Homework 1

Chapter 1: UNDERSTANDING AND WORKING WITH THE FEDERAL TAX LAW

QUESTIONS :

Question 1 List some tax provisions that encourage particular industries

Answer 1

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).
  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
Question 2 . List 3 tax provisions that can be justified by social consideration ?

Answer 2 :

Some provisions of the Federal Tax Laws , particularly those dealing with the Income Tax of

Individuals , can be explained by social considerations .

1. Certain benefits provided to employees through accident and health plans financed by

employers are non taxable to employees. Encouraging such plans is considered as

socially desirable because they provide medical benefits in the event of an employee’s

illness or injury .

2. Most premiums paid by the employer for group term insurance covering the life of the

employee are non taxable to the employee . These arrangements can be justified on social

grounds in that they provide funds for the family unit to help it adjust to the loss of wages

caused by the employee’s death .

3. A tax credit is allowed for amounts spent to furnish care for certain minor or disabled

dependents to enable the taxpayer to seek or maintain gainful employment. For those

employees who do not choose home care for their children, the employers are allowed a

credit for child care provided at the workplace. No one would deny the social desirability

of encouraging tax payers to provide care for their children while the employees are

working.
Question 3 . What purpose is served by refundable earned income credit ?

Answer 3 .

The primary purpose of taxes is to fund the government to meet various social and economic

goals regarding national security, economic stability, income distribution, poverty alleviation and

an efficient allocation of resources. The activities directed to the lower income individuals and

families typically involve grants or transfer payments which are often means-tested. The Earned

Income Tax Credit is a financial boost for people working hard to make their ends meet. It varies

based on the income, filing status and the family size of the tax payers. The Earned Income Tax

Credit encourages work among low income individuals with children. Earnings include wages

and salaries as well as self-employed income but does not include income that is not connected

with employment. A $1 of tax credit reduces the tax liability by $1 . A tax deduction of $1 will

reduce the taxable income by $1 but reduces the tax liability by a marginal rate times $1. For

example an additional $1 deduction for a tax payer in a 10% tax bracket reduces the tax liability

by 10 cents and a tax payer in 39.6% tax bracket would have the tax liability reduced by 39.6

cents . With a refundable tax credit, if a tax payer were to have $ 100 in tax liability and $ 200 in

refundable tax credit , then the tax payer would receive a tax refund of $ 100. The essence of

amount of credit first increases as earnings increases , reaches a plateau and then falls as earnings

increase. For example , for a couple with 2 children , credit is 40% of the first $ 13,090 in

earnings . A maximum credit of $ 5,236 is received by the tax payer with earnings between $

13,090 to $ 22,300. Credit phases out at 21.06% ( means it reduces by 21.06 cents per every

additional $ 1 earning ) for earnings over 4 22,300 and is zero for tax payers earning in excess of

$ 47,162. In order to claim the Earned Income Tax Credit, the tax payer must file the six line

Schedule EIC along with his/her tax return . The schedule provides complete information on
each of the qualifying child . Form 1040, 1040A or 1040 EZ is filed respectively by tax payer

depending on his/her filing status and status of qualifying dependents. In conclusion, the Earned

Income Tax Credit , which was made permanent by the Revenue Act of 1978, is considered both

an anti poverty program and an alternative to welfare because it incentivized work and since it is

work oriented , the amount of credit is based on earnings.

Question 4: What purpose is served by allowing a deduction for charitable contribution ?

Answer 4 :

The deduction for charitable contribution attempts to shifts some of the financial and

administrative burden of socially desirable programs from public ( the government) to the private

( the citizen) sector. Private citizens get the opportunity to help the less fortunate and with

December being a great month for many charities , it also prepares the tax payer for a tax season

where the tax payer can deduct qualified charitable contributions on his/her taxes . Private

citizens or concerns can contribute to an organization which is on the Internal Revenue Service’s

list of qualified charities or religious groups. Deductions are claimed under Schedule A Line 16

for cash donations made to qualified charities . Schedule A Line 17 overs non cash donations in

the form of clothing and household goods . In case the non cash donation is in excess of $ 500

the specifications of such donations are made separately by filling Form 8283. Schedule A Line

18 refers to donations which were done in previous year which could not be claimed as a

deduction owing to income limitations. Private tax payers are able to perform a tax planning

exercise by calculating whether it is more suitable for them to claim standard deduction instead

of using Schedule A to itemize their deductions . If the total deduction from Schedule A does not

add up to more than the amount of standard deduction permissible for the applicable filing status

of the tax payer ,

Question 5 : What is the reason for the disallowance of certain fines and penalties ?

Answer 5

Tax deductions claimed by tax payers for certain expenditures that are deemed to be contrary to

public policy are disallowed under the federal tax laws. Section 162(a) of the Internal Revenue

Code allows for the tax payers to deduct ordinary and necessary expenses paid or incurred, in

carrying on trade or business , from their gross income . Tax payers who engage in illegitimate

or illegal business activities and claim Section 162 deductions for expenses are disalloerd the

deduction under the violation of public policy.

Section 162 ( c ) (1) covers illegal bribes, kickbacks to domestic government official or agency

Section 162 (f) covers fines paid to the government for violating the law

The Internal Revenue Service charges interest to tax payers for delayed payment of their taxes,

penalties are levied on tax payers for claiming false deductions, for valuation misstatement

declarations, for negligence or disregard of tax laws by underpayment of taxes or for non

compliance with the tax codes.

Additionally Section 280 ( E) prevents the tax payer from taking deductions relating to business

of selling illegal controlled substances such as illicitly used drugs or prescription medications

that are designated as controlled drugs .

Public policy consideration is also used to disallow gambling losses in excess of gambling gains

and political campaign expenditures which are in excess of the permissible campaign

contributions . Social considerations dictate the tax laws to be enforced in a manner so that by

virtue of disallowing such deductions, activities defying public policy are discouraged by law.
Question 6 : What is the justification for the favorable treatment of home ownership ?

Answer 6 :

The Federal Government has a significant impact on the ability of the American households to

achieve home ownership and on the incentives for households to choose home ownership over

rental housing. Home ownership is backed by equity considerations on two grounds ;

a) Economic : As an economic consideration , home ownership stimulates the development

and rehabilitation of low income housing benefits by constructing such dwellings The

Tax Reforms Act of 1986 constructed a tax policy for deductibility of home mortgage

interest and property taxes from taxable incomes. The US Department of Housing and

Urban Development Section 235 and Farmers Home Administration Section 502

Programs provided for low rate mortgages to low income households to purchase homes

and to subsidize home ownership.

b) Social : The Cranston-Gonsalez National Affordable Housing Act enacted in 1990 set

forth home ownership as an objective to fulfill the national housing goal which is that

every American family should be able to afford a decent home in a suitable living

environment . The national housing policy aimed at :

- Ensuring that every resident of the US has access to decent shelter or assistance in

avoiding homelessness

- Increase nation’s supply of decent housing affordable to low income and moderate

income families

- Improve housing opportunities for disadvantaged minorities on non discriminatory

basis
 - Make neighborhoods safe and livable

- Provide the American community with readily available mortgage finance at lowest

possible interest rates

- Encourage tenant empowerment and improve self sufficiency.

The tax and credit programs thus evolved into support for house ownership Arguments could

also be made to the contrary looking at the market prices , allocations and tax considerations

which would render it ineffective . At the same time one cannot take away the encouragement

that home ownership can provide to young individuals who are freshly entering the work force

and on non neutral grounds would enjoy a wide public support for first time home buyers to be

awarded grants by the government to enhance their social goal and build their confidence.

Question 7 What is the justification for the various credits , deductions and exclusions that are

designed to encourage taxpayers to obtain additional education ?

Answer 7

Tax credits are available to help individuals to off set the cost of higher education by reducing

the amount of income tax. The Federal tax system provides incentives in the form of credits and

deductions to tax payers who desire to have access to higher education for their dependents and

for themselves with affordable and beneficial options and alternatives. Here below is a

description of each of the following credits examining its individual salient features that would

encourage taxpayers to plan education :

a) American Opportunity Tax Credit : This is a partially refundable tax credit which helps

students and families to pay for the first your years of post secondary education . The

objective of this tax credit is to cover 2/3rd of the cost of tuition at an average public
 college or university and make tuition completely free by qualifying for a $ 4,000

refundable credit in exchange for 100 hours of community service in a government unit ,

hospital or 501 ( c) 3 organization which are non profit making organizations that are

exempt from federal income tax . These organizations are charitable , religious,

educational, scientific , literary , prevention of cruelty to children and animals,

organizations that foster amateur sports competitions and testing for public safety .  The

eligibility of maximum tax credit that is available for each eligible student is $2,500

which covers the cost of tuition, fees and course materials paid during the taxable

year. Also, 40% of the credit (up to $1,000 per eligible student ) is refundable. This

means that the tax payer can obtain the refund even if he/she owes no tax. For the

American opportunity tax credit, qualified expenses have been expanded to include

expenditures for course materials, as well as tuition and required fees. For this purpose,

the term "course materials" means books, supplies and equipment needed for a course of

study whether or not the materials are purchased from the educational institution as a

condition of enrollment or attendance. Some or all of these expenses will be recorded

on Form 1098-T, Tuition Statement. The student should receive a Form 1098-T from the

educational institution that the student attended. If the student does not receive a Form

1098-T, the student should contact the educational institution and request the form. An

expenditure for a computer would qualify for the credit if the computer is needed as a

condition of enrollment or attendance at the educational institution.

b) Lifetime Learning Credit :

Life time learning credit helps the tax payers to offset the cost of higher education. The credit

does so by reducing the income tax owed by individuals paying for certain college related
expenses. In other words, unlike a deduction, which reduces the amount of income subject to tax,

a credit directly reduces the tax itself . For the tax year, the tax payer may be able to claim a

lifetime learning credit of up to $2,000 for qualified education expenses paid for all eligible

students. There is no limit on the number of years the lifetime learning credit can be claimed for

each student. The lifetime learning credit is a non refundable credit. This means that it can

reduce the tax payer’s tax to zero, but if the credit is more than the tax payer’s tax the excess

will not be refunded to him/her . The allowable lifetime learning credit may be limited by the

amount of the income and the amount of the tax of the tax payer. For each student, the tax payer

can elect for any year only one of the credits. For example, if the tax payer elects to claim the

lifetime learning credit for a child on his/her 2014 tax return, then he/she cannot, for that same

child, also claim the American opportunity credit for 2014.

  If the tax payer is eligible to claim the lifetime learning credit and also eligible to claim the

American opportunity credit for the same student in the same year, the tax payer can choose to

claim either credit, but not both.   If the tax payer pays qualified education expenses for more

than one student in the same year, he/she can choose to claim certain credits on a per-student,

per-year basis. This means that, for example, the tax payer can claim the American opportunity

credit for one student and the lifetime learning credit for another student in the same year. For

purposes of the lifetime learning credit, qualified education expenses are tuition and certain

related expenses required for enrollment in a course at an eligible educational institution. The

course must be either part of a postsecondary degree program or taken by the student to acquire

or improve job skills.    An eligible educational institution is any college, university, vocational

school, or other postsecondary educational institution eligible to participate in a student aid

program administered by the U.S. Department of Education. It includes virtually all accredited
public, nonprofit, and proprietary (privately owned profit-making) postsecondary institutions.

The educational institution should be able to tell you if it is an eligible educational institution.

An eligible educational institution is any college, university, vocational school, or other

postsecondary educational institution eligible to participate in a student aid program

administered by the U.S. Department of Education. It includes virtually all accredited public,

nonprofit, and proprietary (privately owned profit-making) postsecondary institutions. The

educational institution should be able to tell you if it is an eligible educational institution. These

include the work study programs, Federal grants and Federal loan programs. The tax payer can

claim a lifetime learning credit for qualified education expenses paid with the proceeds of a loan.

He/she can use the expenses to figure the lifetime learning credit for the year in which the

expenses are paid, not the year in which the loan is repaid. The tax payer can therefore treat loan

disbursements sent directly to the educational institution as paid on the date the institution credits

the student's account.

c) Coverdell Education Savings Account :

The Coverdell Education Savings Account is a tax advantaged investment designed to encourage

savings to cover future education expenses ( elementary, secondary or college ) such as tuition

books, uniform etc.  For 2014, the total of all contributions to all Coverdell ESAs set up for the

benefit of any one designated beneficiary cannot be more than $2,000. Contributions to a

Coverdell ESA are not deductible, but amounts deposited in the account grow tax free until

distributed.   If, for a year, distributions from an account are not more than a designated

beneficiary's qualified education expenses at an eligible educational institution, the beneficiary

will not owe tax on the distributions To be treated as a Coverdell ESA, the account must be
designated as a Coverdell ESA when it is created. The document creating and governing the

account must be in writing and must satisfy the following requirements:

1. The trustee or custodian must be a bank or an entity approved by the IRS.

2. The document must provide that the trustee or custodian can only accept a contribution

that meets all of the following conditions.

a. The contribution is in cash.

b. The contribution is made before the beneficiary reaches age 18, unless the

beneficiary is a special needs beneficiary.

c. The contribution would not result in total contributions for the year (not including

rollover contributions) being more than $2,000.

3. Money in the account cannot be invested in life insurance contracts.

4. Money in the account cannot be combined with other property except in a common trust

fund or common investment fund.

5. The balance in the account generally must be distributed within 30 days after the earlier

of the following events.

a. The beneficiary reaches age 30, unless the beneficiary is a special needs

beneficiary.

b. The beneficiary's death.

The qualified education expenses are the expenses required for the enrollment or attendance of

the designated beneficiary at an eligible educational institution. For purposes of Coverdell ESAs,

the expenses can be either qualified higher education expenses or qualified elementary and

secondary education expenses. Eligible elementary or secondary school is any public, private, or

religious school that provides elementary or secondary education (kindergarten through grade

12), as determined under state law. Eligible post secondary school is any college, university,

vocational school, or other postsecondary educational institution eligible to participate in a

student aid program administered by the U.S. Department of Education. It includes virtually all

accredited public, nonprofit, and proprietary (privately owned profit-making) postsecondary

institutions. The educational institution informs the tax payer if it is an eligible educational

institution.

Question 8 In mitigating the effect of the double taxation of income at the Federal level, what

relief does a deduction for state income taxes paid provide ? Would a credit be preferable ?

Answer 8

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 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 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).

Owners of C corporations who wish to reduce or avoid double taxation have several

strategies they can follow:
1. Retain earnings. ...
2. Pay salaries instead of dividends. ...
3. Employ family. ...
4. Borrow from the business. ...
5. Set up a separate flow-through business to lease equipment or property to the C
corporation.

Problem :

Bart exchanges some real estate (basis of $800,000 and fair market value of $1 million) for

other real estate owned by Roland (basis of $1.2 million and fair market value of $900,000) and

$100,000 in cash. The real estate involved is unimproved and is held by Mary and Roland,

before and after the exchange, as investment property.

a. What is Bart's realized gain on the exchange? Recognized gain?

b. What is Roland's realized loss? Recognized loss?

c. Support your results in (a) and (b) under the wherewithal to pay concept as applied to like-

kind exchanges (s 1031)

Answer a )
Bart has a realized gain of $200,000

-Bart's recognized gain is limited to the lesser of realized gain of $200,000 or the other property

(boot) received of $100,000. Thus, the recognized gain is limited to other property (boot)

received of $100,000 [the amount of cash (boot) received by Bart]. § 1031

b. Roland has a realized loss of $300,000,

None of Roland's realized loss can be recognized.

c. Under the wherewithal to pay concept, forcing Bart to recognize a gain of $100,000 makes

sense. Because of the $100,000 cash received, not only has Bart's economic position changed,

but he now has the means to pay the tax on the portion of the realized gain that is recognized.

The disallowance of Roland's realized loss is consistent with the usual approach of the

wherewithal to pay concept. Not only is this the price that must be paid for tax-free treatment,

but also a carryover basis and adjustment under § 1031(d) prevents a deterioration of Roland's

tax position. Note: After the exchange, Roland has a basis of $1,300,000 in the real estate

received from Bart [i.e., $1,200,000 (basis in the real estate given up) + $100,000 (cash given

up)].