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 Co ntents ~ Individua l s v ii

Co mpliance and Procedura l Consideratio ns 9-47 Inventories 11-11

Substa ntiati ng Travel and Entertainment Expenses 9-4 7 Determination of Inventory Cost 11-1 1
Reporting Employee Business Expenses 9-47 Special Accounting Methods 11-15
Reporting Office in Home Expenses 9-48 Long-Term Contracts 11-15
Qualification of Pension and Profit-Sharing Plans 9-48 Install ment Sales Met hod 11-17
Prob le m Materia ls 9-51 Deferred Payment Sales 11-21
Discussion Questions 9-51 Imputed Int erest 11-22
Issue Identification Questions 9-53 Imputed Interest Computation 11-23
Problems 9-54 Accrual of Interest 11-23
Comprehensive Problem 9-61 Gift, Shareholder, and Other Loans 11-24
Tax Strategy Problem 9-62
Change in Account ing Methods 11-25
Tax Form/Return Preparation Problems 9-62
Amou nt of Change 11-26
Case Study Problems 9-63
Reporting the A1nou nt of t he Change 11-27
Tax Research Problem 9-64
Obtaini ng IRS Consent 11-27
CHAPTER 10 Tax Planning Considerat ions 11-28
... DEPRECIATION, COST RECOVERY, AMORTIZATION, ANO Accounting Periods 11-28
DEPLETION 10-1 Accounting Methods 11-28
Install ment Sales 11-28
Depreciatio n and Cost Reco very 10·2
Genera l Considerations 10-2 Compl iance and Procedural Considerat ions 11-28
Depreciation Methods 10-4 Reporting Installment Sales on Form 6252 11-28
Calculation of Depre.ciation 10-5 Procedures for Changing to LIFO 11-30
MACRS Restrictions 10-12 Problem Materials 11 -30
Amortization 10-17 Discussion Questions 11-30
Sec. 197 Intangibles 10-17 Issue Identification Questions 11-31
Research and Experimental Expenditures 10-19 Problems 11-32
Computer Software 10-20 Comprehensive Problem 11-34
Depletion, Intangi ble Drilli ng and Develop ment Tax Strategy Proble1ns 11-35
Tax Form/Return Preparation Problem 11-35
Costs 10· 21
Case Study Problems 11-35
Depletion Methods 10-22
Tax Research Problems 11-36
Treatment of Intangible Drilling and Development
Costs 10-23
Tax Planning Consi derations 10-24 C H APT E R 1 2
... PROPERTY TRANSACTIONS: NONTAXAflLE
Alternative Depreciation System Under
MACRS 10-24 EXCHANGES 12-1
Use of Units of Production Depre.ciation 10-24 Like-Kind Exchanges 12·2
Structuri ng a Business Combination 10-24 Like-Kind Property Defined 12-2
Compliance a nd Procedural Considerat ions 10-25 A Direct Exchange Must Occur 12-4
Reporting Cost Recovery, Depreciation, Depletion, and Three-Party Exchanges 12-4
A1nortization Deductions 10-25 Receipt of Boot 12-5
Basis of Property Received 12-6
Prob le m Materials 10-28
Exchanges Benveen Related Parties 12-7
Discussion Questions 10-28
Transfer of Non- Like-Kind Property 12-8
Issue Identification Questions 10-30
Holding Period for Property Received 12-8
Problems 10-30
Comprehensive Problem 10-35 Involuntary Co nversions 12·9
Tax Strategy Problem 10-36 Involuntary Conversion Defined 12-10
Tax Form/Return Preparation Problems 10-36 Tax Treatment of Gai n Due to Involuntary Conversion
Case Study Problems 10-37 into Boot 12-10
Tax Research Problem 10-37 Replacement Property 12-12
Obtaini ng Replacement Property 12-13
CHAPTER 11 Time Requirements for Replacement 12-14
... ACCOUNTfNG PERIODS ANO METHODS 11-1 Sa le of Principal Residence 12-15
Accounting Periods 11·2 Principal Residence Defined 12-16
Required Payments a nd Fiscal Years 11-3 Sa le of More than One Principal Residence Within a
Changes in t he Accou nting Period 11-4 Two-Year Period 12-17
Returns for Periods of Less than 12 Months 11-5 Nonqualified Use After 2008 12-19
Involuntary Conversion of a Principal Residence 12-20
Overall Acco unt ing Method s 11· 7
Cash Receipts and Disbursements Method 11-7 Tax Planning Considerat ions 12-20
Accrual Method 11-9 Avoiding the Like-Kind Exchange Provisions 12-20
Hybrid Method 11-10 Sa le of a Principal Residence 12-21
viii Individuals .,.. Contents
Co mpliance and Procedura l Consideratio ns 12· 22
Reporting of Involuntary Conversions 12-22
Reporting of Sa le or Exchange of a Principal
Residence 12-23
Problem Mat eria ls 12·23
Discussion Questions 12-23
Issue Identification Questions 12-24
Problems 12-25
Comprehensive Problem 12-29
Tax Strategy Problem 12-29
Tax Form/ Return Preparation Problems 12-30
Case Study Problem 12-31
Tax Research Problems 12-31
CHA PTER 13
... PROPERT Y TRANSACTIONS: SECTION 1231 AND
RECAPTURE 13-1
H istory of Sec. 1231 13-2
Overview of Basic Tax Treatment for Sec. 1231 13·3
Net Ga ins 13-3
Net Losses 13-3
Tax Rate for Net Sec. 1231 Gain 13-4
Section 1231 Property 13·5
Section 1231 Property Defined 13-5
Real or Depreciable Property Used in Trade or
Busi ness 13-5
Involu ntary Conversions 13-6
Condemnations 13-6
Other Involuntary Conversions 13-7
Proced ure for Sec. 1231 Treatment 13·7
Recapture Provisions of Sec. 1245 13-8
Purpose of Sec. 1245 13-9
Recapture Provisions of Sec. 1250 13·10
Purpose of Se.c. 1250 13-11
Section 1250 Property Defined 13-11
Unrecaptured Section 1250 Gain 13-12
Taxation of Gains on Sale or Exchange of Depreciable
Real Property 13-12
Low-Income H ousing 13-15
Add itio nal Recapture for Co rpo rat ions 13-16
Su,nmary of Secs. 1231, 1245, and 1250 Ga ins 13-17
Recapture Provisions-Other App lications 13·18
Gifts of Property Subject to Recapture 13-18
Transfer of Property Subje.c t to Recapture at
Death 13-18
Charitable Contr ibutions 13-18
Like-Kind Exchanges 13-19
Involu ntary Conversions 13-19
Installment Sa les 13-19
Section 179 Expensing Election 13-20
Conservation and Land Clearing Expenditures 13-20
Intangible Drilling Costs and Depletion 13-21
Gain on Sale of Deprecia ble Property Between Related
Parties 13-22
Tax Planning Considerations 13·23
Avoiding the Recapture Provisions 13-23
Compliance and Procedura l Considerations 13·24
Reporting Sec. 1231 Gains and Losses on Form
4797 13-24
Reporting Gains Recaptured as Ordinary Income on
Form 4797 13-24
Reporting Casualty or Theft Gain or Loss on Form
4684 13-24
Problem Materials 13·28
Discussion Questions 13-28
Issue Identification Q uestions 13-29
Problems 13-30
Comprehensive Problem 13-35
Tax Strategy Problems 13-35
Tax Form/Return Preparation Problems 13-36
Case Study Problems 13-36
Tax Research Problem 13-37
CHAPTER 14
... SPECIAL TAX COMPUTATION MET HODS, TAX CREDITS,
ANOPAYMENT OFTAX 14-1
Alternative Minimum Tax 14·2
AMT Computation 14-3
AMT Tax Rates and Brackets 14-3
AMT Exemption Amount 14-3
AMT Tax Preference Items 14-4
AMT Adj usnnents 14-4
AMT Credits 14-6
Summary Illustration of the AMT
Computation 14-7
Self-Employment Tax 14-8
What Constitutes Self-Employment Income 14-9
Perso nal and Business Tax Credits 14· 10
Use and Importance of Tax Credits 14-10
Value of a Credit Versus a Deduction 14-10
Nonrefundable Personal Tax Credits 14-11
Foreign Tax Credit 14-17
Business Related Tax Credits 14-19
Refundable Personal Credits 14-23
Provisions Related to Healt h Insurance 14-24
Health Insurance Premium Assistance Credit (Also
Known as Premiu m Tax Credit) 14-24
Payment of Taxes 14-26
Withholding of Taxes 14-27
Estimated Tax Payments 14-28
Tax Planning Considerat ions 14-30
Avoiding the Alternative Minimum Tax 14-30
Avoiding the Underpayment Penalty for Estimated
Tax 14-31
Cash-Flow Considerations 14-31
Use of General Business Tax Credits 14-31
Foreign Tax Credits and the Foreign Earned Income
Exclusion 14-32
Compliance and Procedural Considerations 14-32
Alternative Mi nimum Tax (AMT) Fi ling
Procedures 14-32
Withholdings and Estimated Tax
Payments 14-32
General Business Tax Credits 14-33
Nonrefundable Personal Tax Credits 14-33
Problem Materials 14· 33
Discussion Questions 14-33
Issue Identification Q uestions 14-35
 Contents .... I ndi vidual s ix

Proble,ns 14-36 Computation of Tax for Controlled Groups 16-14

Comprehensive Proble,n 14-40
Tax Strategy Problem 14-41
Tax Form/Return Preparation Problems 14-42
Case Study Problems 14-43
Tax Research Problem 14-43
CHAPT ER 15
... TAX RESEARCH 15·1
Overview of Tax Research 15·2
Steps in the Tax Research Process 15·3
Importance of the Facts to the Tax Consequences 15·5
Creating a Factual Situation Favorable to the
Taxpayer 15-6
The Sources of Tax Law 15· 7
The legislative Process 15-7
The Internal Revenue Code 15-8
Treasury Regulations 15-9
Administrative Pronouncements 15-11
Judicial Decisions 15-14
Tax Treaties 15-24
Tax Periodicals 15-24
Tax Services 15-25
The Internet as a Research Tool 15·26
Ke}'\vord Searches 15-27
Search by Citation 15-28
Noncom mercial Internet Services 15-28
Citators 15·28
Using the Citator 15-30
Professional Guidelines for Tax Services 15·30
Treasury Depart1nent Circular 230 15-30
AICPA's State1nents on Tax Standards 15-31
Sample Work Papers and Client Letter 15-34
Problem Materials 15·34
Discussion Questions 15-34
Problems 15-35
Comprehensive Problem 15-38
Tax Strategy Problem 15-38
Case Study Problem 15-39
Tax Research Problems 15-39
CHAPT ER 1 6
... CORPORATIONS 16-1
Definition of a Corporation 16·2
Similarities and Differences Between the Taxation of
Corporations and Individuals 16-3
Specific Rules Appl icable to Corporations 16-4
Capital Gains and losses 16-4
Dividends-Received Deduction 16-5
Net Operating losses 16-6
Charitable Contributions 16-7
Compensation Deduction l i,nitation for Publicly
Held Corporations 16-8
Computation of Tax 16·9
Computation of Taxable Income 16-9
Computation of Regu lar Tax 16-9
The Corporate Alternative Minimum Tax (AMT)
and the Minim um Tax Credit (MTC) 16-10
Penalty Taxes 16-11
Consolidated Returns 16-16
Transfers of Property to Controlled
Corporations 16-17
Section 351 Nonrecognition Requirements 16-17
Basis Considerations 16-18
Treatment of liabilities 16-19
Corporate Capital Structure 16-21
Earnings and Profits 16-21
Calculation of Earnings and Profits 16-21
Current Versus Accumulated E&P 16-22
Noncash Distri butions 16-24
Tax Consequences to the Shareholders 16-24
Tax Consequences to the Distributing
Corporation 16-24
Stock Rede,nptions 16-25
Determining Whether a Redemption Is a Dividend or
Capital Gain 16-26
Corporate Distributions in Complete
Liquidation 16·28
Tax Consequences to the liquidating
Corporation 16-28
Tax Consequences to the Shareholders 16-29
Se.ction 332: liquidation of a Subsidiary
Corporation 16-29
Tax Planning Considerations 16-30
Capital Structure and Section 1244 16-30
Dividend Policy 16-31
Use of losses 16-31
Charitable Contributions 16-31
Dividends-Received Deduction 16-31
Reduced Taxes on Taxpayer Stock Sales 16-32
Compliance and Procedural Considerations 16-32
Filling Requirements 16-32
Schedule M-1 and M-2 Reconciliations 16-33
Schedule M-3 Reconciliation 16-34
Maintenance of E&P Records 16-34
Problem Materials 16·34
Discussion Questions 16-34
Issue Identification Questions 16-39
Problems 16-40
Tax Strategy Problems 16-45
Tax Form/Return Preparation Problems 16-46
Case Study Problems 16-4 7
Tax Research Problems 16-48
CHAPT ER 17
... PARTNERSHIPS ANDS CORPORATIONS 17-1
Types of Pass-Through Entities 17·2
Partnerships 17-2
S Corporations 17-3
limited liability Compan ies 17-3
limited liability Partnersh ips 17-4
Taxation of Partnerships 17-4
Formation of a Partnership 17-4
Partnership Operations 17-8
Special Allocations 17-9
Allocation of Partnership Income, Deductions, losses,
and Credits to Partners 17-10
x In di v i du als .,.. Contents

Basis Ad jusanents for Operating Items 17-11 The Exempt Model 18-10
Special Deductions and Li,nitations 17-12 The Pension Model 18-10
Limitations on Losses and Restoration of Multiperiod Strategies 18-14
Basis 17-14 Summary and Comparison of Basic Investment
Transactions Between a Part ner and the Models 18-15
Partnersh ip 17-15 Other Applications of Investment Models 18· 15
Partnersh ip Distr ibutions 17-16 Roth Conversion Decision 18-16
Sale of a Para1ersh ip Interest 17-17 Pass-Through Entity Versus C Corporation 18-19
Optional and Mandatory Basis Ad justments 17-19
Implicit Taxes and Clienteles 18·24
Partnersh ip Elections 17-20
Problem Mat erials 18·27
Taxation of S Corporations 17· 21 Discussion Questions 18-27
Q ual ification Requirements 17-21 Problems 18-28
Election Requ irements 17-23
Tennination Conditions 17-24
S Corporation Operations 17-25 TA BLE S
Basis Ad jusanents to S Corporation 2017 Tax Tables and Rat e Schedules and 2018 Wit hholding
Stock 17-27 Tables (Partial) T· 1
S Corporation Losses and Lin1itations 17-28
O ther S Corporation Considerations 17-30
APP E ND I CES
Tax Planning Considerations 17-33
Use of Operating Losses 17-33 ... APPENDlX A
Income Shifting Among Family Members 17-34
Optional Basis Adjusunent Election Under Sec. Tax Research Working Paper File A·1
754 17-34 ... APPENDlX S
Compliance and Procedural Considerat ions 17·35 Tax Forms B· 1
Partnersh ip Filing Requirements and
Elections 1 7-35 ... APPENDlX C
Reporting Partnership Items on Form
MACRS Tables C-1
1065 17-35
S Corporation Fili ng Requ irements and Accounting
Method Elections 17-36 ... APPENDlX O
Reporting S Corporation Items on Form Glossary D· 1
11205 17-36
Comparison of Alternative Forms of Business ... APPENDlX E
Organizations 17-36 AICPA St atements on Standards
Problem Materials 17·36 for Tax Services Nos. 1- 7 E· 1
Discussion Questions 17-36
... APPENDlX F
Issue Identification Questions 17-41
Problems 17-41 Index of Code Sections F·1
Comprehensive Proble,n 17-4 7
Tax Strategy Problems 17-4 8 ... APPENDlX G
Tax Form/ Return Preparation Index of Treasury Regu lations G· 1
Problems 17-49
Case Study Problems 17-49 ... APPENDlXH
Tax Research Problems 17-50 Index of Government Promulgations H· 1
... APPEND()( I
CHAPTER 18
... TAXES ANO lNVESTMENT PLANNING 18-1 Index of Court Cases 1·1
Investment Models 18·2
... APPENDlX J
The Current Model 18-2
The Deferred Model 18-5 Subject Index J· 1
ABOUT THE EDITORS
Timothy J. Rupert is a Professor at the D' Amore-McKim School of Business at Northeast-
ern University. He received his B.S. in Accounting and his Master of Taxation from the
University of Akron. He also earned his Ph.D. from Penn State University. Professor
Rupert's research has been published in such journa ls as The Accounting Review, The Jour-
nal of the American Taxation Association, Behavioral Research in Accounting, Advances
in Taxation, Applied Cognitive Psychology, Advances in Accounting Education, and Jour-
nal of Accounting Education. In 2010, he received the Outstanding Educator Av,ard from
the Massachusetts Society of CPAs. He also has received the University's Excellence in
Teaching A,vard and the D'Amore-McKim School's Best Teacher of the Year av,ard multi-
ple times. He is active in the American Accounting Association and the American Taxation
TIMOTHY J. RUPERT Association (ATA) and has served as president, vice president, and secretary of the ATA.

Kenneth E. Anderson is the Pugh CPAs Professor of Accounting at the University of

Tennessee. He earned a B.B.A. from the University of Wisconsin- M ilwa ukee and subse-
quently attained the level of tax manager ,vith Arthur Young (no,v part of Ernst & Young).
He then earned a Ph.D. from Indiana University. He teaches corporate taxation, partner-
ship taxation, and tax strategy. Professor Anderson also is the Director of the Master of
Accountancy Program. He has published articles in The Accounting Review, The Journal
of the American Taxation Association, Advances in Taxation, the Journal of Accountancy,
the Journal of Financial Service Professionals, and a number of other journals.

KENNETH E. ANDERSON

ABOUT THE AUTHORS

Thomas R. Pope is the Ernst & Young Professor of Accounting at the University of Kentucky.
He received a B.S. from the University of Lou isville and an M.S. and D.B.A. in busi-
ness administration from the University of Kentucky. He teaches international taxation,
partnership and S corporation taxation, tax research and policy, and introductory taxa -
tion and has ,von outstanding teaching a,vards at the Un iversity, College, and School of
Accountancy levels. He has published articles in The Accounting Review, the Tax Adviser,
Taxes, Tax Notes, and a number of other journals. Professor Pope's extensive profes-
sional experience includes eight years ,vith Big Four accounting firms. Five of those years
,vere ,vith Ernst & Whinney (no,v part of Ernst & Young), including rwo years with
their National Tax Department in Washington, D.C. He subsequently held the position
of Senior Manager in charge of the Tax Department in Lexington, Kentucky. Professor
Pope also has been a leader and speaker at professional tax conferences all over the United
States and is active as a tax consultant.

xi
xii Individua ls ..,. About the Authors

0. Dale Bandy is the Professor Emeritus in the School of Accounting at the University of
Central Florida. He received a B.S. from the University of Tulsa, an M.B.A. from the
University of Arkansas, and a Ph.D. from the University of Texas at Austin . He helped to
establish the Master of Science in Taxation programs at the University of Central Florida
and California State University, Fullerton, \Vhere he previously taught. In 1985, he was
selected by the California Society of Certified Public Accountants as the Accounting
Educator of the year. Professor Bandy has published 8 books and more than 30 arti-
cles in accounting and taxation. His articles have appeared in the Journal of Taxation,
the Journal of Accountancy, Advances in Taxation, the Tax Adviser, The CPA Journal,
Management Accounting, and a number of other journals.

N. Allen Ford is the Larry D. Homer/KPMG Peat Marwick Distinguished Teaching Professor
of Professional Accounting at the University of Kansas. He received an undergraduate de-
gree from Centenary College in Shreveport, Louisiana, and both the M.B.A. and Ph.D. in
Business from the University of Arkansas. He has published over 40 articles related to tax-
ation, financial accounting, and accounting education in journals such as The Accounting
Review, The Journal of the American Taxation Association, and The Journal of Taxation.
He served as president of the American Taxation Association in 1979- 80. Professor Ford
has received numerous teaching awards, at the college and university levels. In 1993, he
received the Byron T. Shutz Award for Distinguished Teaching in Economics and Business.
In 1996 he received the Ray M. Sommerfeld Outstanding Tax Educator A\vard, \vhich is
jointly sponsored by the American Taxation Association and Ernst & Young, and in 1998
he received the Kansas Society of CPAs Outstanding Education A,vard.

David S. Hulse is an Associate Professor of Accountancy at the University of Kentuck'Y,

\Vhere he teaches introductory and corporate taxation courses. He received an undergrad-
uate degree from Shippensburg University, an M.S. from Louisiana State Un iversity, and a
Ph.D. from the Pennsylvania State University. Professor Hu lse has published a number of
articles on tax issues in academic and professional journals, including The Journal of the
American Taxation Association, Advances in Taxation, the Journal of Financial Service
Professionals, the Journal of Financial Planning, and Tax Notes.

LeAnn Luna is a Professor of Accounting at the University of Tennessee. She is a CPA and
holds an undergraduate degree from Southern Methodist University, an M.T. from the
University of Denver College of Law, and a Ph.D. from the University of Tennessee. She
has taught introductory taxation, corporate and partnership taxation, and tax research.
Professor Luna also holds a joint appointment \Vith the Center for Business and Economic
Research at the University of Tennessee, \Vhere she interacts frequently \Vith state policy-
makers on a variety of policy-related issues. She has published articles in the Journal of
Accounting and Economics, National Tax Journal, The Journal of the American Taxation
Association, and State Tax Notes .

Charlene Henderson is a faculty member in the Department of Accounting at Louisiana State

University. She earned undergraduate and master's degrees in accounting from Mississippi
State University. After working in public accounting and banking, she earned a Ph.D.
from Arizona State Un iversity. She has taught introd uctory taxation, corporate taxation,
and tax research. Her research has appeared in several journals, incl uding Journal of the
American Taxation Association, Journal of Accounting Auditing and Finance, Auditing: A
Journal of Practice and Theory, and a number of other journals.
 About the Authors ..,. Indiv i d u als xiii

Jared Moore is the Mary Ellen Phillips Associate Professor of Accounting at O regon State
University (OSU). He earned his undergraduate, Master of Taxation, and Ph.D. degrees
at Arizona State University. He is a CPA (AZ-inactive) and ,vorked in both public and
private accounting before pursuing his doctoral degree. Professor Moore has received sev-
eral teaching awards, incl udi ng the Byron L. Nev,ton Av,ard for Excellence in Teaching at
OSU, and has taught individual and business taxation, introductory and intermediate fi -
nancial accou nting, and doctoral-level fina ncial accounting research. His research interests
incl ude both tax and fina ncial accounting, and he has published in journals incl uding the
Journal of the American Taxation Association and the National Tax Journal.

William 0. Brink, Ph.D., CPA, CFP is an Assistant Professor in the Department of Accountancy
at the Farmer School of Business at Miami Un iversity in Oxford, O hio. He received his
B.S. from Appalachian State University in 2005 and his Masters in Accountancy from
The University of North Carolina Wilmington in 2007. Before attending the University of
South Carolina to obtai n his Ph.D. in Accountancy in 2014, he \VOrked in public account-
ing for RSM McGladrey. He teaches tax courses at both the undergraduate and graduate
level focusi ng on individual taxation, busi ness taxation, tax policy, tax academ ic research,
and tax legal research. He has co-authored articles in Journal of Business Ethics, Journal
of the American Taxation Association, Behavioral Research in Accounting, Advances in
Accounting Education, Advances in Taxation, The Conversation, CGMA Magazine, and
The Tax Advisor. He ,vas the Winner of the O utstandi ng Author Contribution in the 2017
Emerald Literati Net\vork A,vards for Excellence for an article published in Advances in
Accounting Education and has received numerous teaching a,vards.

Susan Porter is an Associate Professor of Commerce at the University of Virginia \vhere

she teaches both undergraduate and graduate tax courses. She earned her undergraduate
degree from Babson College. After working in public and private accounti ng, she earned
a Ph.D. from the University of Washington. She has published articles in the Journal of
Accounting and Economics, Contemporary Accounting Research, Journal of Accounting,
Auditing, and Finance, The Journal of the American Taxation Association, and a number
of other journa ls.

Michael S. Schadewald, Ph.D., CPA, is a Clinical Associate Professor in the Fisher School
of Accounting at the University of Florida, where he teaches courses in accou nting and
taxation. A graduate of the University of Mi nnesota, Professor Schade\vald has published
more than 50 articles in academic and professional journa ls, incl uding The Accounting
Review, Journal of Accounting Research, and Contemporary Accounting Research. He
also has served on numerous editorial boards, including The Journal of the American
Taxation Association, International Tax Journal, Journal of State Taxation, and Issues in
Accounting Education. Prior to joini ng the faculty at the University of Florida, Professor
Schade,vald taught at the University of Wisconsi n-Mi lwa ukee, ,vhere he also served as the
Director of the Deloitte Center for M ultistate Taxation, and the University of Texas in
Austi n. Prior to en teri ng academics, he \VOrked in the Mihvaukee office of Arthur You ng
(no,v EY).
PREFACE
New to this Edition

INDIVIDUALS
• Complere updaring of the chapter marerial for rhe provisions in the Tax Curs and Jobs Acr of 2017 affecring individual taxpayers,
including an explanation of the new rules and the relared implications of rhe following irems:
• Reduction in marginal tax rares
• Elimi nation of personal and dependency exe,nprions
• Changes in the deductabi liry of state and local taxes and casualty losses
• Elimi nation of miscellaneous ite1nized deductions
• Changes ro the a lrernative min i,num tax
• Increase in rhe ch ild rax credit
• Complete updating of sign ificant courr cases and IRS rul ings and procedures duri ng 2017 and early 2018
• All tax rare schedu les have been updated to reflect the rates and inflarion adjusrments for 2018
• Whenever new updates become available, they wi ll be accessi ble via MyLab Accou nting
• Updating of the end-of-chaprer tax return problems to 2017 (2017 tax forms are included because the 2018 tax forms ,vere not
ava ilable ,vhen t his edition ,vent to print ), but also including a supplemental expla nation for each tax return proble,n of ho,v the
solution wi ll change for the 2018 tax year given the provisions of the Tax Cuts and Jobs Act.

CORPORATIONS
• Complere updating of the chapter material for the provisions in t he Tax Cuts and Jobs Acr of 2017 affecring corporations and ot her
entities, including an explanation of the new ru les and the related i1nplications of the following items:
• Reduced corporate tax rate
• Qualified business income deduction
• New li,nitations on interest, business losses, and NOLs
• New ru les for t he taxation of international transactions
• The comprehensive corporate tax return, Problem C:3-65, has all new numbers for t he 2017 forms
• The comprehensive part nersh ip tax return, Problem C:9-58, has all new numbers for the 2017 forms
• The comprehensive S corporation tax return, Problem C:1 1-62, has all new numbers for the 2017 forms
• All tax rate schedu les have been updated to reflect the rates and inflation adjustments for 2018
• Whenever new updates become available, t hey ,viii be accessible via MyLab Accou nting

SOLVING TEACHING AND LEARNING CHALLENGES

The Rupert/Anderson 2019 Series in Federa l Taxation is appropriate for use in any firsr course in federal taxation, and comes in a
choice of three volumes:
• Federal Taxarion 2019: Individuals
• Federal Taxarion 2019: Corporations, Parrnerships, Esrates & Trusrs (the compan ion book to Individuals)
• Federal Taxarion 2019: Comprehensive (1 4 chapters from Individuals and 15 chapters from Corporarions)
• • For a custon1ized edirion of any of the chaprers for these texrs, contact your Pearson represenrarive and he or she can create a custom
rexr for you.
• The Individuals volume covers all entities, although the rrearment is ofren briefer rhan in the Corporations and Co,nprehensive vol-
umes. The Individuals volume, therefore, is appropriate for colleges and universities that require on ly one semester of raxation as ,veil
as those that require more than one semester of taxarion. Further, this volume adaprs the suggestions of the Model Tax Curriculum as
promu lgated by the A,nerican Insrirure of Certified Public Accou nranrs.
• T he Corporations, Partnerships, Estates & Trusts and Co111prehensive volu mes contain three comprehensive tax rerurn problems
,vhose data change wit h each edition, rhereby keepi ng the problems fresh . Problem C:3-65 conrains the comprehensive corporare
tax rerurn, Problem C:9-58 conrains the comprehensive partnersh ip rax rerurn, and Problem C:1 1-62 conta ins the comprehensive
S corporarion rax rerurn, ,vhich is based on the same facts as Proble,n C:9-58 so that srudents can compare t he returns for t hese
rwo entities.
• The Coyporations, Partnerships, Estates & Trusts and Co1nprehe11sive volumes contain sections called Financial Statement Impli-
cations, which discuss the i1nplications of Accounting Standards Codification (ASC) 740. The main discussion of accounting for
income taxes appears in Chapter C:3. The financial statement implications of other rransactions appear in Chaprers C:7, C:8, a nd
C:16 (Corporarions volume only).
xiv
 Pref ace ..,. I ndivi d ual s xv

Rupert/Anderson 2019 Series in Federal Taxation has an appropriate blend of technica l content of the tax law with a high level of
readability for students. It is focused on enabling students to apply tax principles within the chapter to real-life situations using many
strong pedagogical aids:
Real-World Example
These co,nments relate the text material to events, cases, and statistics occu rring in the tax and business environment. T he statistical
data presented in some of these comments are taken from the IRS's Statistics of Income at W\V\V.irs.gov.
Book-to-Tax Accounting Comparison
These comments compare the tax discussion in the text to the accounting a nd/or financial state1nent treatment of this material. Also,
the last section of Chapter C:3 discusses the financial statement implications of federal income taxes.
What Would You Do in This Situation?
Unique to the Rupert/Anderson series, these boxes place students in a decision-making role. The boxes include many controversies
that are as yet unresolved or are currently bei ng considered by the courts. These boxes make extensive use of Ethical Material as they
represent choices that may put the practitioner at odds with the cl ient.
Stop & Think
These «speed bu1nps" encourage students to pause and apply what they have just learned. Solutions for each issue are provided in the box.
Ethical Point
These conunents provide the ethic.al implications of material discussed in the adjoining text. Apply what they have just learned.
Tax Strategy Tip
These comments suggest tax planning ideas related to material in the adjoining text.
Additional Comment
These comments provide supplemental information pertaining to the adj acent text.

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AN INTRODUCTION
TO TAXATION
LEARNING OBJECTIVES
After studying this chapter, you should be able to
1 Discuss the history of taxation in the United States
2 Describe the three types of tax rate structures
3 Describe the various types of taxes
4 Discuss the criteria for a "good" tax structure, the objectives of the
federal income tax law, and recent tax reform proposals
5 Describe the tax entities in the federal income tax system
6 Identify the various tax law sources and understand their implications
for tax practice
7 Describe the legislative process for the enactment of the tax law
s Describe the administrative procedures under the tax law
9 Describe the components of a tax practice
1o Understand the importance of computer applications in taxation
1 -2 Individ ual s ~ Chapt er 1
C H APTER OUTLINE
History of Taxation in t he United
States ... 1-2
Types of Tax Rate St ructures... 1-4
Other Types of Taxes ...1-7
Criteria for a Tax Structure ... 1-1 2
Entities in t he Federal Income Tax
System ...1-1 6
Tax Law Sources ... 1-24
Enactment of a Tax Law... 1-24
Administration of the Tax Law
and Tax Practice lssues ...1-26
Components of a Tax
Practice ... 1-29
Computer Applications in Tax
Practice ... 1-31
KEY POINT
In many situations, t he use of
t he tax laws to in fluence human
behavior is deliberate. As w ill be
seen later in this chapter, tax laws
a re often used to achieve social
and economic objectives.
Discuss the history of
taxation in the United
States
H ISTORICAL NOTE
The reinstatement of the income
tax in 1894 was t he subject of
heated political controversy. In
general, the representatives in
Congress from the agricultural
South and West favored t he
income tax in lieu of customs
duties. Representatives from the
industrial eastern states were
against the income tax and fa-
vored protective tariff legislation.
1 Pollockv. Famters' Loan & Tr11st Co., 3 AFTR 2602 (USSC, I 895). Nore,
however, char a federal income rax on corporacions char was enacted in 1909
Federal income taxes have a significant effect on business, investor, and personal decisions in
the United States. Because tax rates can be as high as 21 o/o on corporations and over 40% on
individuals, virtually every transaction is impacted by income taxes. The follo\ving examples
illustrate the impact of the tax la\V on various decisions in our society:
~ Because of the deductibi lity of home mortgage interest and real estate taxes, an indi-
vidual may decide to purchase a home rather than to continue to rent an apartment.
~ An investor may decide to delay selling some stock because of the significant taxes that
may result from the sale.
~ A corporation may get a larger tax deduction if it leases property rather than purchas-
ing the property.
The purpose of th is text is co provide an introduction co the study of federal income
taxation. Ho\vever, before discussing the specifics of the U.S. federa l income tax law, it is
helpful to have a broad conceptual understanding of the taxation process. This chapter
provides an overvie,v of the follo\ving topics:
~ Historical developments of the federal tax system
~ Types of taxes levied and structural considerations
~ Objectives of the tax la,v, incl uding a discussion of recent tax reform proposals
~ Taxpaying entities in the federal income tax system
~ Tax la\v sources and the legislative process
~ Internal Reven ue Service (IRS) collection, examination, and appea ls processes
~ The nature of tax practice, includ ing computer applications and tax research
H ISTORY OF TAXATION
IN THE UNITED STATES
EARLY PERIODS
The federal income tax is the dominant form of taxation in the Un ited States. In addition,
most states and some cities and counties also impose an income tax. Boch corporations
and ind ividuals are subject co such taxes.
Prior to 1913 (the date of enactment of the modern-day federa l income tax), the fed-
eral government rel ied predominantly on customs duties and excise taxes co finance its
operations. The first federal income tax on individuals ,vas enacted in 1861 co finance the
Civil War but ,vas repealed after the \Var. The federal income tax was reinstated in 1894,
however, that tax ,vas challenged in the courts because the U.S. Constitution required that
an income tax be apportioned among the states in proportion co their populations. This
type of tax system, ,vhich \VOu ld be both impractical and difficu lt to admin ister, \VOuld
mean chat different tax races ,vould apply co individua l taxpayers depending on their
states of residence.
In 1895, the Supreme Court ruled that the tax \Vas in violation of the U.S. Constitution. 1
Therefore, it \Vas necessary to amend the U.S. Constitution to permit the passage of a
federal income tax la,v. This was accomplished by the Sixteenth Amendment, \Vhich was
ratified in 1913. The Sixteenth Amendment, ,vhile being an extraordinarily important
amendment, consists of one sentence.
Sixteenth Amendment to the Constitution of the United States
The Congress shall have t he power to lay and collect taxes on incomes, from whatever
source derived, without apportionment among the several States, and without regard to any
census or enu 1neration.
was held to be conscirucional because it was treated as an excise rax. See Flint
v. Stone Tracy Co., 3 AFTR 2834 (USSC, 1911).

HISTORICAL NOTE
The Revenue Act of 1913 con-
tained sixteen pages.
HISTORICAL NOTE
Before 1939, the tax laws were
contained in the most current rev-
enue act, a reenactment of a prior
revenue act plus amendments. In
1939, a permanent lax code was
established; it was revised in 1954
and 1986.
ADDITIONAL COM MENT
In 2016, 150 million individual
income tax returns were filed,
and collections from individuals
totaled S1.46 trillion.
TYPI CAL MISCONCEPTION
It is often assumed that t he tax
revenue from corporation income
taxes is the largest source of tax
revenue. However, the revenue
generated from this tax only
represents approximately 9% of
total federal revenues in 2017.
2 Richard Goode, The Individual Income Tax (\Vashingron, DC: The Brookings
lnsrirurion, 1964), pp. 2-4.
An Introduction to Taxation "' Individual s 1-3
REVENUE ACTS FROM 1913 TO THE PRESENT
The Revenue Act of 1913 imposed a flat 1 o/o tax (\vich no exemptions) on a corporation's
net income. The rate varied from 1 % co 7% for individuals, depending on the individual's
income level. However, very fe,v individuals paid federa l income taxes because a $3,000
personal exemption ($4,000 for married individuals) \Vas permitted as an offset to taxable
income. These amounts ,vere greater than the incomes of most individua ls in 1913.
Various amendments co the original la,v ,vere passed bet\veen 1913 and 1939 as separate
revenue acts. For example, a deduction for dependency exemptions ,vas provided in 1917.
In 1939, the separate revenue acts ,vere codified into the Internal Revenue Code of 1939.
A similar codification ,vas implemented in 1954. The 1954 codification, ,vhich was known
as the Internal Revenue Code of 1954, included the elimination of many "dead,vood" pro-
visions, a rearrangement and clarification of numerous code sections, and the addition of
major tax la,v changes. Whenever changes co the Internal Revenue Code (IRC) are made,
the old language is deleted and the new language added. Thus, the statutes are organized as
a single document, and a tax advisor does not have to read through the applicable parts of
all previous tax bills to find the most current law. In 1986, significant changes ,vere made to
the tax law, and the basic tax la,v ,vas redesignated as the Internal Revenue Code of 1986.
In December 2017, the Tax Cuts and Jobs Act (TCJA) ,vas passed by Congress, effective on
January 1, 2018. While the major changes relate to businesses, there are significant changes
for all taxpayers. The important changes of TCJA are included in this textbook.
The federal income tax became a " mass tax" on individuals during the ea rly 1940s.
This change ,vas deemed necessary to finance the revenue needs of the federa l govern-
ment during World War II. In 1939, less than 6% of the U.S. population ,vas subject to
the federa l income tax; by 1945, 74% of the population ,vas taxed. 2 To accommodate the
broadened tax base and to avoid significant tax collection problems, Congress enacted
pay-as-you-go withholding in 1943.
A major characteristic of the federal income tax since its inception to today is the manner
in ,vhich the tax law is changed or modified. The federa l income tax is changed on an incre-
mental basis rather than a complete revision basis. Under so-called incrementalism, ,vhen a
change in the tax la,v is deemed necessary by Congress, the entire la,v is not changed, but
specific provisions of the tax la,v are added, changed, or deleted on an incremental basis.
Thus, the federal income tax has been referred co as a "quilt\vork" of tax laws, referring
co the patch,vork nature of the law. Without question, one of the principal reasons for the
complexity of the federal income tax today is the incremental nature of tax legislation.
REVENUE SOURCES
As mentioned earlier, the largest source of federal revenues is individual income taxes. Other
major revenue sources include Social Security (FICA) taxes and corporate income taxes (see
Table 1:1-1). T,vo notable trends from Table 1:1-1 are (1) the gradual increase in social insur-
ance taxes from 1960 to 2017 and (2) the gradual decrease in corporate income taxes for the
same period. Individual income taxes have remained fairly stable during the past 50 years.
T TABLE 1:1-1
Breakdown of Federal Revenues
1960 1975 2000 2017
Individual income taxes 440fc, 450fc, 500fc, 480fc,
Social insurance taxes and contribution 16 32 32 35
Corporation income taxes 23 15 10 9
Other 17 8 8 8
Total 1OOOfc, 1OOOfc, 1OOOfc, 1OOOfc,
Source: Council of Economic Advisers, Economic Jndicator:s (Washington, DC: U.S. Government Printing Office, 1967.
1977, 2017).
1 - 4 Indivi duals ~ Chapter 1
Describe the three types
of tax rate structures
A DDITIONA L COMMENT
In the 1950s, the top marginal tax
rate for individual taxpayers
reached 92%. This astonish-
ingly high rate only applied to
taxpayers with very high taxable
incomes but still is an extremely
confiscatory tax rate.
EXAMPLE 1:1 - 1 .....
LEGISLATIVE
BACKGROUND
Beginning with tax year 2018,
the top rate for high-income indi-
vidual taxpayers was decreased to
37% from 39.6%.
EXAMPLE 1:1 -2 .....
EXAMPLE 1:1 -3 .....
3 4
See the inside from cover for the 2018 cax rares and Chapter 1:2 for a d iscus..
sion of the computation procedures. 201 7 rare schedules and tax cables are
locaced immediacely before Appendix A.
TYPES OF T AX RATE STRUC T URES
THE STRUCTURE OF INDIVIDUAL
INCOME TAX RATES
Virtually all tax structures are comprised of t\vo basic parts: the tax base and the tax rate.
The tax base is the amount to wh ich the tax rate is applied to determine the tax due. For
example, an individual's tax base for the federa l income tax is taxable income, as defined
and determined by the income tax law. Similarly, the tax base for the property tax is
generally the fa ir market val ue of property subject to the tax. The tax rate is merely the
percentage rate applied to the tax base.
Tax rates may be progressive, proportional, or regressive. A progressive rate structure
is one \Vhere the rate of tax increases as the tax base increases. The most notable tax that
incorporates a progressive rate structure is the federa l income tax. Thus, as a taxpayer's
taxable income increases, a progressively higher rate of tax is applied. For 2018, the fed-
eral income tax rates for individuals begin at 10% and increase to 12o/o, 22%, 24%,
32%, 35%, and 37% as a taxpayer's taxable income increases. 3 Examples 1:1-1 and 1:1-2
shov, ho\v the progressive rate structure of the federal income tax operates.
Alice, who is single, has S30,000 taxable income in 2018. Her federal income taxes for the year are
S3,410, computed as follows: the f irst $9,525 of taxable income is taxed at 10% and t he remain-
ing $20,475 at 12%. (Fo r tax rates, see the inside front cover.) In 2017, t he tax would have been
S4,034, which demonstrates the reduction of income taxes under the Tax Cuts and Jobs Act.
Allen, w ho also is single, has taxable income of SG0,000. A 10%, rate applies to the first S9,525
of taxable income, 12% on the next $29, 175, and a 22% rate applies to the taxable income over
$38, 700. Thus, Allen's total tax is $9, 140 ((0.10 x $9,525) + (0.12 x S29, 175) + (0.22 x $21,300)).
If Allen's taxable income is $120,000, a 24% rate applies to $37,500 of his taxable income
($120,000 - $82,500) because the 24% rate appli es to taxable income above $82,500 for a
single individual and his tota l tax for the year is $23,090. Thus, the tax rates are prog ressive
because the rate of tax increases as a taxpayer's taxable income increases. .....
Notice in Example 1:1-1 that taxable income has doubled in size in the three cases, but
the income taxes have more than doubled (i.e., $3,410 to $9,140 to $23,090). This dem-
onstrates ho,v a progressive rate structure operates.
Assume the same facts as in Example 1: 1-1 except that Alice has taxable income of $240,000. Of
Alice's taxable income, $40,000 (S240,000 - $200,000) is subject to the 35% rate. A lternatively,
if Allen has taxable income of SG00,000, $100,000 ($600,000 - SS00,000) is subject to the top
marginal rate of 37%. .....
A proportional tax rate, sometimes called a flat tax, is one \vhere the rate of tax is
the same for all taxpayers, regardless of the level of their tax base. This type of tax rate
is generally used for real estate taxes, state and local sales taxes, personal property taxes,
customs duties, and excise taxes. A flat tax has been the subject of considerable discus-
sion over the past t\venty years and promises to be a controversial topic as the debate on
federal income tax reform continues into the future.
Assume the same facts as in Example 1:1-1, except that a 17%, tax rate applies to all amounts
of taxable income. Based on the assumed f lat tax rate structure, Alice's federal income tax is
SS, 100 on $30,000 of taxable income; A ll en's tax is $10,200 on SG0,000 of taxable income and
S20,400 on $120,000 of taxable income. The tax rate is proportional because the 17% rate ap-
pli es to both taxpayers without regard to their income level. As you can see, a proportional tax
rate resu lts in substantially lower taxes for higher income taxpayers.4 .....
This example assumes the same cax base (taxable income) for the Aar cax as
with the current federal cax. Jvlost nar cax proposals allow only a few deduc,.
tions and, rherefore, would generate higher taxes than in che example.

SELF-STUDY QUESTION
Assume a tax system with a tax
of $1,000 on taxable income of
$10,000 and a S1,500 tax on tax-
able income of $20,000. Is the tax
rate system progressive, propor-
tional, or regressive?
A NSWER
This tax system is regressive. Even
though the amount of tax has
increased, the rate of taxation has
decreased from 10% on the first
$10,000 of taxable income to 5%
on the second $10,000 of taxable
income.
A DDITIONAL COMM ENT
In recent years, many countries
around the world significantly
reduced their tax rates on corpo-
rations. As a result, the top 35%
tax rate in the United States was
one of the highest statutory cor-
porate rates in the world and led
many U.S. corporations to move
their international operations
to other countries. For example,
Ireland imposes a 12.5% rate on
corporations.
EXAM PLE 1:1- 4 ....
5 See the discussion of equiry and fairness lacer in this chapter.
6 See Chapter 1:16 of rhjs rexcbook for a more complete discussion of che
taxation of C Corporations.
An Introduction to Taxation ..,. Individuals 1 -5
A regressive tax rate decreases ,vith an increase in the tax base (e.g., income).
Regressive taxes, wh ile not consistent with the fa irness of the income tax, 5 are found in
the United States. The Social Security (FICA) tax is regressive because a fixed rate of tax
of 6.20o/o for OASDI for both the employer and employee is levied up to a ceiling amount
of $ 128,400 for 2018. So, for example, assume Taxpayer A has income subject to Social
Security of $80,000 and Taxpa yer B income of $400,000. Taxpayer A's OASDI ,vould be
$4,960 ($80,000 X 0.062), Taxpayer B's OASDI v,ould be $7,961 ($128,400 X 0.062).
Taxpayer IVs average rate of OASDI tax is 6.2 % ,vhile Taxpayer B's average rate of tax is
1.99% ($7,961/$400,000). Sales taxes, ,vhich are levied by many states, are also regres-
sive when measured against the income base.
T H E S TRU CT UR E OF C ORPORATE T A X RAT ES
Corporations are separa te entities and are subject to income tax. 6 Beginning ,vith
the 2018 tax year, corporations are subject to a flat rate of 21 %,7 a rate that is a
substantial reduction from the top rate for 2017 of 35%. For 2017 and many earlier
years, the corporate tax rates ,vere progressive in nature, ranging from 15% to 35%.
The reduction in corporate tax rates for 2018 and future years ,vere made for t,vo
principal reasons: (1) to make the corporate income tax rate in the Un ited States
more competitive with other countries around the ,vorld, and (2) to attempt to stim-
ulate the economy and create jobs in the Un ited States. Time will tell if this strategy
for corporate income taxes is effective.
MAR G INAL , AV E RA GE, AND
E FFE CT IV E TA X RATES FO R T A X PAY E R S
A taxpayer's marginal tax rate is the tax rate applied to an incremental amount of taxable
income that is added to the tax base. The marginal tax rate concept is useful for planning
because it measures the tax effect of a proposed transaction.
Tan ia, who is sing le, is considering the purchase of a personal residence that w ill provid e a
S20,000 tax d eduction for interest expense and real estate taxes in 2018. Tan ia's taxable in-
come wou ld be reduced from S180,000 to $160,000 if she purchases t he residence. Because a
32% tax rate applies to taxable income from $160,000 to $180,000, Tan ia's marginal tax rate
is 32%,. Thus, Tan ia's tax savings from purchasing the persona l residence wou ld be $6,400
(0.32 x $20,000). ....
Wh ile the marginal tax rate measures the tax rate applicable to the next $ 1 of in-
come or deduction for a taxpa yer, there are t\vo other tax rates that are used primarily
by tax policymakers: average tax rate and effective tax rate. The average tax rate is
computed by dividing the tota l tax liability by the amount of taxable income. This rep-
resents the average rate of tax for each dollar of taxable income. For example, a single
taxpayer ,vith taxable income of $550,000 in 2018 would incur a total tax liability of
$169,190. The taxpayer's marginal tax rate is 37%, but his average tax rate is 30.8%
($169,190/$5 50,000) .
7 Sec. I l (b).
1 -6 Individ ual s ~ Chapter 1
ADDITIONAL COMMENT
One method of calculating eco-
nomic income is to start with
adjusted gross income (AGI), add
back items of excludible income,
such as tax-exempt bond interest,
proceeds of life insurance poli-
cies, etc., and then deduct certain
nondeductible business expenses,
such as life insurance premiums,
penalties and f ines, etc.
EXAM PL E 1:1-5 ....
- STOP & THI N K
ADDITIONAL COMMENT
In the determination of tax rates,
one should consider the inci-
dence of taxation that involves
the issue of who really bears the
burden of the tax. If a city raises
the real property tax but land-
lords simply raise rents to pass on
the higher taxes, the tax burden
is shifted to their tenants. The
concept has important implica-
tions in determining any kind
of average or effective tax rate.
8 Congressional Budget Office, Effect;ve Federal Tax Rares Under Current
Law, 2001 ro 2014 (\Vashingcon, DC: U.S. Govemmenr Priming Office,
August, 2004 ), p. 10.
The effective tax rate is the total tax liability divided by total economic income. Total eco-
nomic income includes all types of economic income that a taxpayer has for the year. Thus,
economic income is much broader than taxable income and includes most types of excludible
income, such as tax-exempt bond interest, and generally permits business deductions but not
personal-type deductions. It should be pointed out that economic income is not statutorily de-
fined and experts may disagree on a precise calculation. The basic purpose of calculating the
effective tax rate is to provide a broad measure of taxpayers' ability to pay taxes. Accordingly,
the effective tax rate mainly is used by tax policymakers to determine the fairness of the in·
come tax system.
Amelia, who is single, has adjusted gross income of $140,000 and economic income of $175,000
in 2018. The difference is attributable to $35,000 of tax-exempt bond interest. If Amelia has
personal deductions of $30,000, t hen her taxable income is $1 10,000, and her total tax is
$20,690. Her average tax rate is 18.81 %, ($20,690 "' S110,000). Amelia's effective tax rate is
11 .82% ($20,690 "' $175,000). Amelia's effective tax rate is considerably lower than her average
tax rate because of her substantial amount of tax-exempt income. .....
Question: G\ven, a single taxpayer, has seen her income climb to $ 190,000 in the current
year. She wants a tax planner to help her reduce her tax liability. In planning for tax cli-
ents, tax professionals almost exclusively use the marginal tax rate in their analysis rather
than the average tax rate. W hy is the marginal tax rate much more important in the tax
planning process than the average tax rate?
Solution: Because tax planning is done at the margin, a single taxpayer \Vho has taxable
income of $190,000 has a marginal tax rate of 32%, (at 2018 rates), but an average tax
rate of 22.36o/o, computed as follo\VS :
Taxable income $ 190,000
Tax on first $157,500 of taxable income $32,090
Remaining taxable income $32,500
Times: Marginal tax rate x 0.32 10,400
Total tax liability $ 42,490
Total tax $ 42,490 - 0
Average tax rate = T bl . $ 190,000 - 22 36
· X,
axa e income
If a tax planner could reduce G\ven's taxable income by $10,000, Gwen's tax liability
\VOuld decrease by $3,200 ($10,000 X 0.32). W hen the taxpayer ,vants to know how much
she can save through tax planning, the appropriate marginal tax rate yields the ans\ver.
Overall, estimated effective federal income tax rates for individuals have increased slightly
during the period 2003-2012, 8 amounting to 12.6% in 2012 as compared ,vith 9.1 %
in 2003. For the highest 20% of households, the effective individual income tax rate in-
creased to 18.0%, in 2012 from 14.4% in 2003. The effective tax rate for individuals in
the United States is relatively lo,v compared to most other industrialized countries.
DETERMINATION OF TAXABLE
INCOME AND TAX DUE
As ,viii be discussed in later chapters, the federal income taxes imposed on all taxpayers
(individuals, corporations, estates, and trusts) are based on the determination of taxable
income. In general, taxable income is computed as follows:
Total income (income from \Vhatever source derived) $xxx
Minus: Exclusions (specifically defined items, such as
tax-exempt bond interest) (xx)

Describe the various types
of taxes
ADDITIONAL COMM ENT
States that do not impose a state
income tax depend on other taxes
to support the government mis-
sion, principally sales taxes.
ADDITIONAL COM MENT
State income tax rates for individ-
ua ls have increased significantly
in the past 20 years. More than
23 states now have marginal tax
rates of 6% or higher.
9 For a thorough discussion of srare and local caxes, see the chapter enrit1ed
Multistate Income Tax ation chat accompanies this cexrbook in electronic form
on the Pearson Federal Taxation 2019 \-Veb page at www.prenhall.com/phcax.
JO These scares are Alaska, Florida, Nevada, South Dakota, Texas,
\"(lashingron, and \Vyoming. New Hampshire has an income tax th.at is levied
An Introduction to Taxation "' Individuals 1 -7
Gross income $xxx
Min us: Deductions (business expenses and itemized deductions) (xx)
Taxable income $xxx
Times: Applicable tax rate x .xx
Income tax before credits $xxx
Minus: Tax credits (xx)
Total tax liability $xxx
Minus: Prepayments (xx)
Balance due or refund $xxx
Each different type of taxpayer (individuals, corporations, etc.) computes taxable income
in a slightly different manner, but all use the general frame,vork above. An introductory
discussion of the various types of taxpayers is provided later in this chapter. More detailed
discussions of individual taxpayers (Chapter 1:2) and corporation taxpayers (Chapter 1:16)
are examined in this Individuals book. Corporations, estates, and trusts are further examined
in Pearson's Federal Taxation: Corporations, Partnerships, Estates & Trusts.
OTHER TYPES OF TAXES
STATE AND LOCAL INCOME AND
FRANCHISE TA X ES
In addition to federal income taxes, many states and local jurisdictions impose income
taxes on individuals and businesses. These state and local taxes have gradually increased
over the years and currently represent a significant source of revenue for state and local
governments but also represent a significant tax burden on taxpayers.
State and local income taxes vary flireatly in both form and rates. 9 Only seven states do
not impose an individual income tax. In most instances, state income tax rates are mildly
progressive and are based on an individual's federal adjusted gross income (AGI), ,vith minor
adjustments. 11 For example, a typical adjustment to a state income tax return is interest in-
come on federal government bonds, which is subject to tax on the federal return but is not
subject to state income taxes. Some states also allow a deduction for federal income taxes in
the computation of taxable income for state income tax purposes.
States imposing a state income tax generally requ ire the withholding of state income
taxes and have established mandatory estimated tax payment procedures. The due date
for fi ling state income tax returns generally coincides ,vith the due date for the federa l
income tax returns (e.g., the fifteenth day of the fourth month follo,ving the close of the
tax year for individ uals).
Most states impose a corporate income tax, although in some instances the tax is
called a franchise tax. Franchise taxes usually are based on a weighted-average formula
consisting of net ,vorth, income, and sales.
WEALTH TRANSFER TAXES
U.S. citizens are subject to taxation on certain transfers of property to another person. The
tax la,v provides a unified transfer tax system that imposes a single tax on transfers of prop-
erty taking place during an individual's lifetime (gifts) and at death (estates). (See the inside
back cover of the text for the transfer tax rate schedules.) Formerly, the gift and estate tax
laws were separate and distinct. The federal estate tax ,vas initially enacted in 1916. The
original gift tax la,v dates back to 1932. The gift tax ,vas originally imposed to prevent wide-
spread avoidance of the estate tax (e.g., taxpayers could make tax-free gifts of property be-
fore their death). Both the gift and estate taxes are ,vealth transfer taxes levied on the transfer
only on dividend and interest income and Tennessee's income rax applies only
to income from stocks and bonds.
11
See Chapter 1:2 for a discussion of the AGI computation.
1 -8 Individ ual s ~ Chapter 1

of property and are based on the fair market value (FMV) of the transferred property on the
date of the transfer. TCJA made some significant changes to estate and gift taxes effective
January 1, 2018. Those changes will be discussed belov,. Following are brief descriptions of
the gift tax and estate tax.

KEY POINT
The $15,000 annual exclusion is
an important tax-planning tool
for wealthy parents who want to
transfer assets to their children
and thereby minimize their gift
and estate taxes. A husband and
wife who have three children
could transfer a maximum of
$90,000 [(S15,000 x 2) x 3) to
their children each year without
incurring any gift tax.
ADDITIONAL COM M ENT
The gift tax was enacted to make
the estate tax more effective.
Without a gift tax, estate taxes
could be easily avoided by large
gifts made before death.
The Federal Gift Tax. The gift tax is an excise tax that is imposed on the donor (not the donee)
for transfers of property that are considered to be a taxable gift. A gift, generally speaking, is a
transfer made gratuitously and ,vith donative intent. However, the gift tax law has expanded
the definition to include transfers that are not supported by full and adequate consideration. 12
To arrive at the amount of taxable gifts for the current year, a $15,000 (2018) annual exclusion
is allo\ved per donee. 13 In addition, an unlimited marital deduction is allo,ved for transfers
bet\veen spouses. 14 The formula for computing the gift tax is as follO\VS:
FMV of all gifts made in the current year $x,xxx
Minus: Annual donee excl usions ($15,000 per donee) $xx
Marital ded uction for gifts to spouse xx
Charitable contribution deduction xx (xxx)
Plus: Taxable gifts for all prior years xxx
Cumulative taxable gifts (tax base) $x,xxx
Times: Unified transfer tax rates x .xx
Tentative tax on gift tax base $ xxx
Minus: Unified transfer taxes paid in prior years (xx)
Un ified credit (xx)
Unified transfer tax (gift tax) due in the curren t year $ xx
Note that the gift tax is cumulative over the taxpayer's lifetime (i.e., the tax calculation
for the current yea r includes the taxable gifts made in prior years). The detailed tax rules
relating to the gift tax are covered in Chapter C:12 in both Pearson's Federal Taxation:
Corporations, Partnerships, Estates & Trusts and the Comprehensive volume. The fol-
lo,ving general concepts and rules for the federal gift tax are presented as background
material for other chapters of this text dealing ,vith individual taxpayers:
~ Gifts bet\veen spouses are exempted from the gift tax due to the operation of an un-
limited marital deduction.
~ The primary liability for pa yment of the gift tax is imposed on the donor. The donee is
contingently liable for payment of the gift tax in the event of nonpayment by the donor.
~ A donor is permitted a $15,000 annual exclusion for gifts of a present interest to each
donee. 15
~ Charitable contributions are effectively exempted from the gift tax because an unlim-
ited ded uction is allo\ved.
~ The tax basis of the property to the donee is generally the donor's cost. It is the lesser
of the donor's cost and the property's FMV on the date of the gift if the property is
sold by the donee at a loss. (See Chapter I:5 for a discussion of the gift tax basis ru les.)
~ A unified tax credit equi valen t to an $11,180,000 deduction, adjusted for inflation, is
available to offset any gift tax on taxable gifts that exceed the $15,000 annual exclu-
sion.16 The exclusion amount in 2017 \Vas $5,490,000.

EXAM PL E 1:1 -6 .... Antonio makes the following g ifts in the year 2018:
~ $50,000 cash g ift to his wife
~ $20,000 contribution to the United Way
12 Sec. 2512(b). a future interest comes into being ar some furure date (e.g., property is trans-
13 Sec. 2503(b). The annual exclusion for gift rax purposes had been S10,000 ferred by gift ro a trust in which the donee is nor entitled to the income from
for many years. However, for 2002- 2005, rhe inflation adjustment increased rhe property until the donor dies) and is nor eligible for rhe $15,000 annual
the exclusion to S 11,000, for 2006-2008, the exclusion was increased ro exclusion.
$12,000, for 2009-2012 ro $13,000, and for 2013-2017 ro $14,000. for 16
11,e applicable exclusion amount had been S 1,000,000 since 2002. Beginning
2018 and later years, che current exclusion has been increased to $15,000. in 201 t, the exclusion was increased to $5,000,000, adjusted for inAarion.
14
Sec. 2523(a). Now, effective in 2018, che exclusion has been increased to S11,180,000. For
15
A gifr of a present interest is an imeresr rhar is already in existence and the further derails, see Pearson's Federal Taxation: Corporarfons~ Partnerships#
donee is currently entitled to receive rhe income from the property. A gifr of Estates & Tn,sts, 2019 Edicion, Chapcers C:12 and C:13.
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