Taxation 2 Study Notes Faculty : Prof Chandru Kanaya

BBA 3 MU Finance Chapter 1 Understanding and working with

The Federal Tax Law

The Federal Tax Law is a mix of statutory provisions , administrative pronouncements, and
court decisions. Anyone who has attempted to work with this body of knowledge is aware of its
complexities.

Former IRS Commissioner Sheldon Cohen indicates that “taxes are dry, arcane and difficult,
but tell me a person’s philosophy of taxes, and I will tell you his or her philosophy of life.”

The tax law is complex and some of its provisions sometimes defy logic. The IRS publishes
more than 649 tax forms, schedules, and separate instructions, totaling more than 16,000
lines. The Internal Revenue Code has sections numbered from 1 to 9833, although there is not
a section for each number. For example, there are no Code sections numbered 6 through 10
or 200 through 210 but some numbers have more than one section such as § 280A to 280H.
There are over151,000 regulations supporting these code sections as well as court cases,
rulings and other pronouncements interpreting the code.

Most often, there are reasons for the tax rules.One may not agree with the reasons but,
nonetheless, they exist.Knowing these reasons can go a long way in helping to understand the
tax law.This knowledge is what Chapter 1 conveys.Chapter 1 also provides an instructor with
the opportunity to review some of the concepts covered in the first course in taxation.

THE WHYS OF THE TAX LAW

The major objective of the Federal Tax Law is raising revenue. Despite the importance of the
fiscal needs of the government, the economic, social , equity and political factors play a
significant role in evolution of the Federal tax laws . Influence of the IRS and the courts also
has its impact.

Revenue Needs

The foundation of any tax system is to raise revenue in order to cover and absorb the cost of
government operations. The annual outlays should not exceed the anticipated revenues. This
will result in a balanced budget with no deficits

Many states achieve the objective to have balanced budgets by passing laws or constitutional
amendments precluding deficit spending. Unfortunately the federal government has no
such prohibitions and national debt keeps growing .
Taxation 2 Study Notes Faculty : Mr Chandru Kanaya
BBA 3 MU Finance Chapter 1 Understanding and working with
The Federal Tax Law
When enacting legislation, Congress considers revenue neutrality.

a. Changes in the tax law should not increase or decrease the net revenues
collected.

b. However, individual taxpayers may have their taxes increase or decrease.

Revenue neutrality does not mean that any one tax payer’s liability remains the same. Since
this liability depends upon the circumstances involved, one tax payer’s increased liability could
be another tax payer’s tax savings. Revenue neutral tax reforms do not reduce deficits but they
do not aggravate problems.

Economic Considerations

Tax law is often used to accomplish economic objectives and encouraging certain
activities. This process involves amending the Internal Revenue Code through tax
legislations and emphasizing measures designed to help control the economy or
encourage certain activities and business.

Control of the Economy and Encourage Certain Activities.

 Congress has used depreciation and tax rates to control the economy. The
shorter asset lives and accelerated methods should encourage additional
investments in depreciable property acquired for business use. Conversely
longer life assets and use of straight line method of depreciation dampens tax
incentive for capital outlays . The write off allowed upon acquisition of asset is
defined under Section 179 election to immediately expense assets up to $
128,000 in 2008 and prior provisions were admitted up to 50% additional first
year depreciation.
 A change in tax rate structure has a more immediate impact on the economy.
When tax rates are lowered , tax payers are able to obtain additional spendable
funds, In the interest of revenue neutrality, rate decrease may be accompanied
by reduction or elimination of deductions or credits. Thus lower rates do not
always mean lower taxes.
 Technological progress is encouraged by allowing the immediate expensing of
research and development costs.Incremental R & D expenditures also are
allowed a special credit. Under the tax laws such expenditures can be deducted
in the year incurred or alternatively capitalized and amortized over a period of 60
Taxation 2 Study Notes Faculty : Mr Chandru Kanaya
BBA 3 MU Finance Chapter 1 Understanding and working with
The Federal Tax Law

months or more. In terms of timing the tax savings, such options are preferable to
a capitalization of cost with a write off over estimated useful life of asset created.
 Ecology is encouraged by allowing pollution control facilities to be amortized over
60 months. Also there are various tax credits for home energy conservation and
the purchase of hybrid energy vehicles.
 Low-income housing tax credits stimulate the construction of these dwellings.
 Saving which leads to capital formation is stimulated by incentives to increase
private retirement plans. The encouragement of private-sector pension plans can
be justified under social considerations as well. Contributions to the Keogh (H.R
10) plans and certain Individual Retirement Accounts (IRA) accumulate on a tax
free basis .

Encouragement of Certain Industries.

 Tax laws favor farming by allowing expensing of soil and water conservation and
fertilizers. Also farmers defer the gain recognition on crop insurance proceeds.
 Natural resource exploration and development is encouraged by allowing
expensing of intangible drilling and development costs. Also, percentage
depletion often allows a larger write-off for mineral interests that qualify.
 Publishing industry is aided by immediately expensing certain circulation
expenditures.
 Railroad industry benefits from amortization procedures allowed with regards to
railroad rolling stock.
 Manufacturing industry currently receives the benefit of the domestic production
activities deduction.

Encouragement of Small Business.

a. Congressional favoritism for small business is based on the notion that what is
good from small businesses is good for the economy as a whole.

b. Special provisions illustrating this positive bias for small business include the
following.

 Special treatment of small business corporation stock leading to ordinary

(rather than capital) loss treatment (§ 1244 stock).
Taxation 2 Study Notes Faculty : Mr Chandru Kanaya
BBA 3 MU Finance Chapter 1 Understanding and working with
The Federal Tax Law
 S corporation elections allow the avoidance of corporate income tax and
the pass-through of losses to the shareholders.

In corporate tax areas, several provisions can be explained by the desire to benefit
small businesses. One provision enables a shareholder in small business corporations
to obtain an ordinary deduction for any loss recognized on stock investment . Normally
such a loss will receive less attractive capital loss treatment . This is done to encourage
additional equity investment in small business corporations.

Another provision permits shareholders of small business corporations to make a

special election that generally avoids imposition of corporate income tax. Such an
election enables corporation to pass through to its shareholders any of its operating
losses.

The tax rates applicable to corporations tend to favor small business in that size is
relative to the amount of taxable income generated in any one year. Since a corporate
tax rate of 34% applies only to taxable income in excess of $ 75,000 corporations that
stay within this limit are subject to lower average tax rates.

If a corporation has taxable income in excess of $ 100,000 the benefits of lower

brackets are phased out until all income is taxed at the minimum rate of 34% . Once
taxable income reaches $ 10 million, the rate becomes 35%.

For example, during a calendar year 2011 , Brown Corporation has a taxable income of $
75000 and Red Corporation has taxable income of $ 100000. The Corporate tax for
Brown Corporation would be $ 13750 and Red corporation would be $ 22250. Brown
corporation is subject to an average rate of tax of 18.33% while Red Corporation is
subject to average rate of 22.5% tax

If a corporation has taxable income in excess of $ 100000 the benefit of lower tax bracket is
phased out until all income is taxed at maximum rate of 34% . Once taxable income
reaches $ 10 million the rate becomes 35 percent.

The justification for enacting such tax laws governing corporate is the economic benefit it
provides to small businesses so that they can compete more effectively with larger
concerns.
Taxation 2 Study Notes Faculty : Mr Chandru Kanaya
BBA 3 MU Finance Chapter 1 Understanding and working with
The Federal Tax Law

Social Considerations

Many of the tax provisions passed by Congress can be explained by social desirability.
These provision encourage individuals to work, give to charities, obtain educations, and
adoption. Rather than using loans, grants and other programs to reach desired goals,
Congress uses Tax Codes to provide incentives and benefits .Employers are
encouraged to provide accident, health, and group-term life insurance as well as
retirement plans for employees.

 Credit for the elderly. This credit was designed to provide a measure of relief for
certain senior citizens with low incomes and small or no Social Security benefits.
Congress believed it was socially and economically desirable to provide a modest tax
benefit for this type of taxpayer.

 Abandoned spouse provisions permit certain married persons living apart from their
spouses to be treated as unmarried for tax purposes.

 This treatment may enable persons with dependents to be taxed under the more
favorable head of household standard deduction and tax rates (when compared
to the rates applicable to married persons filing separately). These special rules
are not only socially desirable but also equitable.

 Due to reducing the marriage penalty in recent years, those without dependents
are similarly placed when filing single or married filing separately.

 Refundable earned income tax credit

 Premiums paid by employers for group insurance covering the life of the
employee Non taxability of such funds is justified when these funds help the
family unit to adjust to the loss of wages caused owing to the death of such an
employee

 Employer contributions to employee pension funds or profit sharing plans.

Contributions are not taxed until such time these funds are distributed. Private
retirement plans are encouraged because they supplement the subsistence
income level that the employees would otherwise have under the social security
system.

 Contributions to qualified charitable organizations

Taxation 2 Study Notes Faculty : Mr Chandru Kanaya
BBA 3 MU Finance Chapter 1 Understanding and working with
The Federal Tax Law

 Various tax credits , deductions and exclusions that are designed to encourage
taxpayers to obtain additional education example HOPE scholarship credit, life
time learning credit and Coverdell education savings account.

 Credit allowed for amounts spent to furnish care to minors and disabled
dependents to enable the taxpayer to seek or maintain gainful employment.

 Adoption tax credit of up to $ 11, 650 in 2008 to cover expenses incurred by

individuals who adopt or attempt to adopt a child.

Disallowance of tax deduction for certain expenditures that are deemed to

be contrary to the public policy. This disallowance extends to items such as
fines, kickbacks, penalties, bribes to government officials , disallow
gambling losses in excess of gambling gains and political campaign
expenses in excess of campaign contributions. Social considerations
dictate that tax laws should not encourage these activities by permitting
such deductions.

Equity Considerations

Equity is a relative concept and people often disagree as to what is equitable. For tax
purposes, equity is equal application of what the tax law recognizes. Equity is not what
appears fair or unfair to any one tax payer or group of tax payers. It is instead what the
tax law recognizes. Some recognition of equity does exist that alleviate effect of multiple
taxation and postpone recognition of gain when the taxpayer lacks the ability or
wherewithal to pay the tax. Equity also helps mitigate effect of application of annual
accounting period concept and helps taxpayers cope with eroding result of inflation.

Alleviate the effect of multiple taxation.

a. Taxpayers are allowed a deduction for state and local income taxes and a
deduction or credit for foreign income taxes. Also, some state income tax laws
allow a deduction for Federal income taxes.

b. Triple taxation relief for corporations is provided by dividends received deduction.

In the case of individual shareholders, qualified dividends are taxed at a
Taxation 2 Study Notes Faculty : Mr Chandru Kanaya
BBA 3 MU Finance Chapter 1 Understanding and working with
The Federal Tax Law

maximum rate of 15% (Beginning in 2013, dividends will be taxed as ordinary

income for individuals if Congress does not act to extend the reduced tax rate).

Wherewithal to Pay Concept.

This concept is based on equity. It recognizes that it is inequitable to tax transactions

when the taxpayer has no ability to pay the tax. It is particularly suited to situations
when tax payer’s economic position has not changed significantly as a result of the
transaction.

(1) Applies only where Congress specifically provides, thus, one cannot
conclude that a transaction is nontaxable just because no cash results from
the exchange.

(2) Most wherewithal to pay provisions in the tax law do not permanently
avoid gain or loss but operate on a deferral principle. Because of the basis
carryover rules, gain or loss merely is postponed to the future disposition.
The following are examples of this deferral concept.

 Like-kind exchanges (§ 1031).- whenever you sell business or

investment property and you have a gain, you have to pay tax on the
gain at the time of sale. IRC Section 1031 provides an exception and
allows you to postpone paying tax on your gain if you reinvest the
proceeds in similar property as part of a qualifying like kind exchange.
Gain deferred in a like kind exchange under IRC Section 1031 is tax
deferred but not tax free. Owners of investment and business property
may qualify for this deferral, individuals, C Corporations, S
Corporations, Partnerships, LLCs , trusts and other tax paying entities
may set up an exchange of business or investment properties for
business or investment properties under Section 1031. Properties or
businesses must be held for use in a trade or business or for
investment. Property used primarily for personal use like a primary
residence or a second home or a vacation home does not qualify for
like kind exchange treatment. Section 1031 does not apply to
exchange of inventory or stock in trade, stocks bonds or notes,
securities or debts, partnership interests and certificates of trust. You
have 45 days from the date you sell the relinquished property to
identify potential replacement properties. The identification must be in
writing signed by you and delivered to a person involved in the
Taxation 2 Study Notes Faculty : Mr Chandru Kanaya
BBA 3 MU Finance Chapter 1 Understanding and working with
The Federal Tax Law
exchange like the seller of replacement property or a qualified
intermediary. Notice to attorney, real estate agent , accountant or any
other agent is not sufficient. Replacement properties must be clearly
described in the written identification. In the case of real estate this
means a legal description, street address or a distinguishable name.
the second limit is that replacement property must be received and
exchange completed no later than 180 days after the sale of
exchanged property or due date of income tax return for the tax year in
which relinquished property was sold whichever is earlier. The
replacement property received must be substantially the same property
identified within the 45 days limit described above.

Form 8824 asks for the description of property exchanged, dates that
properties were identified and transferred, relationship between parties
to the exchange, value of like kind and other property received, gain or
loss on sale of other non like property given up, cash received or paid ,
liabilities relieved or assumed, adjusted basis of like kind property
given up or a realized gain.

If you do not specifically follow the rules for like kind exchanges , you
may be held liable for taxes, penalties and interests on your
transactions.

 Involuntary conversions (§ 1033).

If the property as a result of its destruction in whole or in part, theft,
seizure or requisition or condemnation or threat or imminence thereof
is compulsorily or involuntarily converted into similar property , no gain
shall be recognized. If conversion involves money or into non similar
property the gain shall be recognized

 A transfer of property to a controlled corporation (§ 351).

 A transfer to a partnership (§ 721).
 Transfers of lessee made improvements on the leased property to the
lessor upon termination of the lease (§ 109).

Mitigating the Effect of the Annual Accounting Period Concept.

a. For administrative ease, all taxpayers have to file tax returns yearly. However, all
taxpayers do not have a one year business cycle. To mitigate the effect of annual
accounting period concepts, taxpayers are allowed the following.
Taxation 2 Study Notes Faculty : Mr Chandru Kanaya
BBA 3 MU Finance Chapter 1 Understanding and working with
The Federal Tax Law

 Deductions for net operating losses that occur in other tax years.
 Installment treatment.
 Deduction determination after the year-end when it is difficult to accurately
assess the proper amount by year-end. Examples are contributions to IRA
and H.R. 10 (Keogh) retirement plans.

Coping with Inflation. :

During periods of inflation, the bracket creep has plagued the working persons.
Because of the progressive nature of the income tax, any wage adjustment to
compensate for inflation can increase the income tax bracket of the recipient. The
overall impact is the erosion of purchasing power. Congress adopted the indexation
procedure based upon the rise in consumer price index over the prior year. For example
due to inflation factor, the amount of personal and dependency exemption has been
increased over the years. Indexation also applies to dollar amounts of other
components including tax brackets and standard deduction.

Political Considerations

The effect of political considerations on tax law is divided into special interest litigation, political
expediency and state and local influences .

Special Interest Legislation provides benefits to limited groups of taxpayers. However,

this legislation should not be condemned if justified on economic or social grounds. For
example is there any other reason why prepaid subscription and dues income is not
taxed until earned while prepaid rents are taxed to the landlord in the year received ?
these exceptions came about because certain organizations convinced Congress that
special tax treatments were needed to cover income received from multilayer dues and
subscriptions.
Special interest legislations are not necessarily to be condemned if it can be justified on
economic or social grounds . It is still an inevitable product of the political system.

Political Expediency. Congress is sensitive to the general public’s sentiment regarding

taxes. The AMT is a response to the general public’s disapproval of large profitable
corporations paying little or no income taxes. Measures that deter more affluent tax
payers from obtaining preferential tax treatments have always had a popular appeal and
consequently the support of the Congress. Provisions such as the alternative minimum
Taxation 2 Study Notes Faculty : Mr Chandru Kanaya
BBA 3 MU Finance Chapter 1 Understanding and working with
The Federal Tax Law
tax , the imputed interest rules and the limitations on deductibility of interest on
investment indebtedness can be explained on this basis. The provisions raising income
tax rates on more affluent taxpayers and increasing amount of earned income credit are
also partially attributable to political expediency.

State and Local Influences on Federal taxation may be less apparent. Of prime
importance in this regard has been the effect of the community property system
employed in some states. At one time the tax position of residents of these states was
so advantageous that many common law states adopted the community property
system. The political pressure placed on the Congress to correct the disparity of tax
treatment was considerable. To a large extent this was accompanied by the Revenue
Act of 1948 which extended many of the community property tax advantages to
residents of common law jurisdictions . Thus common law states avoided the trauma of
discarding the time honored legal system which was familiar to everyone.

Influence of the Internal Revenue Service

IRS as Protector of the Revenue. IRS is influential in many areas beyond its role in
issuing administrative pronouncements. It is proactive in closing “loopholes” in tax laws.

IRS has secured from Congress legislation of a more general nature that enables it to
make adjustments based on substance rather than formal construction of what a tax
payer has done. One provision for example authorizes IRS to establish guidelines on
capitalization issue. This question involves when corporate debt will be recognized as
debt for tax purpose and when it will be reclassified as equity or stock . Another
provision permits IRS to make adjustments to tax payer’s method of accounting when
method used by tax payer does not clearly reflect income. IRS is also granted authority
to allocate income and deductions among businesses owned or controlled by same
interests when allocation is necessary to prevent evasion of taxes or reflect income of
each business clearly. Congress has also given authority to IRS to prevent tax payers
from acquiring corporations to obtain a tax advantage when principal purpose of
acquisition is evasion or avoidance of federal income tax
Taxation 2 Study Notes Faculty : Mr Chandru Kanaya
BBA 3 MU Finance Chapter 1 Understanding and working with
The Federal Tax Law

Administrative Feasibility.

a. Some tax laws are justified on the grounds that they simplify the collecting the
revenue and administering the law. Such items as the pay-as-you-go basis for
collecting taxes and the imposition of interest and penalties on taxpayers for
noncompliance with the tax law help ease revenue collection.

b. Laws to aid in the audit process conducted by the IRS.

(1) Standard deduction reduces the number of taxpayers claiming itemized

deductions. Fewer deductions to check simplifies the audit function.

(2) The $1,730,800 unified gift tax credit providing an exclusion amount of $5
million and the annual $13,000 gift exclusion.

Influence of the Courts

The Federal Courts have influenced tax laws in formulating judicial concepts that serve
as guidelines for applying tax provisions and key decisions have led to changes in the
IRC .

Judicial Concepts Relating to Tax Law.

In a transaction which involves many steps, any one step may be collapsed or
disregarded to arrive directly at the result reached. The substance over form concept
plays an important role in transactions involving corporations.

a. Substance over form is one of the most important tax concepts developed by the
courts.

b. Step transaction approach (also called telescoping or collapsing) allows the tax
law to disregard any step in a transaction involving many steps, if the results
would be the same.

c. Statutory relief provisions that operate to benefit taxpayers are narrowly

construed against taxpayers if there is any doubt about their application.

d. Arm’s-length transaction concept. Transactions should be constructed such that

unrelated parties would have handled the transaction in the same manner.
Taxation 2 Study Notes Faculty : Mr Chandru Kanaya
BBA 3 MU Finance Chapter 1 Understanding and working with
The Federal Tax Law
e. Continuity of interest, which applies primarily to corporation restructuring, has
been incorporated into statutory provisions. The concept permits tax free
treatment only if tax payer retains a substantial continuing interest in the property
transferred to the new business. Due to the continuing interest retained, the
transfer should not have tax consequences because position of the taxpayer has
not changed.

f. Business purpose concepts principally apply to corporations. Tax avoidance is

not considered to be a sound business purpose. Under this concept some sound
business reason that motivates a transaction must be present in order for the
prescribed tax treatment to result. The avoidance of taxation is not considered to
be a sound business purpose.

Judicial Influence on Statutory Provisions.

Courts interpret the tax law and may have substantial impact on statutory provisions.

a. Congress generally accepts the decisions of the courts, and those decisions
become part of the tax law. In some cases, Congress may see fit to incorporate
the result of a decision and make it part of the tax law.
b. On occasion, a decision leads to uncertainty by failing to provide guidelines for
similar but not identical factual situations.To clarify the matter, Congress may
amend the tax law to establish such guidelines.
c. If Congress does not choose to accept a judicial decision, it can change the tax
law to neutralize the result. Congress has the last word on what the Federal tax
law should be barring certain exceptions (e.g., constitutional issues).

Working with the tax laws

Understanding taxation requires a mastery of the sources of tax law. These sources not only
include the legislative provisions in the Internal Revenue Code but also includes reports from
Treasury, Regulations from Committees and court decisions. Thus the primary sources of tax
information comes from three branches of the government namely legislative, executive and
judicial.

The law is of very little significance until it is applied to sets of facts and circumstances. The
tax consultant must not only be able to read and interpret the source of law but must also
understand the weight of authority within the set rules.

Learning to work with tax laws involves three basic steps

Taxation 2 Study Notes Faculty : Mr Chandru Kanaya
BBA 3 MU Finance Chapter 1 Understanding and working with
The Federal Tax Law

- Familiarity with sources of law

- Application of research techniques
- Effective use of planning procedures

The Legislative Process

Federal tax legislation originates in the House of Representatives . Tax bills originate in the
Senate where they act as riders to other legislative proposals.

The typical legislative process is summarized as under

- Committee of House Ways and Means

- Consideration by House of Representatives
- Senate Finance Committee
- Consideration by Senate
- Approval or Veto by the President
- Incorporated into the code if approved by the President

The Administrative Sources of the Tax Law

The administrative sources of the Federal tax law can be grouped as follows
- Treasury department regulations
- Revenue rulings and procedures

The treasury department regulations are issued by the US Treasury department under the
authority granted by the Congress. It is interpretative by nature and provides tax payers with
guidance on the meaning and application of tax codes. Since the regulations interpret the
code, they are arranged in a particular sequence. Sometimes the treasury department issues
temporary regulations relating to elections and other matters where immediate guidance is
critical. Temporary regulations have same value as final regulations and automatically expire
within three years after the date of its issuance.

Revenue rulings are official pronouncements of the National Office of the Internal Revenue
Service. Revenue rulings are designed to provide interpretation of tax laws. However, they do
not carry the same legal force and effect as regulations and deal primarily with restricted
problems.

Revenue ruling results from specific tax payer request for a letter ruling. If IRS believes that tax
payer’s request for a letter ruling needs an official publication due to its widespread impact the
holding is converted into a revenue ruling.
Taxation 2 Study Notes Faculty : Mr Chandru Kanaya
BBA 3 MU Finance Chapter 1 Understanding and working with
The Federal Tax Law

Revenue procedures are issued in the same manner as revenue rulings but deal with internal
management practices and procedures of the IRS . Familiarity with these procedures
increases tax payers compliance and helps make administration of tax laws more efficient.
Revenue procedures involve mechanical rules and sometimes substantive positions are
included in them as well . Both the revenue rulings and revenue procedures serve important
functions as they provide guidance to both the IRS and tax payers in handling routine tax
matters.

Other administrative pronouncements include

- Treasury decisions which are issued by the Treasury department to set new tax
regulations , to amend or change existing regulations or to announce government
decisions on selected court decisions.
- Technical information releases are issued to announce revenue rulings and revenue
procedures
- Letter rulings are issued for a fee by the National Office of the IRS upon a tax payer
request and describes how IRS will treat a proposed transaction for tax purposes. In
general they apply only to the tax payer who asks for and obtains the ruling.
- Technical advise memorandums are also issued by the National Office of the IRS and
they deal with the completed transactions rather than proposed transactions and are
requested for questing relating to exemptions and employee plans. The purpose is to
determine accuracy related penalties. Both the letter rulings and technical advice
memos are issued with multi digit file numbers
- Determination letters , like letter rulings, are issued at the request of tax payers and
provide guidance concerning application of a tax law.

The Judicial sources of tax law

The judicial process in general :

After the tax payer has exhausted some or all of the remedies available within the IRS and no
satisfactory settlement has been reached, the dispute can be taken to the Federal courts. The
dispute is first considered by a court of original jurisdiction also called the trial court with any
appeal either by tax payer or IRS taken to the appropriate appellate court. The tax payer has
the choice of four trial courts
- Federal district court
- US Court of federal claims
- Tax court
- Small cases division of the tax court
Taxation 2 Study Notes Faculty : Mr Chandru Kanaya
BBA 3 MU Finance Chapter 1 Understanding and working with
The Federal Tax Law

The jurisdiction of small cases division of tax courts is limited to $ 50000 or less. Proceedings
are informal and its decisions are not precedents for any other court decisions and are not
reviewable by any higher courts.

Trial courts

- Only one court of Federal claims and only one Tax court but many Federal District
courts The tax payer does not select the District Court that will hear the dispute but
must sue in the one that has jurisdiction
- The US Court of federal claims has jurisdiction over any claim against the US that is
based on the Constitution , any act of Congress or regulation of Executive department
- Each of the 94 district courts has only one judge , the court of federal claims has 16
judges, tax court has 19 regular judges .
- The court of federal claims meets in Washington D C while District court meets at a
particular district . Each state has at least one district court and more populous states
have more than one district court.
- Tax court hears only tax cases . court of federal claims and district courts hear non tax
litigations as well . tax court has more expertise in tax matters.
- The only court in which tax payer can obtain jury trial is district court. Juries decide only
on questions of fact and not questions of law . judge decides all issues.
- Before the court of federal claims or district court can have jurisdiction, tax payer must
pay the tax deficiency assessed by the IRS and then sue for refund. If tax payer wins,
the tax paid plus an appropriate interest is recovered. Jurisdiction in tax court is
obtained without first paying the assessed tax deficiency . in the event tax payer loses,
the tax court recovers the deficiency with accrued interest.

Appellate courts

If the IRS loses at trial court level, it need not appeal. The fact that an appeal is not made does
not indicate that the IRS agrees with the result and will not litigate similar issues in the future.

IRS may decide not to appeal for many reasons

- Current litigation load is very heavy and available personnel should be assigned to more
important cases
- IRS may determine that this is not a good case to appeal . for example the tax payer
may be in a sympathetic position
- If the appeal is from district court or tax court , the court of appeals of jurisdiction could
have some bearing on whether the IRS decides to pursue an appeal
Taxation 2 Study Notes Faculty : Mr Chandru Kanaya
BBA 3 MU Finance Chapter 1 Understanding and working with
The Federal Tax Law
The role of an appellate court is limited to a review of the trial record compiled by the trial
court. Thus appellate process involves a determination of whether the trial court applied the
proper law in arriving at its decision. Usually an appellate court will not dispute a lower court
fact finding determination. An appeal can have any number of possible outcomes. The
appellate court may approve ( affirm) or disapprove ( reverse) the lower court findings. It can
also send back the case for further consideration ( remand ). When many issues are involved,
it is not unusual to encounter mixed results. When more than one judge is involved in the
decision making process, disagreement is not uncommon. In addition to the majority view, one
or more judges may agree with the result reached but not with all reasoning or disagree with
the result. Such concurring views can have influences on other courts when composition of
the court has changed even on the same court.

Appealing from Tax court

Tax court is a national court meaning that it hears and decides cases from all parts of the
country. For many years, the tax court followed a policy of deciding cases based on what it
thought the result should be even when decision was appealed differently. Some years ago
this policy changed and now tax courts will decide a case as it feels the law should be applied
only if court of appeals of appropriate jurisdiction has not yet ruled on the case . if court of
appeals of appropriate jurisdiction has previously held squarely , the tax court will conform
even though it may disagree . this policy is known as the Golsen rule.involving similar facts but
different taxpayer.

Tax Research

Tax research is a method used to determine the best available solution to a situation that
possesses tax consequences. In other words, it is the process of finding a competent and
professional conclusion to a tax problem. The problem may originate from either a completed
or a proposed transaction. In the case of a completed transaction, the objective of the research
is to determine the tax result of what has already taken place. For example, is the expenditure
incurred by tax payer deductible or not for tax purposes ? When dealing with proposed
transactions, the tax research process is concerned with the determination of possible
alternative tax consequences . To the extent that tax research leads to a choice of alternatives
or otherwise influences future actions of the tax payer, it becomes the key to effective tax
planning.

Tax research involves the following procedures

- Identifying and refining the problem
- Locating the appropriate tax law sources
- Assessing the validity of tax law sources
Taxation 2 Study Notes Faculty : Mr Chandru Kanaya
BBA 3 MU Finance Chapter 1 Understanding and working with
The Federal Tax Law

- Arriving at a solution or alternative solution while giving due consideration to nontax

factors
- Effectively communicating the solution to the tax payer or tax payer’s representative
- Following up on solution in light of new developments.

Problem identification starts with the compilation of relevant facts involved. All the facts that
might have a bearing on the problem must be gathered as any omission can modify the
solution reached.

Refining a problem – example : before a bad debt deduction can arise, it must be established
that a debt really existed. In a related party setting ( aunty and nephew) the IRS may contend
that the original advance was not a loan but was a gift. Of key significance would be whether
the lender ( aunty) had an honest and real expectation of payment by the borrower (nephew) .
Indicative of this repayment expectation is whether the parties preserved the formalities of the
loan which include
- A written instrument evidencing the obligation
- If loan arrangement provided for interest
- Did the instrument have a specified and set due date
- Was collateral available to lender in the event of default by borrower
The presence of some or all of these formalities does not however guarantee that a bona fide
loan will be found. At the same time, the absence of some or all does not make the advance a
gift.

Locating appropriate tax law sources – once the problem is clearly defined, most tax research
begins with the hard copy or online tax service copy or turn directly to IRC and Treasury
Regulations . If researcher does not have a personal copy of the Internal Revenue Code or
Treasury Regulations, paperback publications can be purchased and can be used twice in
each year.

Assessing validity of tax law sources - It involves a careful interpretation of the tax law , its
relevance and validity. The validity of a treasury regulation is assessed by keeping the
following observations in mind
- In a challenge, the burden of proof is on the taxpayer to show that the Regulation is
wrong. Court may invalidate a regulation that varies from the language of the statute
and has no support in the committee reports
- If tax payer loses the challenge, negligence penalty may be imposed . This shows an
intended disregard of rules and regulations on the part of the taxpayer
- Some regulations clearly reflect the intent of Congress and therefore cannot be
overturned by nature of it being hard and solid .
Taxation 2 Study Notes Faculty : Mr Chandru Kanaya
BBA 3 MU Finance Chapter 1 Understanding and working with
The Federal Tax Law
- Regulations issued pursuant to authority possess the force and effect of law and are
called legislative regulations.

Arriving at alternative solutions

A clear cut answer may not be possible as to a bad debt deduction . The uncertainty does not
detract from the value of the research. Often a guarded judgment is the best possible solution
to a tax problem.

Communicating tax research

Once the problem has been adequately researched, a memo, letter , or a spoken presentation
setting forth the results is required. Whatever form of communication it takes, a good tax
research communication should contain the following elements
- A clear statement of the issue
- In more complex situations, a short review of factual pattern that raises the issue
- A review of the tax law sources
- Any assumptions made for arriving at the solutions
- Solution recommended and logic or reasoning to support it
- References consulted in the research process

Tax Planning

Tax research and tax planning are inseparable. The main purpose of an effective tax planning
is to reduce the taxpayer’s total tax bill. This reduction does not mean that the course of action
selected must produce the lowest possible tax under the circumstances. The minimization of
tax payment must be considered in the context of the legitimate business goals of the
taxpayer.

Components of tax planning

Popular perception of tax planning is often restricted to ‘ defer income and accelerate
deductions”.
Taxation 2 Study Notes Faculty : Mr Chandru Kanaya
BBA 3 MU Finance Chapter 1 Understanding and working with
The Federal Tax Law

Preferable to deferring income is complete avoidance. For example, corporate employee who
chooses non taxable fringe benefits over a fully taxable future pay increase. Complete
avoidance of a gain recognition also occurs when the owner of appreciated property transfers
it by death. Presuming a set up in basis occurs, the built in appreciation forever escapes
income tax.

If recognition of income cannot be avoided, its deferral will postpone income tax
consequences. A tax paid in future costs less than tax paid today because of the time value of
money. Deferral of income can take many forms such as retirement plans put off income tax
consequences until payout period. Deferral of gain recognition can also occur when
appreciated property is transferred to newly formed corporation or a partnership.

In case income cannot be avoided , deferred or shifted , the nature of the gain can be
converted. By changing the classification of property , income tax can be reduced. Thus a tax
payer who transfers appreciated inventory to a controlled corporation has converted ordinary
income property to a capital asset. When the stock is later sold, preferential capital gain rates
apply.

Effective tax planning requires careful consideration be given to choice of entity used for
conducting a business. The corporate form results in double taxation but allows shareholder-
employees to be covered by fringe benefit programs . Partnerships and S Corporations allow a
pass through of losses and other tax attributes but transferring ownership interests as gifts to
family members may be difficult. Question of whether an advance to a corporation is a loan or
a contribution to capital will depend upon the existence of the note payable. How is the
advance listed on the books of account ? What do the corporate minutes have to say about the
nature of the advance ?

Effective tax planning needs consistency on the part of tax payers . A shareholder who treats
corporate distribution as a return of capital cannot later avoid a stock basis adjustment by
contending that the distribution was really dividend.

Conclusively, key components of tax planning include the following :

- Avoiding recognition of income
- Deferring recognition of income
- Converting classification of income to a more advantageous form such as converting a
deduction into a capital gain
- Choosing a business entity with desired tax attributes
Taxation 2 Study Notes Faculty : Mr Chandru Kanaya
BBA 3 MU Finance Chapter 1 Understanding and working with
The Federal Tax Law
Thus , coming back to the example of the bad debt between aunty and nephew , what should
be done to protect the aunty bad debt deduction ?

- All formalities of loan should be present such as a written instrument, a definite and
realistic due date
- On default, the aunt /lender should make a reasonable effort to collect from the
borrower / nephew . If not, the aunt should be in a position to explain why such effort
would be of no avail
- If interest is provided for, it should be paid
- Any interest paid should be recognized as income for the aunt
- Because of annual exclusion of $ 13000 it appears doubtful that the actual interest will
necessitate filing a federal gift tax return by the aunt.
- If no interest is provided for, the nephew should keep track of his net investment
income. This record keeping is important since income that the aunt must recognize is
limited by the amount.

Tax planning is based on validating the advice resulting from tax research. A change in the tax
law be it legislative, judicial or administrative , can alter the original conclusion. Additional
research may therefore become necessary to test the solution in the light of current
developments.

Revenue neutrality :

The term Revenue Neutral implies changes in the tax laws that result in no change in the
amount of revenue coming into the government's coffers. In other words, a tax proposal is
revenue neutral if it neither increases nor decreases tax revenues when compared to existing
law. For instance, a revenue neutral provision may require individuals to pay less tax, but
corporations will pay correspondingly more taxes. The concept was the decisive factor in
drafting the Tax Reform Act of 1986 “whereby provisions estimated to add revenue were offset
by others estimated to reduce revenue, so that on paper the new bill would generate the same
amount of revenue as the old tax laws.”

Revenue neutrality is a fiscal policy tool that can be used to overcome political resistance to an
increase in environmental taxes by seeking to have the same proportional reduction in income
tax, pension contributions or possibly even value-added taxes (VAT), while striving to maintain
a net-zero increase in the overall taxation of the economy