . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
The Legislative Process 51
Internal Revenue Code 53
Administrative Sources of Authority 54
Treasury Regulations 54 • Other IRS Rulings 55
Judicial Sources of Authority 55
Table of Contents
Table of Contents v
What Is Income?
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88
Taxable versus Gross Income 88

Tax versus Financial Accounting 89
Return of Capital Principle 89
When Is Income Recognized? . . . . . . . . . . . . . . . . . . . . . . . . 90
The Tax Year 91
Accounting Methods 93
Cash Method 93
Limits on Use of Cash Method 94
Accrual Method 95
Who Recognizes the Income? . . . . . . . . . . . . . . . . . . . . . . . 96
Assignment of Income Doctrine 96
Community Property Laws 97
Sources of Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
Interest Income 97
Interest on Municipal Bonds 97 • Original Issue
Discount 99 • Market Discount 100 • Below-Market-Rate
and Interest-Free Loans 100
Dividend Income 102
Stock Dividends 103
Annuity Income 104
Transfers from Others 105
Prizes and Awards 105 • Government Transfer Payments 105 •
Legal Settlements 107
Discharge of Indebtedness 109
Tax Benefit Rule 110
Exclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110
Gifts and Inheritances 110
Insurance Proceeds 111
Life Insurance 111 • Accident and Health Insurance 113
Scholarships 114
Other Exclusions 114

Jurisdictional Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
International Issues 115
Taxpayers Subject to U.S. Taxation 116
State and Local Taxation 117
Expanded Topics—Special Methods . . . . . . . . . . . . . . 118
Installment Method 118
Long-Term Contracts 119
Revisiting the Introductory Case . . . . . . . . . . . . . . . . . . . 120
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122
Test Yourself . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122
Problem Assignments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123
Check Your Understanding 123
Crunch the Numbers 124
Think Outside the Text 127
Identify the Issues 128
Develop Research Skills 128
Tax Research . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
Gather the Facts and Identify the Issues 57
Locate and Evaluate the Relevant Authority 57
Communicate the Recommendations 58
Keeping Up-To-Date 59
Tax Compliance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
Filing a Tax Return 59
Late Filing and Late Payment Penalties 60 • Statute
of Limitations 60
Selecting Returns for Audit 61
Types of Audits 63
The Appeals Procedure 63
Taxpayer Noncompliance Penalties 64

Collection Procedures 65
Offer in Compromise 65 • Innocent Spouse Relief 65
Professional Responsibilities and Ethics 66
Avoidance versus Evasion 66 • Tax Preparer Penalties 66
Tax Professionals’ Dual Responsibilities 67
Sources of Guidance 67
Revisiting the Introductory Case . . . . . . . . . . . . . . . . . . . . 70
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
Test Yourself . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
Problem Assignments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72
Check Your Understanding 72
Crunch the Numbers 73
Think Outside the Text 74
Identify the Issues 75
Develop Research Skills 75
Search the Internet 77
Develop Planning Skills 77
Answers to Test Yourself . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
Appendix 2A Tax Research . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
Gather the Facts and Identify the Issues 79
Locate and Evaluate the Relevant Authorities 79
Reading the Code 80 • Committee Reports 80 • Regulations 80
Revenue Rulings and Letter Rulings 80 • Acquiescence
Policy 80 • Other Pronouncements 81 • Court Decisions 81 •
Using a Citator 83 • When to Stop Researching 83
Communicating the Recommendations 83
Problem Assignments 85
Check Your Understanding 85
part

II INCOME AND EXPENSE
DETERMINATION 86
3 Determining Gross Income . . . . . . . . . . . . . . . . . . . 87
Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
Setting the Stage—An Introductory Case . . . . . . . . . . 88
vi Table of Contentsvi Table of Contents
Credit for Foreign Taxes 167
Moving Expenses 168
Tax Reimbursement Plans 168
Tax Treaties 169
Revisiting the Introductory Case . . . . . . . . . . . . . . . . . . . 169
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 170
Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171
Test Yourself . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171
Problem Assignments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172
Check Your Understanding 172
Crunch the Numbers 173
Think Outside the Text 177
Identify the Issues 177
Develop Research Skills 178
Search the Internet 179
Develop Planning Skills 179
Answers to Test Yourself . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180
5 Business Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182
Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182
Setting the Stage—An Introductory Case . . . . . . . . . 183
Criteria for Deductibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . 183
General Provisions for Trade or Business
Expenses 183
Ordinary and Necessary 184

Contrary to Public Policy 185
Related to Tax-Exempt Income 185
Accrued to Related Party 186
Obligation of Another Taxpayer 186
Substantiation 186
Timing of Deductions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187
Accrual Method 187
Cash Method 188
Restrictions on Prepaid Expenses 189
Disputed Liabilities 190
Costs of Starting a Business . . . . . . . . . . . . . . . . . . . . . . . . 190
Business Investigation and Start-up Expenses 191
Organization Costs 192
Operating Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192
Business Meals and Entertainment 192
Directly Related to or Associated with Entertainment 193 •
Restrictions on Deductions 193
Travel and Transportation Expenses 194
Travel Away from Home 194 • Temporary Assignments 195 •
Transportation Expenses 195 • Combining Business with
Pleasure Travel 196
Bad Debt Expenses 197
Insurance Premiums 198
Legal Expenses 198
Taxes 198
Search the Internet 129
Develop Planning Skills 129
Answers to Test Yourself . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130
4 Employee Compensation . . . . . . . . . . . . . . . . . . . . 131
Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131

Setting the Stage—An Introductory Case . . . . . . . . . 132
Employee Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . 132
Payroll Taxes 132
Employee versus Independent Contractor 133
Timing of Compensation Deduction 135
Reasonable Compensation 135
S Corporations and Unreasonably Low Salaries 136 •
Employing Children 136
Employee Fringe Benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . 137
Group Term Life Insurance Premiums 139
Health and Accident Insurance Premiums 140
Child and Dependent Care Programs 140
Cafeteria Plans 141
Meals and Lodging 141
No-Additional-Cost Services 142
Employee Purchase Discounts 143
Employee Achievement Awards 143
De Minimis Fringe Benefits 143
Working Condition Fringe Benefits 144
Employee Relocation Expenses 146
Distance Test 146 • Time Test 147
Education Expenses 147
Substantiating Business Expenses 150
Employee Stock and Stock Options . . . . . . . . . . . . . . . . 150
Restricted Stock 151
Stock Options 152
Nonqualified Stock Options 152 • Incentive Stock
Options 153
Phantom Stock and Stock Appreciation Rights 154
Deferred Compensation and Retirement

Planning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 154
Qualified Retirement Plans 154
Types of Retirement Plans 156
Contribution Limits 157
Nonqualified Deferred Compensation Plans 158
Individual Retirement Accounts 159
Roth IRAs 160
Self-Employed Individuals . . . . . . . . . . . . . . . . . . . . . . . . . . 161
Employment Tax Consequences 162
Fringe Benefits Limited 163
Retirement Plans 163
Expanded Topics—Foreign Assignments . . . . . . . . . 165
Foreign Earned Income Exclusion 165
Excess Housing Cost Exclusion 166
Table of Contents vii
Limited Expense Deductions
. . . . . . . . . . . . . . . . . . . . . . . 199
Residential Rental Property 199
Home Office Expenses 201
Hobby Expenses 203
Expanded Topics—Book/Tax Differences . . . . . . . . . 204
Accounting for Income Tax Expense 204
Calculating Tax Expense 206 • Effects of NOL Carryovers 207 •
Realizing Deferred Tax Assets 208 • FIN 48: Accounting for
Uncertainty in Income Taxes 209 • APB 23 Exception
for Foreign Earnings 211
UNICAP Rules and Inventory 212
Revisiting the Introductory Case . . . . . . . . . . . . . . . . . . . 213
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 214
Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215

Test Yourself . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215
Problem Assignments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216
Check Your Understanding 216
Crunch the Numbers 217
Think Outside the Text 222
Identify the Issues 222
Develop Research Skills 223
Search the Internet 224
Develop Planning Skills 225
Answers to Test Yourself . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
part
III PROPERTY CONCEPTS
AND TRANSATIONS 227
6 Property Acquisitions
and Cost Recovery Deductions
. . . . . . . . . . . . . 228
Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228
Setting the Stage—An Introductory Case . . . . . . . . . 229
Capital Expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229
Basis of Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230
Acquisition in a Taxable Exchange 232
Acquisition by Gift 232
Acquisition by Inheritance 233
Cash Flow and After-Tax Cost . . . . . . . . . . . . . . . . . . . . . . 234
MACRS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235
Averaging Conventions 236
Half-Year Averaging Convention 236 • Mid-Quarter Averaging
Convention 237 • Mid-Month Averaging Convention
for Realty 238
Year of Disposition 240

Alternative Depreciation System (ADS) 240
Section 179 Expensing Election 241
Provisions Limiting Depreciation . . . . . . . . . . . . . . . . . . 243
Mixed-Use Assets 243
Reduction in Business Use 244 • Additional Requirements
for Employees 245
Limits for Passenger Vehicles 245
Automobile Leasing 246
Depletion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 248
Amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249
Research and Experimentation Expenditures 250
Software 251
Expanded Topics—Bonus Depreciation . . . . . . . . . . . 251
Revisiting the Introductory Case . . . . . . . . . . . . . . . . . . . 253
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253
Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 254
Test Yourself . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 254
Problem Assignments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255
Check Your Understanding 255
Crunch the Numbers 256
Think Outside the Text 260
Identify the Issues 260
Develop Research Skills 260
Search the Internet 261
Develop Planning Skills 261
Answers to Test Yourself . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
7 Property Dispositions . . . . . . . . . . . . . . . . . . . . . . . . . 263
Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263
Setting the Stage—An Introductory Case . . . . . . . . . 264
Determining Gain or Loss on Dispositions . . . . . . . . 264

Property Dispositions and Cash Flow 264
Types of Dispositions 265
Amount Realized 266
Realized versus Recognized Gain or Loss 267
Holding Period 267
Character of Gains and Losses 268
Section 1231 Assets 268 • Capital Assets 269 •
Ordinary Income Assets 270
Mixed-Use Assets 270
Disposition of Section 1231 Property . . . . . . . . . . . . . . 270
Depreciation Recapture 271
Section 1245 Full Recapture 272 • Section 1250
Partial Recapture 273 • Additional Section 291
Corporate Recapture 273
Unrecaptured Section 1250 Gains for Individuals 274
Section 1231 Netting 274
Corporate Taxpayers 275 • Individual Taxpayers 275
Section 1231 Look-Back Rules 277
Disposition of Capital Assets . . . . . . . . . . . . . . . . . . . . . . . 279
The Capital Gain and Loss Netting Process 279
Tax Treatment of Net Capital Gains and
Losses 280
Corporate Taxpayers 280 • Individual Taxpayers 282
Disposition of Ordinary Income Property . . . . . . . . . 284
Mixed-Use Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 285
viii Table of Contentsviii Table of Contents
Special Rules for Small Business Stock . . . . . . . . . . . . 286
Losses on Section 1244 Stock 286
Section 1202 Gains on Qualified Small Business Stock 287
Comparison of Sections 1244 and 1202 288

Sale of Principal Residence—Section 121 . . . . . . . . . 289
Losses on Related Party Sales . . . . . . . . . . . . . . . . . . . . . . 291
Expanded Topics—Individual Capital
Gains Tax Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .291
Determining the Long-Term Capital Gains Tax Rate 292
Modified Capital Gains Rates 293
Planning 294
Revisiting the Introductory Case . . . . . . . . . . . . . . . . . . . 295
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295
Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296
Test Yourself . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296
Problem Assignments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297
Check Your Understanding 297
Crunch the Numbers 298
Think Outside the Text 303
Identify the Issues 303
Develop Research Skills 304
Search the Internet 305
Develop Planning Skills 306
Answers to Test Yourself . . . . . . . . . . . . . . . . . . . . . . . . . . . . 307
8 Tax-Deferred Exchanges . . . . . . . . . . . . . . . . . . . . . 308
Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308
Setting the Stage—An Introductory Case . . . . . . . . . 309
Basics of Tax-Deferred Exchanges
. . . . . . . . . . . . . . . . . 309
Basis Adjustments 310
Holding Period 311
Like-Kind Exchanges—Section 1031
. . . . . . . . . . . . . . 311
Qualifying Properties 312

Determining Realized Gain or Loss and the Effect
of Boot 312
Basis and Holding Period of Like-Kind Property 314
Indirect Exchanges 315
Other Tax-Deferred Exchanges . . . . . . . . . . . . . . . . . . . . . 316
Wash Sales 317
Involuntary Conversions . . . . . . . . . . . . . . . . . . . . . . . . . . . 317
Casualty and Theft Losses 318
Measuring the Loss 318 • Insurance and Basis
Considerations 319 • Deductible Amount 319 •
Taxable Year of Deduction 321
Gains on Involuntary Conversions—Section 1033 321
Tax Deferral on Involuntary Conversions 322 •
Qualifying Replacement Property 323 • Time Limits
for Replacement 324
Involuntary Conversion of a Principal Residence 324
Asset Transfers to Businesses . . . . . . . . . . . . . . . . . . . . . . . 325
Transfers to Sole Proprietorships 325
Transfers to Controlled Corporations—Section 351 325
The Control Requirement 325 • Property Other
Than Stock Received 326 • Transferred Services 326 •
Basis and Holding Period 327 • Effect of Liabilities 328 •
Transfers to Existing Corporations 328
Transfers of Property to a Partnership 329
Basis and Holding Period of a Partnership Interest 329 •
Partnership Basis and Holding Period in Contributed
Property 330 • Effect of Liabilities 330
Corporate Reorganizations . . . . . . . . . . . . . . . . . . . . . . . . 331
Revisiting the Introductory Case
. . . . . . . . . . . . . . . . . . . 332

Summary
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 332
Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333
Test Yourself . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333
Problem Assignments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334
Check Your Understanding 334
Crunch the Numbers 335
Think Outside the Text 340
Identify the Issues 340
Develop Research Skills 341
Search the Internet 342
Develop Planning Skills 342
Answers to Test Yourself . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343
Appendix 8A Reorganizations . . . . . . . . . . . . . . . . . . . . . 343
Acquisitive Reorganizations 343
Basic Tax Consequences 343 • Type A Reorganization 345 •
Type B Reorganization 346 • Type C Reorganization 346 •
Type D Acquisitive Reorganization 346 • Type D Divisive
Reorganization 346
Other Reorganizations 347
Other Considerations 348
Problem Assignments 348
Check Your Understanding 348
part
IV BUSINESS TAXATION 349
9 Taxation of Corporations . . . . . . . . . . . . . . . . . . . . 350
Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350
Setting the Stage—An Introductory Case . . . . . . . . . 351
Introduction to Corporations . . . . . . . . . . . . . . . . . . . . . . 351
Corporate Advantages 352

Disadvantages of the Corporate Form 353
Capital Structure 353
Taxation of C Corporations . . . . . . . . . . . . . . . . . . . . . . . . 354
Dividend Received Deduction 355
Charitable Contribution Deduction 356
Capital Gains and Losses 357
Table of Contents ix
Deduction for Qualified U.S. Production
Activities 357
Net Operating Losses 358
Computing the Corporate Income Tax 359
Reconciling Book and Taxable Income 360
Tax Credits 362
Alternative Minimum Tax 363
Filing and Payment Requirements 364
Consolidated Returns
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 365
Consolidated Net Income 366
Corporate Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 367
Property Distributions 367
Stock Dividends 368
Corporate Redemptions 369
Partial Liquidation 371
Liquidating Distributions 371
Dividend and Redemption Planning Issues 372
Issues for Closely Held Corporations . . . . . . . . . . . . . . . 373
Constructive Dividends 373
Penalty Taxes to Encourage Dividend Payments 374
Personal Holding Companies 374 • Accumulated
Earnings Tax 375

Controlled Corporate Groups 375
Expanded Topics—Earnings and Profits . . . . . . . . . . 377
Revisiting the Introductory Case . . . . . . . . . . . . . . . . . . . 379
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380
Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380
Test Yourself . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 381
Problem Assignments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 381
Check Your Understanding 381
Crunch the Numbers 382
Think Outside the Text 385
Identify the Issues 385
Develop Research Skills 386
Search the Internet 387
Develop Planning Skills 387
Answers to Test Yourself . . . . . . . . . . . . . . . . . . . . . . . . . . . . 388
Appendix 9A Exempt Organizations . . . . . . . . . . . . . . . 388
Unrelated Business Income Tax 389
Excise Taxes on Certain Transactions 390
Private Foundations 390
Problem Assignments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 390
Check Your Understanding 390
Appendix 9B Multistate Issues . . . . . . . . . . . . . . . . . . . . . 391
Income Taxes 391
Sales Taxes 392
Problem Assignments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 393
Check Your Understanding 393
10 Sole Proprietorships
and Flow-Through Entities
. . . . . . . . . . . . . . . . . . 394
Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 394

Setting the Stage—An Introductory Case . . . . . . . . . 395
Introduction to Flow-Through Business
Entities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 395
The Sole Proprietorship . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 396
Forming the Sole Proprietorship 396
Operating the Sole Proprietorship 397
Self-Employment Taxes 399
Partnerships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400
Types of Partnerships 400
Advantages and Disadvantages of Partnerships
and LLCs 401
Entity versus Aggregate Concepts 401
Partnership Operations 402
Partner’s Basis and Capital Account 402 • Partner’s
Interests 402 • Selection of a Partnership Tax Year 402 •
Partnership Operating Results 403
Partner’s Basis Account 404
Effects of Liabilities 404
Loss Limitation Rules 405
General Loss Rules 405 • At-Risk Rules 406 •
Passive Loss Rules 406
Partnership Distributions 407
Guaranteed and Nonguaranteed Payments 407 • Nonliquidating
Distributions 407 • Liquidating Distributions 408
Selling a Partnership Interest 409
S Corporation Characteristics . . . . . . . . . . . . . . . . . . . . . . 410
Eligibility Requirements for S Status 410
Corporate Restrictions 410 • Shareholder Restrictions 411
Making the S Election 411
Terminating the S Election 411

Termination Election 411 • Terminating Events 412
S Corporation Operations 412
Loss Limitations 413
Basis Adjustments 414
The Accumulated Adjustments Account 414
Property Distributions 415
The S Corporation Schedules M-1, M-2, and M-3 416
S Corporation Taxes 416
The Built-in-Gains Tax 416 • The Excess Net Passive
Investment Income Tax 416 • LIFO Recapture Tax 417
Redemptions and Liquidations by S Corporations 417
The U.S. Production Activities Deduction . . . . . . . . . . 418
Comparison of Total Tax Burden by Entity . . . . . . . . 419
Expanded Topics—The Passive Deduction
Limitations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 420
Rental Relief for Middle-Income Taxpayers 421
Real Property Business Exception 422
x Table of Contents
Revisiting the Introductory Case . . . . . . . . . . . . . . . . . . . 422
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 424
Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 424
Test Yourself . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 425
Problem Assignments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 426
Check Your Understanding 426
Crunch the Numbers 426
Think Outside the Text 432
Identify the Issues 432
Develop Research Skills 433
Search the Internet 433
Develop Planning Skills 433

Answers to Test Yourself . . . . . . . . . . . . . . . . . . . . . . . . . . . . 434
part
VTAXATION OF INDIVIDUALS 435
11 Income Taxation of Individuals . . . . . . . . . . . . 436
Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 436
Setting the Stage—An Introductory Case . . . . . . . . . 437
The Individual Tax Model . . . . . . . . . . . . . . . . . . . . . . . . . . . 437
Income 437
Deductions for Adjusted Gross Income 438
Educator Expenses 439 • Student Loan Interest
Deduction 439 • Tuition and Fees Deduction 440 •
Health Savings Accounts 440 • Penalty on Early Withdrawals
of Savings 441 • Other Deductions for AGI 441
Adjusted Gross Income 442
Deductions from Adjusted Gross Income 422
Determining the Tax Liability 422
Personal and Dependency Exemptions . . . . . . . . . . . 443
Qualifying Child 444
Qualifying Relatives 444
Support Test 445 • Gross Income Test 446
Phaseout of Exemptions 447
Filing Status . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 448
Married Filing Jointly 448
Surviving Spouse 449
Married Filing Separately 449
Head of Household 450
Single (Unmarried) Individual 451
Standard Deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 451
Basic Standard Deduction 451
Additional Standard Deduction 452

Standard Deduction for Dependents 452
Itemized Deductions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 453
Medical Expenses 454
Taxes 455
Income Taxes 456 • Real Property Taxes 456
Interest Expense 457
Investment Interest 457 • Qualified Residence
Interest 458
Charitable Contributions 459
Contributions of Property 460 • Maximizing the Tax
Benefit from Contributions 461
Casualty and Theft Losses 462
Miscellaneous Itemized Deductions 463
Phaseout of Itemized Deductions for High-Income
Taxpayers 464
Net Operating Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 464
Computing the Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 465
Tax Credits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 467
Credits versus Deductions 467
Child Tax Credit 467
Education Credits 467
Earned Income Credit 469
Dependent Care Credit 470
Retirement Contributions by Low-Income
Wage Earners 470
Excess Payroll Tax Withheld 471
Credits to Encourage Energy Efficiency 471
Payment of Income Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 472
Who Must File a Return? 472
Expanded Topics—Additional Taxes . . . . . . . . . . . . . . 473

Alternative Minimum Tax 473
Revisiting the Introductory Case . . . . . . . . . . . . . . . . . . . 477
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 478
Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 478
Test Yourself . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 479
Problem Assignments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 480
Check Your Understanding 480
Crunch the Numbers 481
Think Outside the Text 483
Identify the Issues 484
Develop Research Skills 484
Search the Internet 485
Develop Planning Skills 485
Answers to Test Yourself . . . . . . . . . . . . . . . . . . . . . . . . . . . . 487
12 Wealth Transfer Taxes . . . . . . . . . . . . . . . . . . . . . . . . . 488
Key Concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 488
Setting the Stage—An Introductory
Case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 489
Overview of Wealth Transfer Taxation . . . . . . . . . . . . . 489
The Unified Transfer Tax 489
Major Exclusions 490
Annual Gift Tax Exclusion 490 • Lifetime Transfer
Tax Exclusion—The Unified Credit 491
Table of Contents xi
The Federal Gift Tax
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 491
Transfers Subject to Gift Tax 491
Transfers for Insufficient Consideration 492 • Joint Property
Transfers 492 • Life Insurance Transfers 493 • Transfers
to a Trust 493 • Cessation of Donor’s Control 494

Transfers Excluded from Gift Taxes 494
Transfers of Marital Property Pursuant
to a Divorce 494 • Other Exclusions 495
Valuation of Gift Property 495
Special Rules Affecting the Annual Gift
Tax Exclusion 495
Present versus Future Interests 496 • Gifts to Minors 496 •
Gift Splitting 497
Gift Tax Deductions 498
Charitable Deduction 498 • Marital Deduction 498
Tax Consequences for Donees . . . . . . . . . . . . . . . . . . . . . 498
Kiddie Tax 499
Special Education Savings Plans 499
The Taxable Estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500
Identifying the Gross Estate 500
Valuation Issues 502
Estate Deductions 503
Generation-Skipping Transfer Taxes 503
Transfer Tax Planning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 504
Selecting the Right Property to Give 504
Advantages of Making Lifetime Gifts 505
Shielding of Post-Gift Appreciation from Estate
Taxes 505 • Using the Annual Exclusion and Gift
Splitting 505 • Nontax Advantages of Trusts 506
Disadvantages of Lifetime Gifts 506
Carryover Basis on Gift Property 506 • Early Payment
of Transfer Taxes 507
Fiduciary Income Tax Issues . . . . . . . . . . . . . . . . . . . . . . . . 507
The Decedent’s Final Tax Return 507
Income Tax Consequences of Inherited Property 507

Income Taxation of Trusts and Estates 508
Expanded Topics—The Tax Calculations . . . . . . . . . . 509
Computing the Gift Tax 509
Computing the Estate Tax 510
Computing the Kiddie Tax 511
Computing the Fiduciary Income Tax 512
Revisiting the Introductory Case . . . . . . . . . . . . . . . . . . . 513
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 514
Key Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 514
Test Yourself . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 514
Problem Assignments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 515
Check Your Understanding 515
Crunch the Numbers 516
Think Outside the Text 520
Identify the Issues 520
Develop Research Skills 521
Search the Internet 521
Develop Planning Skills 521
Answers to Test Yourself . . . . . . . . . . . . . . . . . . . . . . . . . . . . 522
APPENDIX A:
Tax Research Using RIA Checkpoint® . . . . . . . . . . . . . . 523
APPENDIX B:
Present Value and Future Value Tables . . . . . . . . . . . . 543
APPENDIX C:
Sample Filled-in Tax Returns . . . . . . . . . . . . . . . . . . . . . . . . . 545
APPENDIX D:
Tax Return Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 569
Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 577
xii
Focus

This text is designed for a one-semester introductory tax course at either the under-
graduate or graduate level. It is ideal for an MBA course or any program emphasizing
a decision-making approach.
Comprehensive Yet Brief and Concise
This is the only text to introduce all topics on the CPA exam in only 12 chapters
while striking the perfect balance between concepts and details. Tax concepts and
applications are presented in a clear, concise, student-friendly writing style. It
includes sufficient technical detail to provide a foundation for future practice in tax-
ation and consulting while not overwhelming the student with seldom-encountered
minutia.
Tax Planning
The importance of tax planning is emphasized. It is woven into each chapter with mar-
gin icons highlighting planning opportunities. Tax planning strategies are introduced
early in Chapter 2 along with the impact of taxes on cash flow.
Technology Applications
A six-month access card to RIA Checkpoint
®
Student Edition is available as a bun-
dled option with each new text. Appendix A includes a tutorial with screen captures
providing students an overview of searching using RIA Checkpoint
®
before they go
online, saving class instruction time. Internet assignments and research problems
that can be solved with RIA Checkpoint
®
build valuable research skills that are
tested on the CPA examination.
Key Concepts
Each chapter begins with an introduction to the included topics, emphasizing why deci-
sion makers need to understand these topics.This is followed by a list of Key Concepts

that provide an executive summary of the most important concepts students should
master.
Setting the Stage—An Introductory Case
Each chapter-opening case introduces key issues while promoting critical analysis and
decision-making skills. The case is then revisited at the end of the chapter.
Preface
Preface xiii
Examples
Rigorous topics are tackled through numerous simple but realistic examples.
EXAMPLE 46
When Alex Rodriguez, the former Texas Rangers shortstop, lived in Texas (a state with no individ-
ual income tax), he owed more than $271,000 to California (which assesses a 9.3% nonresident
income tax) for games he played in that state during baseball season. It was estimated that if the
Rangers had played all their games at home, A-Rod’s state tax bill could have been reduced by
more than half a million dollars a year. When A-Rod switched to the New York Yankees, his state
and local tax burden increased dramatically. On the $155 million that A-Rod will be paid over
his seven-year contract, he is expected to owe $3.57 million to New York City and an additional
$6.19 million to the State of New York for income taxes.
Key Cases
Key Cases bring real world applications into the classroom.
KEY CASE In May 2006, Richard Hatch was sentenced to 51 months in federal prison
for failing to report $1 million in income won from the first “Survivor” television series along
with income from some other sources. He was also ordered to pay almost $475,000 in taxes,
interest and penalties.
Expanded Topics
The Expanded Topics section included at the end of several chapters contains more
advanced topics for instructors who wish to challenge their students. These advanced
discussions relate to the other material within the chapters, but which our adopters and
reviewers have indicated could be omitted to allow more time for the more critical
material.

Summary
Each chapter closes with a Summary of the most important topics introduced in the
chapter, reinforcing important concepts for students.
Key Terms
A list of Key Terms is included at the end of each chapter. They appear in bold print
and are keyed to the first page on which the term is discussed.
Test Yourself
Each chapter includes a Test Yourself section of five multiple-choice questions for stu-
dents to assess their understanding of topics covered in the chapter. Answers to these
questions follow the end-of-chapter materials.
Problem Assignments
More than 60 problems are included at the end of each chapter. Check Your
Understanding includes a wide variety of noncomputational questions that review
the topics included in the chapter. Crunch the Numbers presents quantitative problems
covering the computational aspects of chapter materials. Comprehensive problems
integrate topics covered in several different chapters.
xiv Preface
Think Outside the Text
For instructors wishing to challenge their students, Think Outside the Text questions
develop critical thinking skills by requiring students to expand their thinking beyond
the material covered in the chapter.
Identify the Issues
Identify the Issues includes short scenarios designed to challenge the students to iden-
tify issues and formulate research questions. These scenarios, however, do not provide
enough information to enable students to develop definitive solutions but are designed
to help students practice the issue-identification step in the research process, a step
that many new tax students consider the most difficult.
Develop Research Skills
Develop Research Skills requires students to research the relevant authorities and
present possible solutions.These can be solved using RIA Checkpoint

®
Student Edition
or free Internet sources. For most of these problems, citations to relevant Internal
Revenue Code sections, cases, and rulings are included only in the Instructor’s Manual
allowing each instructor to decide what, if any, hints should be given to students when
a problem is assigned.
Develop Planning Skills
Develop Planning Skills problems give students the opportunity to test their knowledge
in planning situations. The tax planning suggestions integrated throughout the text con-
tinually remind students of the importance of developing appropriate planning strategies.
Chapter Appendices
End-of-chapter appendices introduce topics not typically covered in a first tax course
including corporate reorganizations, state and local taxation, and taxation of nonprofit
entities. These materials are placed in chapter appendices to allow instructors the flexi-
bility to include or omit them as deemed appropriate.
Tax Research Appendix
PHOTOS: © COPYRIGHT 2007 RIA®. ALL RIGHTS RESERVED.
Preface xv
Appendix A at the end of the text provides a tutorial with screen captures of RIA
Checkpoint
®
Student Edition. Students can use the tutorial to become acquainted with
the basics of searching before going on line. After requiring the students to complete
the tutorial, the instructor can begin to assign basic research problems without taking
up class time on search instruction. For those with access to a paid subscription to the
professional version of RIA Checkpoint
®
, screen captures illustrate some of the addi-
tional resources available in this widely-used professional tax service. This is the only
introductory-level tax text that includes screen captures of RIA Checkpoint

®
.
Sample Tax Returns
Sample Filled-In Tax Returns are included in Appendix C for a C corporation, S corpo-
ration, partnership, and a self-employed individual.
Tax Return Problems
Six Tax Return Problems, covering the four types of business entities as well as individ-
uals, are included in Appendix D. Using an appendix allows the instructor to assign an
entire tax return problem or portion of a problem at whichever point in the term best
suits a particular class.
Up-To-Date
This text has been completely updated for new legislation, including the Pension
Protection Act of 2006 and the Tax Relief and Health Care Act of 2006. This text has
been updated for all IRS pronouncements available as of the end of April 2007,
including the automobile ceiling limits. In addition, reference has been made to
pending legislation that could affect text material where appropriate. We will use the
web site associated with the text at www.thomsonedu.com/taxation/dennis-escoffier
to provide any additional updates.
Organization
This text is ideal for schools with only one required tax course as it includes all the top-
ics specified for the first course in the AICPA’s Model Tax Curriculum. Its 12 chapters
can be covered in one semester, with time for assessments, eliminating the need to omit
chapters. The Model Tax Curriculum emphasizes tax planning to stimulate students’
thinking in terms of the effect taxation has on decisions for entities as well as individ-
uals. Although the text includes entity planning, it does not do so to the exclusion of
individuals.An example of this dual planning orientation is illustrated in the discussion
of employee compensation in Chapter 4. Most authors relegate compensation plan-
ning to the end of the text where, unfortunately, many students never see it. We chose
this topics as an opportunity for students to view transactions from both the individ-
ual’s perspective (minimizing taxable income) and the employer’s perspective (maxi-

mizing deductions while providing a compensation plan that will attract valuable
employees). This chapter is the bridge between the chapters on gross income and busi-
ness expenses. This text maintains this planning orientation and integrates both entity
and individual topics throughout Parts II and III as income, expense, and property
transaction concepts are introduced.
Brief Contents
PART I: INTRODUCTION TO TAXATION AND ITS ENVIRONMENT
Chapter 1: An Introduction to Taxation
Chapter 2: The Tax Practice Environment
Appendix 2A: Tax Research
PART II: INCOME AND EXPENSE DETERMINATION
Chapter 3: Determining Gross Income
Chapter 4: Employee Compensation
Chapter 5: Business Expenses
PART III: PROPERTY CONCEPTS AND TRANSACTIONS
Chapter 6: Property Acquisitions and Cost Recovery Deductions
Chapter 7: Property Dispositions
Chapter 8: Tax-Deferred Exchanges
Appendix 8A: Reorganization
PART IV: BUSINESS TAXATION
Chapter 9: Taxation of Corporations
Appendix 9A: Exempt Organizations
Appendix 9B: Multistate Issues
Chapter 10: Sole Proprietorships and Flow-Through Entities
PART V:TAXATION OF INDIVIDUALS
Chapter 11: Income Taxation of Individuals
Chapter 12: Wealth Transfer Taxes
Appendix A Tax Research Using RIA Checkpoint
®
Appendix B Present Value and Future Value Tables

Appendix C Sample Filled-in Tax Returns
Appendix D Tax Return Problems
Index
Your Course Your Way
Although this text is designed primarily for those who wish to provide an introduction
to all entities before tackling the topics unique to individuals, the flexibility of this text
makes it easy for those who wish to change the sequence of chapters. For example, suf-
ficient notes and references to basic concepts in the preceding chapters are included
within Chapter 11: Income Taxation of Individuals making it easy for instructors who
wish to cover this chapter early in the term (such as after Chapter 4).
Supplements
Supplements include an author-prepared Solutions Manual (including full text of
end-of-chapter problems for easy reference as well as solutions), an Instructor’s
Manual with an extensive Test Bank, and PowerPoint slides. All supplemental items
are conveniently available on the Instructor’s Resource CD-ROM.
Comments and Suggestions
We realize that it is almost impossible for a text to be completely free of technical
errors or to include every relevant topic. We welcome comments and suggestions on
how we can improve the next edition. Please email your comments and suggestions to

Acknowledgments
We wish to acknowledge and thank Howard Godfrey, University of North Carolina at
Charlotte, and Stewart Karlinsky, San Jose State University, for their suggested
improvements to the text. We also wish to thank James Young, Northern Illinois
University, for providing advanced copy of the 2007 inflation adjustments. We are
grateful to the entire Thomson team for their assistance, particularly Keith Chassé and
Jessica Kempf.
Shirley Dennis-Escoffier and Karen A. Fortin
xvi
Preface

xvii
About the Authors
Shirley Dennis-Escoffier is an associate professor at the University of
Miami, where she teaches both graduate and undergraduate tax classes.
She received her Ph.D. from the University of Miami and returned to UM
after teaching at the University of Hawaii and California State University
in Hayward. She is a Certified Public Accountant licensed to practice in
Florida. She served as President of the American Taxation Association for
2000–2001 and remains actively involved in the association receiving the
Outstanding Service Award for 2004. She is also actively involved with the
American Institute of Certified Public Accountants. She has received
several teaching awards including the University of Miami Excellence
in Teaching Award and the School of Business Alumni Association
Excellence in Teaching Award. She has published numerous articles in tax
and accounting journals and is the recipient of an Ernst and Young
Foundation tax research grant. In her free time, she and her husband,
Marcel Escoffier, enjoy seeking out fine wine and gourmet food.
Karen A.Fortin retired from her position as Professor of Accounting and
Taxation at the University of Baltimore, where she had been Department
Chair and taught graduate and undergraduate tax classes in both the
Business School and the Law School. She received her Ph.D. from the
University of South Carolina and held teaching positions at the University
of Wisconsin–Milwaukee and the University of Miami. She is a Wisconsin
Certified Public Accountant and a recipient of a Sells Award. During her
teaching years, she was active in the American Taxation Association and the
American Accounting Association as an editor, reviewer, and chairperson
for numerous events. As a member of the AICPA she served on several
committees and task forces. She has published numerous articles in tax and
accounting journals and has co-authored and edited a number of textbooks.
In between her extensive travels, she teaches part-time and volunteers in a

local grade school tutoring students in mathematics.
To my husband, Marcel.
—S
HIRLEY DENNIS-ESCOFFIER
To my family, especially my ever-patient partner, John,
our children and their spouses, and our grandchildren.
—K
AREN A. FORTIN
part
I
INTRODUCTION
TO
TAXATION
AND
ITS
ENVIRONMENT
CHAPTER 1
AN INTRODUCTION
TO TAXATION
CHAPTER 2
THE TAX PRACTICE
ENVIRONMENT
2
chapter
1
CHAPTER OUTLINE
Setting the Stage—An
Introductory Case
3
An Introduction to

Taxation
3
The Taxing Units and the Basic
Income Tax Models
6
Choice of Business Entity 18
Other Types of Taxes 23
Types of Tax Rate Systems 28
Characteristics of a Good
Tax
31
Revisiting the Introductory
Case
33
Summary 34
Key Terms 35
Test Yourself 35
Problem Assignments 35
Answers to Test Yourself 40
AN INTRODUCTION
TO TAXATION
T
his chapter presents an overview of income taxation and of taxation in gen-
eral as a backdrop to the more detailed provisions of the tax laws that fol-
low in subsequent chapters. In reading this chapter, you should not be concerned
with where the numbers come from. Instead, you should focus on developing a
broad understanding of how the U.S. tax system works.
After defining a tax and providing some background information on the
income tax, this chapter introduces those taxable persons that pay income
taxes—individuals, C corporations, and fiduciaries. The concepts of gross income,

taxable income, tax rates, gross tax liability, and tax credits are introduced in the
context of both the corporate and individual tax models. The individual tax
model includes several unique features, including adjusted gross income, deduc-
tions for adjusted gross income, deductions from adjusted gross income, and
personal and dependency exemptions. Some of the basic concepts related to
property transactions are also introduced.
The various types of business entities, including sole proprietorships, partner-
ships, C corporations, and S corporations, are compared. The individual owner of
a sole proprietorship is taxed on the business’s income. Partnerships and S corpo-
rations are conduits or flow-through entities because they pass their income and
loss items through to their owners for taxation at the owner level. A C corpora-
tion’s income is subject to double taxation, once at the entity level when earned
by the corporation and a second time at the shareholder level when distributed to
shareholders as dividends.
Consumption, wealth, and wealth transfer taxes are discussed. The concepts of
progressive, proportional, and regressive taxes follow the discussion of average
and marginal tax rates. Adam Smith’s canons of taxation are also presented.
These canons provide a framework for assessing a “good” tax.
KEY CONCEPTS
●
Only individuals, C corporations, and fiduciaries pay income taxes.
●
Corporations are taxed on taxable income, which is the difference between gross
income and deductions.The nominal tax rates for corporations vary from 15 to
35 percent.
●
In determining taxable income, individuals are allowed two sets of deductions
from gross income—deductions for adjusted gross income and deductions from
adjusted gross income.They also are allowed to deduct personal and
dependency exemptions. Individual tax rates vary from 10 to 35 percent.

●
Sole proprietorships, partnerships, and S corporations are all business entities
whose income and losses are passed through to owners and included in owners’
tax returns for payment of income taxes.
●
Other taxes levied by governmental units include sales or use taxes, wealth
or property taxes, and wealth transfer taxes.
Chapter 1 An Introduction to Taxation 3
SETTING THE STAGE—AN INTRODUCTORY CASE
Wing Hue, an engineer from China with U.S. residency status, recently obtained per-
manent employment with a U.S. consulting firm. Before coming to the United States,
Hue developed a totally new system of gears for bicycles. He has obtained a patent
on his gear design and plans to solicit some venture capitalists for funds to begin man-
ufacturing and marketing the gears. He would like to sell the gears to both bicycle
manufacturers and to repair shops as replacements for existing gears.
As a student in China, Hue never had sufficient income to pay taxes. He under-
stands that as a U.S. resident, he will be subject to a variety of taxes. He is particularly
interested in the potential taxation of his gear manufacturing enterprise. He asks you
for a brief explanation of the tax landscape that he faces. We will return to this case at
the end of this chapter.
AN INTRODUCTION TO TAXATION
What Is a Tax?
A tax is a forced payment made to a governmental unit that is unrelated to the value
of goods or services provided. Taxes are not voluntary. If we have income, we pay
income taxes on that income to the federal government and possibly to state and local
governments.
1
If we purchase certain goods, the state may require the seller to collect
a sales tax. If we fail to pay or remit these taxes to the government, we may be subject
to civil, or even criminal, penalties. If we own real estate, the local government places

an assessed value on that property and sends us a bill for property taxes. These taxes
must be paid or the government may seize the property.
There are hidden taxes as well. Hidden taxes are those that are paid but that are not
specifically itemized as part of the payment. When we buy gasoline for our automo-
biles, there are significant taxes imbedded in the price paid. The same is true for many
other items, such as cigarettes and alcoholic beverages. Nevertheless, if we want that
particular good (legally, that is), we pay the tax.
Taxes are not levied as punishment (as are fines for speeding), nor are they levied
as payment for particular goods or services rendered by the government (such as a
garbage collection fee). Although we may benefit from many governmental activities
that are paid for by taxes, there is no direct connection between the benefit received
by a taxpayer and the amount of tax the taxpayer must pay. Property taxes to support
education are levied on the value of one’s property, with no relationship to the num-
ber of children, if any, a person may have that are benefiting from free public school
education.Thus, taxes are often termed forced extractions. You must pay them, but you
may not necessarily derive any benefit from them.
A Brief History of Income Taxation in the United States
Although there had been a federal income tax during the Civil War, the income tax
system as we know it today did not begin until 1913 when the 16th Amendment to the
U.S. Constitution was ratified. The 16th Amendment gave Congress the power to lay
and collect taxes “on income, from whatever source derived,” without the previous
requirement that all direct taxes be imposed based on population. This first federal
income tax law enacted in 1913 consisted of only 16 pages and required only a simple
individual income tax return.
Each time the income tax statutes were revised between 1913 and 1939, an entire
set of new provisions replaced the existing law. In 1939 this procedure changed, and
the income tax laws were codified as the Internal Revenue Code. Amendments and
1
Individuals are assessed federal income taxes only if their income exceeds a certain minimum amount.
revisions were then made to the specific sections of the Code, rather than replacing

the old law with an entirely new set of statutes.
In 1954, there was another major overhaul of the tax laws. In this 1954 recodifica-
tion, the income, estate, gift, and excise tax laws were incorporated into the Internal
Revenue Code of 1954. There were many significant tax law changes between then and
1986, each amending the Internal Revenue Code of 1954. Because the Tax Reform Act
of 1986 was so extensive, the Code was renamed the Internal Revenue Code of 1986.
Any current changes to the tax laws are now amendments to the Internal Revenue
Code of 1986; for example, the Jobs and Growth Tax Relief Reconciliation Act of 2003
(the 2003 Act) amended the Internal Revenue Code of 1986.
Over the years, the tax rates have gone up and down numerous times, the exemp-
tions and deductions have varied, additional filing statuses were added, multiple
rate schedules were developed based on these added filing statuses, and the index-
ing of many provisions with specified numerical amounts was expanded. The com-
plexity of business taxation has also expanded at an ever-increasing pace. It is now
almost impossible for one person to be familiar with all areas of the federal tax law.
In addition, as the United States has developed a greater presence in the global
economy, the necessity to understand the tax laws of other countries has become
more apparent. Add to this the tax laws of the 50 states, which often differ from
one another and from federal law, and it is obvious that the tax profession will con-
tinue to grow and to need well-trained professionals to assist both businesses and
individuals.
Objectives of Taxation
Raising revenue is only one of the many goals of taxation. The tax laws foster many
economic and social goals such as wealth redistribution, price stability, economic
growth, full employment, home ownership, charitable activities, and envionmental
preservation. For example, the government encourages contributions to charities
through the charitable contribution deduction. If the charitable organizations did not
exist, the government would have to undertake many of the activities the charities pro-
vide. Thus, the tax law is used to achieve this social objective.
Tax policy struggles to achieve fairness. Differing notions of fairness, however,

guarantee that this goal remains elusive. The fairness debate revolves around two very
different concepts of what is fair. Horizontal equity, one of the key principles of tax
fairness, asserts that persons in similar circumstances should face similar tax burdens.
The difficult part is determining when different taxpayers are in similar circumstances.
EXAMPLE 1
Susan rents a condominium for $2,500 per month. Barry pays $2,500 per month on the mortgage
for his condominium in the same building. Both Susan and Barry are single, have no dependents,
and have annual incomes of $55,000. Susan cannot deduct any portion of her rent, but Barry can
deduct the interest portion of his mortgage payment. In this case, the goal of horizontal equity
gives way to the objective of encouraging home ownership.
The other major fairness concept is vertical equity. Vertical equity asserts that per-
sons with higher incomes should pay not only more tax but also higher percentages of
their income as tax.
2
Underlying this is the economic theory that income has diminish-
ing marginal utility. In other words, as a person’s income rises, each dollar is worth less
to that person. As a result, higher rates are necessary to obtain approximately compa-
rable sacrifices from all taxpayers.Although this has long been a feature of the U.S. tax
system (as evidenced by the progressive tax rates), it remains controversial, especially
among those subject to the higher tax rates.
4
Part I Introduction to Taxation and Its Environment
2
Vertical and horizontal equity are discussed in more detail in the latter part of the chapter.
Chapter 1 An Introduction to Taxation 5
EXAMPLE 2
Bill and Susan are married and have two children. In 2007, they have taxable income of $63,700
and pay taxes of $8,772.50.
3
Their average tax rate is 13.77 percent ($8,772.50͞63,700). Shelly and

John are married and have two children. Their taxable income is $128,500 and they pay taxes of
$24,972.50. Their average tax rate is 19.43 percent ($24,972.50͞128,500). Shelly and John’s income
is 2.02 times ($128,500͞63,700) that of Bill and Susan, but Shelly and John pay 2.85 times
($24,972.50͞8,772.50) the amount of taxes.
Fairness also underlies the preferential treatment given to a married taxpayer who
supports a spouse. The married taxpayer will pay less tax than a single individual with
the same taxable income because of the differences in tax rate schedules applicable to
their taxable income.
EXAMPLE 3
John and Laura each have $50,000 in taxable income in 2007. John is married and files a joint
return, but his wife has no income as she attends college. Laura, however, is single. John’s tax lia-
bility is $6,717.50 while Laura’s is $8,923.75.
On the other hand, two married persons each with moderately high incomes will
pay more taxes than two single persons with the same incomes.This is commonly called
the marriage penalty.
EXAMPLE 4
Barbara is single and has taxable income of $77,100 in 2007. As a single individual, she will pay taxes
of $15,698.75. Shelly and John are married and have $154,200 in taxable income, one-half earned
equally by each of them. They pay $32,168.50 in taxes. This is $771 [$32,168.50 Ϫ (2 ϫ $15,698.75)]
more than they would pay if each of them was taxed separately as a single individual. The $771 is
their marriage penalty.
The 2003 Act, which accelerated scheduled marriage penalty relief for years 2003
and 2004, was extended in the latter part of 2004 by the Working Families Tax Relief
Act of 2004. This relief, however, only eliminates the penalty for a married couple
whose taxable income does not exceed $128,500 in 2007. Although the standard
deduction for a married couple is increased to twice that of the single person, only
the 10 and 15 percent bracket widths in the tax rate schedules are doubled to twice
those of the single person.
4
As a result, upper income taxpayers will still face a mar-

riage penalty. These changes did, however, provide a greater marriage bonus for a
couple when one of the spouses earns all or a greater portion of their combined
income.
Current Influences on the Tax Law
A number of factors influence the tax laws, but probably the makeup of Congress is
the most important. The political parties have different views of the level of taxation
relative to the services that should be provided by the federal government. In gener-
al, the Democratic party believes that the federal government is best able to service
the public, while the Republicans would leave far more in the hands of the states and
local governments. Individual states or regions have particular interests that their
elected representatives espouse and bargain to achieve. This often leads to rather
strange results. Although the federal government successfully sued the tobacco
3
The calculation of taxes paid in this and the following examples will be explained later.
4
The standard deduction for joint filers is doubled to twice that of the standard deduction for single
persons through year 2008; the expansion of the 10% and 15% brackets for joint filers is effective
through 2007.
industry for the harm done by cigarette smoking, it still has subsidy programs for
tobacco farmers.
Washington is full of lobbyists who try to influence representatives and senators to
sponsor or vote for legislation favorable to their particular industries. This influence
is manifested in two ways. First, industries contribute substantial monies to election
campaigns.They will generally pour the greatest amount of money into the campaigns
of persons they believe will support their positions—whether incumbent or not.
Campaign finance reform sought to address some of the perceived abuses of the
unlimited amount of “soft money” that could be contributed to various campaign
organizations. Second, however, is the fact that many of the lobbyists and political
action committees (PACs) have extremely large staffs available to research various
technical issues. They can funnel this research, which is often slanted in their desired

direction, to the various members of Congress. It is not unusual for a lobbyist to pro-
vide the basic text of a tax law to be introduced to Congress.
The attempt to satisfy the many constituencies of our elected representatives has
led to a collection of tax laws that are becoming more and more complex for the tax-
payer to comply with and the IRS to administer effectively. In spite of many calls for
simplification, each tax law adds complexity to the system. The 2003 Act reduced tax
rates on one class of long-term capital gains to 5 percent or 15 percent depending on
the taxpayer’s marginal tax rate. This change, however, was only effective for capital
assets sold after May 5, 2003. Assets sold before May 6, 2003 were taxed under the
prior long-term capital gains rate schedule.Thus, a taxpayer with asset sales before and
after the change date faced a daunting task in calculating his or her 2003 tax liability.
The 2003 Act made numerous temporary changes that were to revert to prior law
after a specified time period. Uncertainty surrounding the extension of those provisions
made tax planning increasingly difficult for tax years beyond 2004. It was not until late
September 2004 that Congress passed the Working Families Tax Relief Act of 2004 that
extended many of the expiring provisions to the 2005 tax year and beyond. It is proba-
bly not by coincidence that these changes were passed shortly before the presidential
and congressional elections of November 2004. This was not the case in 2006, however.
With potential changes in the makeup of the Senate and House of Representatives due
to the increasing controversy over the war in Iraq, the anticipated extenders did not
materialize prior to the general elections. The bills were again brought up during the
lame duck session and many of the expiring provisions were made effective retroac-
tively to 2006 and extended through 2007.
THE TAXING UNITS AND THE BASIC INCOME
TAX MODELS
There are only three types of persons
5
subject to income taxation in the United States:
the individual, the C corporation,
6

and the fiduciary. An individual is a male or female
person subject to the tax. A C corporation is a business entity formed under state law
on which the income tax is levied directly.A fiduciary is either an estate or a trust; it may
be subject to income taxes, but in most cases the income is passed through to the income
beneficiaries and is included in the beneficiaries’ income for taxation. The fiduciary is a
modified “flow-through” entity because the tax may be levied on income retained by
either the estate or the trust, or it may be levied on the recipients to whom the income
is distributed. Partnerships and S corporations are flow-through entities.
6
Part I Introduction to Taxation and Its Environment
5
Any entity subject to the income tax is a taxable person; the term “individual” is reserved exclusively for
a man, woman, or child subject to an income tax.
6
The term “C” or “regular corporation” (called “C” corporation because its governing tax rules are
contained in Internal Revenue Code subchapter C) is used to distinguish it from a Subchapter S (or sim-
ply “S”) corporation (whose rules are contained in IRC subchapter S), which is a flow-through entity.