CHAPTER 1: TAX RESEARCH
I.Overview of Tax Research
A.Introduction. Tax research is the process of solving tax-related problems on the basis of
1.The facts presented
2.Current tax law
B.Advantages and Disadvantages. Tax research can be fun depending on:
1.The outcome of the issue involved (i.e. was it resolved in your favor)
2.The amount of experience gained (Tax builds on itself)
C.Types of Client-oriented Research
1.Closed-fact or Tax Compliance Situations - This involves the client contacting the tax advisor after the transaction has occurred. This may be difficult and quite costly because the facts cannot be restricted to obtain more favorable tax results. See Example C1-1.
2.Open-fact or Tax-Planning Situations - In this situation, the client contacts the tax advisor before the transaction has been finalized. This gives the tax advisor more flexibility to structure the transaction to accomplish the client's objectives. See Example C1-2.
II.Steps in the Tax Research Process
A.Introduction. The text list five (5) steps which should be used in tax research. They are as follows:
a.Determine the facts
b.Determine the issue (or question to be resolved)
c.Determine which authorities are applicable
d.Assess and evaluate the authorities and determine which authority is applicable to the facts at hand.
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e.Communicate your conclusions and recommendations to the client (NOTE, you must always communicate with the client -- NEVER ACT WITHOUT APPROVAL)
III.Tax Law Sources.
A.Introduction. The text also gives you a very lengthy discussion of tax law sources. Although I found it quite interesting, I think this was a little "too much for undergraduates to really appreciate." THEREFORE, I WILL ATTEMPT TO SUMMARIZE IT FOR YOU!!!!
B.Internal Revenue Code. The first and the primary tax source is the "INTERNAL REVENUE CODE." Tax practitioners refer to it as the "bible."
1.The code is very detailed and somewhat hard to read, but it covers all phases of tax.
2.Code Has to Be Interpreted. The code lends itself to interpretation even though it is very detailed. This is where "loopholes" come into play.
3.Other Regulations Interpret the Code. Just as the courts interpret the Constitution, there are several sources which has the primary duty of Interpreting the CODE.
a.Treasury Regulations. The first source is "Treasury Regulations." These regulations reflect the Treasury Dept's interpretation of the CODE.
(1)Very Detailed w/Examples. Such regulations are usually very detailed and they include examples to clarify their points. START ON PAGE 1-17
(2)Regulations may be Legislative or Interpretative. As the text states, Treasury Regulations may be either legislative or interpretative.
(A)Legislative. Legislative regulations are the details of the tax law. GET A CODE AND ILLUSTRATE
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(B)Interpretative. Interpretative regulations do as its name suggests. Its primary purpose is to interpret the Internal Revenue Code. LEGISLATIVE REGULATIONS ARE A HIGHER DEGREE OF AUTHORITY.
(3)Treasury Regs. - Proposed, Temporary, or Final. Treasury regulations may also be issued in three forms; Proposed, Temporary and Final Regulations.
(A)Proposed Regulations. Proposed regulations are issued to provide taxpayers with guidance. They are not very authoritative. The public is usually given an opportunity to comment on them.
(B)Temporary Regulations. Temporary regulations are generally issued after a statutory change. The primary function is to give taxpayers guidance until the final reg. THEY HAVE THE SAME POWER AS THE FINAL REGULATION.
(C)Final Regulations. This is the last step. Usually final regulations have the same weight as the CODE unless held invalid by the court.
b.IRS Pronouncements-p. 1-19. The Internal Revenue Service also issues advice on different aspects of the law. The key is this is usually the IRS's view; if a TP has better authority, he can follow his. EXAMPLES OF IRS PRONOUNCEMENTS INCLUDE:
(1)Revenue Rulings. A Revenue Ruling indicates the IRS's position on a certain tax issue. Although this is just their position, it usually has been thoroughly researched.
(2)Revenue Procedures. Revenue procedures are issued to help TP comply with procedural aspects of filing a return. Text gives you an example of procedures being issued on how to report tips.
(3)Letter Rulings. A letter rulings results from a taxpayer's request for advice on some aspect of the tax law.
(A)The TP writes and asks the IRS to explain the consequences of a certain transaction.
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(B)Letter rulings describe how the IRS will treat a certain transaction.
(C)KEY!!- This ruling is binding upon the IRS only with respect to the person requesting it.
C.Federal Court System.
1.Introduction. The text also discusses the Federal Court System. A couple of comments:
a.Two Levels. There are two level to the Federal Court System.
(1)Trial Level. The first is the trial level. It includes US Tax Court, US District Court and US Claims Court.
(A)Tax Court. The Tax Court hears only tax-related cases. claims up to $10,000. The payment of the deficiency is deferred until the case is settled.
(B)US District Court and Claims Court. These courts may hear any type of claim, including tax-related issues. If a district or claims court is used, the taxpayer must first pay the deficiency and then sue for a refund.
b.Appeals Court. After the trial level, either the taxpayer or the IRS may appeal the case. The first level of appeal is to the US Court of Appeals; the final appeal is to the Supreme Court.
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CHAPTER 2: FORMATION OF THE CORPORATION
I.Organization Forms
A.Introduction. There are several forms a business may adopted when it is started depending on the needs of the investors.
1.This text lists for of the more common ones with their advantages and disadvantages.
B.Sole Proprietorship. As the text states, a sole proprietorship is a business owned by one person.
1.Characteristics. The following are some characteristics of a sole proprietorship.
a.The owner is directly and solely liable for any consequences of the business
b.The owner may be sued directly as it relates to the business activity.
2.Advantages of a Sole Proprietorship. The advantages of a sole proprietorship are:
a.The business itself is not subject to tax. All income is taxed to the owner at his tax rates.
b.The owner can contribute money to, or withdraw money from the business without tax consequences.
c.Losses can be used to offset income from other sources such as income, dividends and interest.
3.Disadvantages of a Sole Proprietorship. The disadvantages of a sole proprietorship are:
a.All profits are taxed to the owner when they are earned even if they are not distributed.
b.A sole proprietor is considered an employee of the business therefore he must pay self-employment taxes based on the income of the business, NOT THE SALARY HE DRAWS.
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c.Generally tax-exempt fringe benefits (e.g. premiums on accident, health and group life insurance) are not available to the sole proprietor.
(1)Note there are several exceptions under Section 162(l) of the Internal Revenue Code - See Note 1 on page 2-3.
C.Partnership. A partnership is an activity or business carried on by two or more people for profit.
1.Characteristics. The following are some characteristics of a partnership;
a.Partnerships can be formed formally or informally
b.A partnership is not taxed. Income passes through to individual partners.
c.Generally, each partner is jointly and severally liable for the acts of the other partners.
d.A partnership must file a tax return (Form 1065) to report the results of their operations:
(1)Each partner must be sent a copy so that he or she can report their applicable income.
2.Example 2-3. Taxpayer is single and owns 50% of Partnership. Profits for the year are $30,000. Taxpayer is in 36% tax bracket.
a.Results. Taxpayer will pay $5,400 in taxes (i.e. 30,000 x .50 x .36).
(1)Taxpayer must pay even if the company does not distribute the money to him.
3.Advantages of Partnership.
a.The partnership itself is exempt from taxation. All income is reported at the partner level.
b.Profits are taxed only when they are earned.
c.Losses can be used to offset income from other sources.
4.Disadvantages of Partnership.
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a.Profits are taxed when earned even if they are not distributed.
b.A partner is not considered to be an employee of the partnership. THUS partners must pay self-employment taxes on their share of self-employment income.
c.Tax exempt benefits usually are not available to the partners (e.g. premiums paid on accident and health insurance and group term life insurance.
(1)If paid by the partnership on behalf of the partner, the payments will be taxable to the partner.
d.Usually the partnership must use a fiscal year for reporting which will coincide with the partners reporting (THEREFORE NO DEFERRAL OF INCOME)
D.Corporations.
1.Types of Corporations. Corporations are divided into two (2) types - "C" Corporation and "S" Corporations.
2."C" Corporation.
a.Characteristics. The following are characteristics of a "C" Corporation.
(1)It is a separate taxing entity.
(2)It can sue or be sued.
(3)It must report all of its income or losses on Form 1120 (US Corporation Income Tax Return)
(4)Shareholders are not taxed on corporate earnings unless they are distributed as dividends.
(5)Income is taxed twice;
(A)First at the corporate level
(B)Then to shareholders when it is distributed as dividends
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b.Example. Taxpayer owns 100% of Corporation Stock. Corporation has taxable income of $50,000.
(1)Corporation pays tax at 15% for first $50,000 thus it pays $7,500.
(2)If no money is distributed to taxpayer, he has no tax obligation.
(3)Assume Distribution. If Corporation distributes the income to taxpayer, then taxpayer must pay taxes (e.g. $50,000-7,500 or 42,500 in taxable income)
(A) Total tax liability assuming taxpayer is in 36% bracket:
TP Tax 42,500 x .36 = 15,300
Corporate Tax 7,500
TOTAL 22,800
c.OTHER KEY POINT. There may be double taxation even if a corporation does not distribute its earnings.
(1)Profits are taxed when earned
(2)Profits may be taxed when shareholder sells his stock or corporation is liquidated.
(3)Example. Taxpayer purchases all of Corporate stock for $60,000. Corporation has taxable income of $50,000 and pays $7,500 in taxes. Corporation does not distribute to Taxpayer
(A)Assume Taxpayer sells his stock for $102,500.
Results: Taxpayer must report a gain of $42,500 (i.e. 102,500-60,000)
d.Advantages of a Corporation.
(1)Corporate tax rates start at 15% therefore its rates may be lower than those of shareholders.
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(2)Shareholders who are employed by their own corporation are treated as employees for tax purposes. THEREFORE;
(a)SHAREHOLDERS CAN RECEIVE DEDUCTIBLE SALARY PAYMENTS
(b)SHAREHOLDERS MAY BE ENTITLED TO TAX-FREE FRINGE BENEFITS
(c)A CORPORATION MAY USE A FISCAL OR CALENDAR YEAR FOR REPORTING PURPOSES (this may allow the taxpayer to defer recognition of income)
C."S" Corporation.
1.Characteristics. An "S" Corporation is a special corporate form. Some of its key characteristics include the following:
a."S" Corporation pays no taxes. It is a "pass through" entity because the taxes are assessed to the shareholders.
b.Shareholders have "limited liability"
2.Example. Taxpayer owns 50% of Corporation Stock. Corporation reports net income of $30,000. Taxpayers marginal tax rate is 36%.
Conclusion. Taxpayer will pay taxes on $15,000 of income (i.e. 30,000 x .50). Taxpayer's taxes on the $15,000 will be $5,400 (i.e. 15,000 x .36)
3.Advantages of "S" Corporation.
a.Corporation generally exempt form taxation. Shareholders pay taxes.
b.Losses flow through to shareholders and can be used to offset income earned from other sources.
c.Shareholders generally can contribute money to or withdraw money from an S Corporation without tax consequences.
d.Profits are taxed only when they are earned.
4.Disadvantages of "S" Corporation.
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a.All of the corporation's profits are taxed to the shareholder (even if not distributed)
b.Tax-free corporate fringe benefits generally are not available to shareholders who are also employees.
c.Generally, no deferrals are allowed when the S Corporation's fiscal year is different from that of the taxpayer.
D.Limited Liability Companies. An LLC combines the features of a partnership and a corporation. It is taxed like a partnership, but provides the limited liability of a corporation.
1.Its owners are called "members".
2.This entity may elect to be taxed as a corporation or partnership. If it elects partnership status, it must file a Form 1065.
E.Limited Liability Partnerships. Under this form, partners are liable for their own acts and the acts of individuals under their direction. Other partners are not liable for the negligence and misconduct of other partners.
D.Characteristics of a Corporation
1.Must have associates (i.e. shareholders)
2.An objective to carry on a business
3.Continuity of Life (i.e. death, insanity, etc. will not dissolve business).
4.Centralized Management (Persons who have responsibility of making decisions).
5.Limited Liability
6.Free Transferability of Interest
E.Distinguishing between Partnership and Corporation. The key differences are items 3-6 above.
II.Legal Requirements for Forming a Corporation.
A.A minimum amount of capital
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B.Filing the Articles of Incorporation. Must contain:
1.Name of Corporation
2.Purpose of Corporation (THIS IS NOT REQUIRED ANYMORE)
3.Amount and type of stock authorized
4.Name of individuals on the Board of Directors
5.Name of Initial Incorporator
III.Tax Considerations in Forming a Corporation.
A.Generally. When a corporation is formed certain key things usually happens: For example
1.Assets are transferred to the corporation in exchanges for Stock or assumption of a liability.
a.Types of Assets Transferred. Assets transferred would include things such as (1) cash, (2) equipment, (3) supplies
2.Transfer May Be Taxable. The key question is "will the transfer be taxable currently."
a.Depends. The answer is it depends on the type of transfer.
1.Generally an exchange of stock for assets is current taxable event.
2.If it falls under Section 351 of the Code it is said to be a nontaxable transfer. This is misleading. What it really is a postpone of any gain recognition.
B.Example of a Taxable and Nontaxable Asset Transfer.
1.Example 2-10. Taxpayer operated a sole proprietorship. He decides to form a corporation and transfer everything in the sole proprietorship as follows:
Adj Basis FMV
Assets:
Cash 10,000 10,000
A/R 15,000 15,000
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Inventory 20,000 25,000
Equipment120,000
Minus Depr:<35,000> 85,000 100,000
Total 130,000 150,000
Liabilities & Equity:
A/P 30,000 30,000
Notes Payable 50,000 50,000
Owners' Equity 50,000 70,000
Total 130,000 150,000
2.Analysis. If all assets and liabilities are transferred taxpayer recognizes $5,000 gain on inventory (25,000-20,000) and a $15,000 gain on equipment (100,000-85,000). IF IT MEETS THE TEST OF SECTION 351 ALL THE GAIN WILL BE DEFERRED TO A LATER DATE.
GOOD OVERVIEW ON PAGE 2-11
IV.Section 351: Deferred Gain or Loss Upon Incorporation
A.General Rule. The rule under 351(a) states "no gain or loss is recognized when property is transferred to a corporation in exchange for the corporation's stock, provided that, immediately after the exchange, the transferors are in control of the corporation.
1.Rationale for the Rule. The rationale for this rule is the owner is merely exchanges ownership in one form for ownership in another form.
2.What Happens if Cash or Other Assets are Received. If the transferor receive something other than stock (e.g. stock or securities), he may be required to recognize some or all of the gain.
3.This is Merely a "Deferral" of Gain. NOTE, although the gain is not currently recognized, it will be recognized when the transferor sells or exchanges the stock.
4.Shareholder Must Adjust their Basis in the Stock. A shareholder receiving stock must adjust his basis in the investment to reflect the deferred gain or loss.
a.How is this Done. The basis is adjusted as follows:
FMV of Investment - Deferred Gain
+ Deferred Loss
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b.Example. Look at Prior Example 2-9. The $20,000 recognized gain is deferred until a later date. Taxpayer must adjust his basis in the investment as follows:
70,000 (FMV) - 20,000(Def. Gain) = 50,000
B.Specific Requirements of Section 351(a).
1.Three Requirements. There are three (3) specific requirements for 351(a) to apply. They are:
a.The property must be transferred to the corporation in an exchange transaction.
b.The transferor of the property must be in "control" of the corporation immediately after the exchange.
c.The transferors must receive stock of the transferee corporation in exchange for their property.
2.Requirement 1: Property Requirement.
a.In General. The courts and government have broadly defined what property is, but there are several things which are not considered property including;
(1)Services received in exchange for stock (such as legal or accounting services)
Such an amount will be taxable to the person receiving it but his basis in the stock will be FMV.
(2)Indebtedness of the transferee corporation that is not evidenced by a security.
(3)Interest on an indebtedness of the transferee corporation that accrued on or after the beginning of the transferor's holding period for the debt??????
b.Example. Amy and Bill form Corporation. Amy exchanges cash and other property for 90% of the stock; Bill performs accounting services for 10% worth $10,000.
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Analysis. Amy's transaction is nontaxable. Bill's transaction is taxable "immediately" Bill basis in his stock will be FMV or $10,000.
2.Requirement 2: Control Requirement.
a.Rule. The rule is very specific: Section 351 requires the transferors to be in control of the transferee corporation immediately after the exchange.
1.Types of Transferors. A transferor can be any type of tax entity including (1) an individual, (2) a partnership, (3) another corporation, etc.
b.Control Defined. The term "control is defined under Section 368(c) of the Code. Control is defined as ownership of;
(1) at least "80%" of the total combined voting power of all classes of stock entitled to vote and;
(2)at least "80%" of the total number of shares of all other classes of stock (e.g. nonvoting preferred stock).
c.Example 2-12. Dan exchanges property with adjusted basis of $22,000 and FMV of 30,000 to new corporation for 60% of stock. Ed exchanges $20,000 cash for 40% of stock in new corporation.
Conclusion. Section 351 has been met because Dan and Ed together own more than 80% of the stock immediately after the transfer.
d.Example 2-13. Dana exchanges property having adjusted basis of 18,000 and FMV basis of 35,000 for 70 shares of stock. Ellen exchanges legal services for the other 30 shares. Legal services are valued at 15,000.
Conclusion. Only Dana's property is counted for the control test because Ellen transferred services which are excluded under Section 351.
(1)Dana's Consequences. Dana does not meet the control requirement because she only owns 70% of the stock.
(A)Dana must recognize $17,000 in gain (i.e. 35,000 FMV - 18,000 A/B)
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