CH-1-4 An Introduction to Tax – McGraw-Hill’s Taxation of Individuals and Business Entities 2021 : Chapter Notes

This Document Contains Chapters 1 to 4 Chapter 1 An Introduction to Tax Learning Objectives 1-1. Demonstrate how taxes influence basic business, investment, personal, and political decisions. 1-2. Discuss what constitutes a tax and the general objectives of taxation. 1-3. Describe the different tax rate structures and calculate a tax. 1-4. Identify the various federal, state, and local taxes. 1-5. Apply appropriate criteria to evaluate alternate tax systems. Teaching Suggestions This chapter provides an overview of why taxes are important, what a tax is, how to calculate a tax, various tax rates and tax rate structures, different types of federal, state, and local taxes, and how to evaluate a tax system. One intent of the chapter is to get students thinking about the pervasive influence of taxes and thus why it is important for a business or accounting student to understand taxes. Discussing how taxes affect decisions that they will face (buying a house, investing for retirement, etc.) is an effective way to pique students’ interest. This chapter also provides an opportunity to motivate students by discussing the political importance of taxes and the debate over alternative tax systems. Throughout most of the chapter, you can tie the material discussed back to the debate over alternative tax systems. This is easily done in the section on evaluating alternative tax systems and alternative tax rate structures but may also be done for other parts of the text. For example, when discussing how to calculate a tax, you can point out that once the tax base is computed, it is very easy to calculate virtually any tax. The difficulty is in determining the tax base. The implication of this understanding is that the tax rate structure (e.g., progressive versus proportional) has little effect on tax complexity. In teaching this chapter, the time that you spend in class will vary based on how much discussion that you want to incorporate regarding evaluating tax systems and implicit taxes. Most of the concepts in this chapter are relatively straightforward, and thus, the chapter provides students with an introduction to tax without overwhelming them on the first day or so of class. This is particularly important if your students have some trepidation regarding their first tax course. Implicit tax is typically a difficult concept for students to understand. The text provides a good overview of implicit tax. If you plan to cover implicit tax in some detail, you might alert students that this is a difficult concept and that they should be careful to get familiar with this discussion in the text prior to class. Assignment Matrix Learning Objectives Text Features Problem Time Difficulty LO1 LO2 LO3 LO4 LO5 Research Planning Forms DQ1-1 5 min. Easy X DQ1-2 5 min. Easy X DQ1-3 5 min. Easy X DQ1-4 5 min. Easy X DQ1-5 5 min. Medium X DQ1-6 5 min. Medium X DQ1-7 5 min. Medium X DQ1-8 10 min. Medium X DQ1-9 5 min. Medium X DQ1-10 10 min. Medium X DQ1-11 15 min. Medium X DQ1-12 5 min. Medium X DQ1-13 15 min. Medium X DQ1-14 10 min. Medium X DQ1-15 5 min. Easy X DQ1-16 15 min. Medium X DQ1-17 5 min. Easy X DQ1-18 5 min. Easy X DQ1-19 10 min. Medium X DQ1-20 10 min. Medium X DQ1-21 10 min. Easy X DQ1-22 10 min. Easy X DQ1-23 15 min. Medium X DQ1-24 15 min. Medium X DQ1-25 15 min. Medium X DQ1-26 15 min. Medium X DQ1-27 15 min. Medium X DQ1-28 15 min. Medium X DQ1-29 15 min. Medium X X DQ1-30 20 min. Medium X X DQ1-31 15 min. Medium X X DQ1-32 15 min. Medium X DQ1-33 15 min. Medium X P1-34 20 min. Medium X P1-35 20 min. Medium X P1-36 20 min. Medium X P1-37 20 min. Medium X P1-38 20 min. Medium X P1-39 20 min. Medium X P1-40 20 min. Medium X P1-41 20 min. Medium X P1-42 20 min. Hard X X P1-43 15 min. Medium X X X P1-44 15 min. Medium X X X P1-45 15 min. Medium X X X P1-46 15 min. Medium X X X P1-47 20 min. Hard X P1-48 20 min. Hard X P1-49 20 min. Hard X X P1-50 20 min. Hard X X P1-51 20 min. Hard X P1-52 20 min. Hard X P1-53 20 min. Hard X P1-54 20 min. Hard X P1-55 20 min. Hard X P1-56 20 min. Hard X P1-57 25 min. Hard X X X P1-58 25 min. Hard X X X P1-59 25 min. Medium X X P1-60 25 min. Medium X X Lecture Notes 1) Who Cares About Taxes and Why? a) Businesses b) Politicians c) Individuals 2) What Qualifies as a Tax? a) Definition of a tax i) Key components of definition: payment is required, imposed by a government agency, and not directly tied to any benefit received by the taxpayer from the government b) Earmarked tax—definition and why this is considered a tax c) Quiz students on tax definition using examples in the PowerPoint slides. 3) How to Calculate a Tax a) Tax = Tax Base × Tax Rate i) Tax Base—what is actually taxed, usually expressed in monetary terms ii) Tax Rate—level of taxes imposed on the tax base, usually expressed as a percentage iii) Flat taxes iv) Graduated taxes v) Brackets b) Different ways to measure tax rates i) Marginal tax rate (1) Definition—tax rate that applies to the next additional increment of a taxpayer’s taxable income (or deductions) (3) Useful in tax planning ii) Average tax rate (1) Definition—a taxpayer’s average level of taxation on each dollar of taxable income (2) Formula— (3) Useful in budgeting tax expenses or comparing the relative tax burdens of taxpayers iii) Effective tax rate (1) Definition—taxpayer’s average rate of taxation on each dollar of total income, including taxable and nontaxable income (2) Formula— (3) Provides the best depiction of a taxpayer’s tax burden iv) Work example in the PowerPoint slides calculating tax liability, marginal, average, and effective tax rates. c) Tax rate structures i) Proportional tax rate structure (1) Definition—also known as a flat tax, imposes a constant tax rate throughout the tax base (2) As the tax base increases, the taxes paid increase proportionally. (3) The marginal tax rate remains constant and equals the average tax rate across the tax base. (4) The most common example of a proportional tax is a sales tax. ii) Progressive tax rate structure (1) Definition—imposes an increasing marginal tax rate as the tax base increases. (2) As the tax base increases, both the marginal tax rate and the taxes paid increase. (3) Common examples of progressive tax rate structures include federal and state income taxes and federal estate and gift taxes. iii) Regressive tax rate structure (1) Definition—imposes a decreasing marginal tax rate as the tax base increases. (2) As the tax base increases, the taxes paid increase, but the marginal tax rate decreases. (3) Regressive tax rate structures are not common. In the United States, the Social Security tax and federal and state unemployment taxes employ a regressive tax rate structure. iv) Discuss how different taxes can be viewed as having different rate structures when you consider effective tax rates versus marginal tax rates (e.g., the sales tax). 4) Types of Taxes a) Federal taxes i) Income tax: Imposed on individuals, corporations, estates, and trusts. The largest federal tax. ii) Employment taxes: Employment taxes consist of the OASDI tax (Social Security tax) and the MHI tax (Medicare tax). The tax base for these taxes is wages or salary and employers and employees split these taxes equally. Self-employed individuals must pay these taxes in their entirety. iii) Unemployment taxes: Employers are also required to pay federal and state unemployment taxes, which fund temporary unemployment benefits for individuals terminated from their jobs without cause. iv) Excise taxes: A tax based on quantity of goods or services purchased. Common examples include taxes on alcohol, diesel fuel, gasoline, and tobacco products and on services such as telephone use and air transportation. v) Transfer taxes: The estate tax and gift taxes are based on the fair market values of wealth transfers upon death or by gift, respectively. b) State and local taxes i) Income tax: Most states impose an income tax. The calculation varies by state. ii) Sales and use taxes: The tax base for a sales tax is the retail sales of goods and some services. Retailers collect and remit this tax. The tax base for the use tax is the retail price of goods owned, possessed, or consumed within a state that were not purchased within the state. The purpose of a use tax is to discourage taxpayers from buying goods out of state in order to avoid or minimize the sales tax in their home state. iii) Property taxes: Assessed on the fair market value of real property and personal property. These are ad valorem taxes. iv) Excise taxes c) Implicit taxes i) Indirect taxes that result from a tax advantage the government grants to certain transactions. ii) Defined as the reduced before-tax return that a tax-favored asset produces because of its tax-advantaged status. iii) Difficult to quantify but important to understand in evaluating the relative tax burdens of tax-advantaged investments. iv) Walk through examples of implicit taxes in text. 5) Evaluating Alternative Tax Systems a) Sufficiency i) Involves assessing the aggregate size of the tax revenues that must be generated and making sure that the tax system provides these revenues. ii) Static forecasting: Forecasting revenue ignores how taxpayers might alter their activities in response to a tax law change and to base projected tax revenues on the existing state of transactions. iii) Dynamic forecasting: Forecasting that tries to predict possible responses by taxpayers to new tax laws. iv) Income effect: As tax rates go up, people will work harder to maintain same after-tax income. v) Substitution effect: As tax rates go up, people will substitute nontaxable activities because the marginal value of taxable ones has decreased. vi) Equity: A tax system is considered fair or equitable if the tax is based on the taxpayer’s ability to pay. vii) Horizontal equity: Two taxpayers in similar situations pay the same tax. viii) Vertical equity: Taxpayers with greater ability to pay tax pay more tax relative to taxpayers with a lesser ability to pay tax. Vertical equity can be viewed in terms of tax dollars paid or tax rates. Vertical equity may also be evaluated using effective tax rates instead of simply considering the tax rate structure.ix) Certainty: Taxpayers should be able to determine when to pay the tax, where to pay the tax, and how to determine the tax. b) Convenience i) A tax system should be designed to be collected without undue hardship to the taxpayer. c) Economy i) A tax system should minimize the compliance and administration costs associated with the tax system. d) Compare the income tax and sales tax using the equity, certainty, convenience, and economy criteria. e) Evaluating tax systems—the trade-off i) Much of the debate regarding alternative tax systems reduces to a choice between simplicity and fairness. ii) Those taxes that generally are simpler and easier to administer are typically viewed as less fair. Those taxes that may be viewed as more fair are often more complex to administer. Class Activities 1. Suggested class activities ○ Designing a tax system: Tell students that the class has just seceded from the United States and needs to develop a tax system sufficient to generate $XX, XXX from the class members. Have the students break into groups of three to five to design a tax system. As part of this task, they are to evaluate the advantages and disadvantages of their tax. The group judged by the class to have the most advantageous tax system receives bonus participation points for the day. ○ What is fair? Put two different tax systems in front of the class—one a proportional tax rate, one a progressive tax system. Poll the class by show of hands to determine which tax system each person views as being fairer. Either in groups or as a class, have the students discuss why they view a specific system as being fairer. After the discussion, poll the class by show of hands to determine if anyone has changed their view of which tax is fairer. Then discuss with the class that there is no right answer as to which system is fairer. Instead, the answer depends on a person’s individual views on fairness. ○ One versus the class: Have one student volunteer as the “one” with the other class members being the “group.” Use the key facts boxes in the text to develop multiple-choice questions (A, B, C answers) and then quiz the volunteer and the class on the questions. The volunteer and each class member will need to write the letters A, B, and C on separate sheets of paper and then hold up their appropriate response to the question. Once a student (either the “one” or a member of the “group”) misses a question, he or she is eliminated from the competition. After six (or some other number) of questions, those students left standing receive bonus participation points for the day. ○ Discuss current tax policy topics: Find a few recent articles discussing tax reform, the current income distribution, or the millionaire surtax. Post the articles so that students can read before class and ask a few questions to begin the class discussion. 2. Research activities ○ Show the class the IRS website and some of the materials included in the website—e.g., publications, IRS forms, etc. ○ Have students research the presidential candidates’ tax platforms and compare and contrast the likely changes to the Internal Revenue Code. Chapter 2 Tax Compliance, the IRS, and Tax Authorities Learning Objectives 2-1. Identify the filing requirements for income tax returns and the statute of limitations for assessment. 2-2. Outline the IRS audit process, how returns are selected, the different types of audits, and what happens after the audit. 2-3. Evaluate the relative weights of the various tax law sources. 2-4. Describe the legislative process as it pertains to taxation. 2-5. Perform the basic steps in tax research. 2-6. Describe tax professional responsibilities in providing tax advice. 2-7. Identify taxpayer and tax professional penalties. Teaching Suggestions This chapter provides a summary of the filing requirements for income tax returns, the IRS audit process, tax law sources and tax research, tax professional responsibilities, and taxpayer and tax practitioner penalties. The time allotted to this chapter will vary based on your expectations regarding the students’ abilities to conduct research in the course. The remaining material in the chapter (filing requirements, IRS audit process, tax professional responsibilities, and taxpayer and tax practitioner penalties) can be covered in a class session (or two). Compared to Chapter 1 and later chapters, the material in Chapter 2 could be considered somewhat “dry.” Thus, it is important to bring this material to life in the classroom as much as possible. Some suggestions for the class discussion include: • Filing requirements: Provide a basic overview of the filing requirements by entity and statute of limitations and then use discussion questions 1 through 3 and problems 43 through 49 to quiz students on their understanding. • IRS audit process: Most students are interested in how the IRS selects returns for audit. Discussing high-profile IRS cases (Richard Hatch, Survivor; Willie Nelson; Al Capone) or personal experiences with IRS audits is typically well received. After the discussion, quizzing the students on identifying the selection method and audit type for various fact patterns is an effective way to make sure that your students can apply the concepts from this discussion. • Tax law sources: The depth to which you cover the various sources will vary with your expectations regarding the students’ abilities to conduct research. If students will be expected to research problems, read primary authorities, etc., showing examples of the specific types of authorities that they will research (code sections, regulations, etc.), highlighting their attributes, contrasting different authorities, and discussing how to locate the authorities and make sure that they are “current” should prove beneficial. This discussion could then be followed with a discussion of how to conduct research and an in-class example of a simple research problem. [As an out-of-class exercise, you might assign students to locate specific primary authorities (e.g., court cases, revenue rulings, etc.) and related discussion in an available tax service (CCH, RIA, BNA, etc.) and have the students summarize the issue addressed in the primary authority and tax service and how they located each authority.] If instead students are simply required to have a basic understanding of tax authorities with little or no research expectation, most of the discussion of authorities could focus on comparing different authorities and their relative weights. This discussion can then be reinforced with classroom questions comparing the weight of different authorities or contrasting different authorities using the “one versus the group” activity suggested below. • Tax legislation: This discussion may be aided by displaying Exhibit 2-7. You may also remind your class of the Schoolhouse Rock song “I’m Just A Bill,” which highlights the legislative process. You can watch this song on YouTube. • Basic tax research steps: This discussion may be enhanced by walking students through the research example in the text or through one of the end of chapter research problems. • Tax professional standards/taxpayer and tax practitioner penalties: This discussion may be enhanced by a discussion of the IRS’s crackdown on tax shelters, the dire consequences associated with not meeting professional standards, and the recent increased thresholds to avoid tax practitioner penalties. Assignment Matrix Learning Objectives Text Feature Problem Time Difficulty LO1 LO2 LO3 LO4 LO5 LO6 LO7 Research Planning Forms DQ2-1 5 min. Easy X DQ2-2 10 min. Easy X DQ2-3 10 min. Medium X DQ2-4 5 min. Easy X DQ2-5 10 min. Medium X DQ2-6 10 min. Medium X DQ2-7 10 min. Medium X DQ2-8 15 min. Medium X DQ2-9 15 min. Medium X DQ2-10 10 min. Easy X DQ2-11 10 min. Medium X DQ2-12 5 min. Easy X DQ2-13 15 min. Medium X DQ2-14 10 min. Medium X DQ2-15 10 min. Medium X DQ2-16 10 min. Medium X DQ2-17 15 min. Medium X DQ2-18 15 min. Medium X DQ2-19 5 min. Easy X DQ2-20 20 min. Medium X DQ2-21 15 min. Medium X DQ2-22 10 min. Easy X DQ2-23 10 min. Easy X DQ2-24 15 min. Medium X DQ2-25 15 min. Medium X DQ2-26 15 min. Medium X DQ2-27 15 min. Medium X DQ2-28 15 min. Medium X DQ2-29 15 min. Medium X DQ2-30 10 min. Easy X DQ2-31 15 min. Medium X DQ2-32 15 min. Medium X DQ2-33 15 min. Medium X DQ2-34 15 min. Medium X DQ2-35 15 min. Medium X DQ2-36 20 min. Medium X DQ2-37 15 min. Medium X DQ2-38 10 min. Medium X DQ2-39 15 min. Medium X DQ2-40 15 min. Medium X DQ2-41 15 min. Medium X DQ2-42 15 min. Medium X P2-43 15 min. Medium X P2-44 15 min. Medium X P2-45 15 min. Medium X P2-46 15 min. Medium X P2-47 15 min. Medium X P2-48 15 min. Medium X P2-49 15 min. Medium X P2-50 10 min. Medium X P2-51 15 min. Medium X P2-52 10 min. Medium X P2-53 10 min. Medium X P2-54 10 min. Medium X P2-55 10 min. Medium X P2-56 20 min. Medium X X P2-57 20 min. Medium X X P2-58 15 min. Medium X P2-59 15 min. Medium X P2-60 15 min. Medium X P2-61 15 min. Medium X P2-62 10 min. Medium X P2-63 10 min. Medium X P2-64 15 min. Medium X P2-65 15 min. Medium X P2-66 10 min. Medium X P2-67 10 min. Medium X P2-68 60 min. Medium X X P2-69 60 min. Medium X X P2-70 60 min. Medium X X P2-71 60 min. Medium X X P2-72 60 min. Medium X X P2-73 120 min. Hard X X P2-74 120 min. Hard X X P2-75 60 min. Medium X X P2-76 20 min. Medium X P2-77 20 min. Hard X P2-78 20 min. Medium X P2-79 20 min. Medium X Lecture Notes 1) Taxpayer Filing Requirements a) Filing requirements by entity i) Individuals (show Exhibit 2-1) ii) Corporations b) Tax return due date and extensions i) Individuals and C corporations ii) Partnerships and S corporations c) Statute of limitations i) The period in which the taxpayer can file an amended tax return or the IRS can assess a tax deficiency for a specific tax year. ii) Generally ends three years from the later of (1) the date the tax return was actually filed or (2) the tax return’s original due date. iii) A six-year statute of limitations applies to IRS assessments if the taxpayer omits items of gross income that exceed 25 percent of the gross income reported on the tax return. iv) For fraudulent returns, or if the taxpayer fails to file a tax return, the statute of limitations remains open indefinitely. 2) IRS Audit Selection a) Methods of selection i) DIF system ii) Document perfection iii) Information matching iv) Other methods b) Types of audits i) Correspondence examinations ii) Office examinations iii) Field examinations c) After the audit (show Exhibit 2-2) i) Proposed adjustment ii) 30-day letter iii) Appeals conference iv) 90-day letter v) Petition courts vi) Trial-level courts and their differences: Tax Court, U.S. District Court, U.S. Court of Federal Claims vii) Choosing a trial-level court (show Exhibit 2-3) viii) Circuit Court of Appeals (show Exhibit 2-4) ix) Supreme Court 3) Tax Law Sources a) Primary and secondary sources i) Primary tax authorities (show Exhibit 2-5) ii) Secondary authorities (show Exhibit 2-6) b) Legislative sources: Congress and the Constitution i) U.S. Constitution ii) Internal Revenue Code iii) Legislative process for tax laws (show Exhibit 2-7) iv) Basic organization of the code (show Exhibit 2-8) v) Tax treaties c) Judicial sources: The courts i) The hierarchy of the courts (trial level, appeals, Supreme Court) ii) Stare decisis iii) Golson rule d) Administrative sources: The U.S. Treasury i) Regulations: Three different forms (final, temporary, proposed); three different purposes (interpretative, procedural, legislative); highest administrative authority. ii) Revenue Rulings and Revenue Procedures: More detailed than regulations; second in administrative weight. Definition of each. iii) Letter rulings: Lower authoritative weight; contrast private letter rulings with determination letters and technical advice memorandums. iv) Acquiescence, no acquiescence, and actions on decision: Define and explain why important. 4) Tax Research a) Understand facts i) Open and closed facts ii) How do you determine facts for a research question? b) Identify issues i) Ability to identify issues varies with experience. ii) Understand facts, combine facts with understanding of law, identify general issues. (Is this income taxable? Is this expense deductible?) iii) Research will allow you to identify more specific issues. iv) Discuss Example 2-4 in class. c) Locate relevant authorities i) Annotated tax services: Definition and what they contain. ii) Topical tax services: Definition and what they contain. iii) How to use these services? iv) Keyword search: Area of law and key facts; suggestions if key word searching is not proving beneficial. v) Topical index vi) Browsing the service vii) Discuss Example 2-5. d) Analyze tax authorities i) Questions of fact: Hinges upon the facts and circumstances of the taxpayer’s transaction. In this type of question, the researcher will focus on understanding how various facts affect the research answer and identifying authorities with fact patterns similar to her client’s. ii) Questions of law: Hinges upon the interpretation of the law, such as interpreting a particular phrase in a code section. If a researcher is faced with this type of question, she will spend much of her time researching the various interpretations of the code section and take note of which authorities interpret the code differently and why. iii) Conflicting authorities: The tax researcher should evaluate the hierarchical level, jurisdiction, and age of the authorities, placing more weight on higher and newer authorities that have jurisdiction over the taxpayer. iv) Checking the status of authorities: Citators and methods to check the status of authorities. e) Communicate the results i) The basic parts of a memo: Facts, issues, authorities, conclusion, and analysis. ii) Facts: Discuss facts that provide necessary background of the transaction and those facts that may influence the research answer. iii) Issues: State the specific issues that the memo addresses. Issues should be written as specifically as possible and be limited to one or two sentences per issue. iv) Authorities: The researcher cites the relevant tax authorities that apply to the issue, such as the IRC, court cases, and revenue rulings. Cite enough to provide a clear understanding of the issue and interpretation of the law. v) Conclusion: One conclusion per issue. Each conclusion should answer the question as briefly as possible, and preferably indicate why the answer is what it is. vi) Analysis: The goal of the analysis is for the researcher to provide the reader a clear understanding of the area of law and specific authorities that apply. Typically an analysis will be organized to discuss the general area(s) of law first (the Code section) and then the specific authorities (court cases, revenue rulings) that apply to the research question. After you discuss the relevant authorities, apply the authorities to your client’s transaction and explain how the authorities result in your conclusion. vii) The basic parts of a client letter: Salutation and social graces, research question and limitations, facts, analysis, and closing. 5) Tax Professional Responsibilities a) Tax professionals are subject to various statutes, rules, and codes of conduct. i) AICPA Code of Professional Conduct ii) AICPA Statement on Standards for Tax Services iii) IRS’s Circular 230 iv) State board of accountancy statutes b) Failure to comply with statutes can result in being admonished, suspended, or barred from practicing. 6) Taxpayer and Tax Practitioner Penalties a) Civil penalties i) Generally monetary penalties ii) Imposed when tax practitioners or taxpayers violate tax statutes without reasonable cause. b) Criminal penalties i) Much less common than civil penalties. ii) Penalties are much higher and can include prison sentences. c) Taxpayer underpayment penalty: No underpayment penalty if there is substantial authority that supports the tax return position or if there is a reasonable basis for the position and it is disclosed on the taxpayer’s tax return. d) A tax practitioner will not be subject to penalty if there is substantial authority that supports the tax return position or if there is a reasonable basis for the position and it is disclosed on the taxpayer’s tax return. Class Activities 1. Suggested class activities ○ Let’s choose a court: Split the class into groups. Explain to the class that you will be asking a series of questions to the class regarding the choice of trial-level courts after an audit. After you ask the question, a group may buzz in to answer the question when a group member raises his or her hand. If the person gets the question correct, the group will receive one point. If the person misses the question, the group loses one point. The group with the most points after the series of questions will receive bonus participation points for the day. Use the individual court differences and differences in their respective appellate courts to generate questions. See problem 57 for examples of questions to pose. ○ One versus the class: Have one student volunteer as the “one,” with the other class members being the “group.” Use the key facts boxes in the text to develop basic multiple-choice questions (A, B, C answers) and then quiz the volunteer and the class on the questions. The volunteer and each class member will need to write the letters A, B, and C on separate sheets of paper and then hold up their appropriate response to the question. Once a student (either the “one” or a member of the “group”) misses a question, her or she is eliminated from the competition. After six (or some other number) of questions, those students left standing receive bonus participation points for the day. 2. Research activities ○ Take one or more of the research problems at the end of the chapter and pose the following questions after reading the problem: (1) What are the key facts in the problem? (2) What is the general issue to be addressed? (3) What key words would you use to research this question? Then walk the students through how you would conduct the research using an available on-line service. 3. Ethics discussion From page 2-5: Discussion points: • What are the timing requirements for filing a tax return and paying taxes owed? • Does Bill’s action likely violate any IRS regulation? • If Bill’s action does not violate IRS rules, is it ethical? • Are ethics and IRS rules the same? Chapter 3 Tax Planning Strategies and Related Limitations Learning Objectives 3-1. Identify the objectives of basic tax planning strategies. 3-2. Apply the timing strategy. 3-3. Apply the concept of present value to tax planning. 3-4. Apply the income-shifting strategy. 3-5. Apply the conversion strategy. 3-6. Describe basic judicial doctrines that limit tax planning strategies. 3-7. Contrast tax avoidance and tax evasion Teaching Suggestions This chapter provides an overview of the basic tax planning strategies that represent the building blocks of tax planning. It is placed early in the text to emphasize the importance of tax planning and to allow the students to form an early foundation of the basic planning techniques. In later chapters as you discuss specific technical content (e.g., investments, compensation, property transactions), students should be able to identify and apply the basic tax planning strategies that apply to each transaction. This chapter can be covered in one to one and a half class sessions. Most of the concepts in the chapter are relatively straightforward and thus should not present students with tremendous difficulty. If students have not been exposed to the concept of present value, this discussion may require more time. If students are familiar with present value, a short review should suffice. This chapter should be of interest to students given the importance of tax planning and the related wealth impact that these strategies can have. Thus, students should have a natural interest in the chapter’s material. Nonetheless, discussing real-life examples of these strategies should pique students’ interests even more so (see, for example, the “Taxes in the Real World” boxes in the text). The chapter lends itself to covering in-class examples of each strategy. Included in the text are several basic examples of the strategies, with additional problems in the end of chapter material that may prove useful. Post-TCJA, taxpayers may rethink the income-shifting strategy for their business income to accommodate the lower corporate tax rate (21 percent). We may see more business incorporations take advantage of this lower tax rate. In addition to discussing the basic tax planning strategies, the chapter introduces several judicial doctrines that limit tax planning (and apply in numerous tax settings). These doctrines represent key components of the tax law and will also be discussed later in the text when applicable. When discussing these doctrines, it may be useful to provide specific examples of their application (e.g., Example 3-6 in the text). Finally, this chapter provides a brief discussion of tax avoidance and tax evasion. This discussion provides an opportunity to discuss the importance of ethics in the accounting profession and the negative consequences associated with tax evasion. This discussion also provides an opportunity for students to remember the discussion of tax practitioner professional standards and civil and criminal penalties in Chapter 2. Assignment Matrix Learning Objectives Text Feature Problem Time Difficulty LO3-1 LO3-2 LO3-3 LO3-4 LO3-5 LO3-6 LO3-7 Research Planning Tax Forms DQ3-1 10 min. Easy X DQ3-2 10 min. Easy X DQ3-3 20 min. Medium X DQ3-4 15 min. Medium X DQ3-5 15 min. Medium X DQ3-6 15 min. Medium X DQ3-7 15 min. Medium X DQ3-8 15 min. Medium X X DQ3-9 20 min. Medium X X DQ3-10 15 min. Medium X DQ3-11 15 min. Medium X DQ3-12 5 min. Easy X DQ3-13 15 min. Medium X DQ3-14 10 min. Medium X DQ3-15 15 min. Medium X DQ3-16 15 min. Medium X DQ3-17 10 min. Medium X DQ3-18 15 min. Medium X DQ3-19 10 min. Medium X DQ3-20 15 min. Medium X DQ3-21 15 min. Medium X X X DQ3-22 10 min. Easy X DQ3-23 10 min. Medium X DQ3-24 15 min. Easy X DQ3-25 25 min. Medium X X DQ3-26 10 min. Medium X DQ3-27 20 min. Medium X DQ3-28 15 min. Medium X DQ3-29 10 min. Medium X DQ3-30 10 min. Medium X DQ3-31 15 min. Medium X DQ3-32 10 min. Easy X DQ3-33 10 min. Easy X DQ3-34 15 min. Medium X P3-35 15 min. Medium X X P3-36 15 min. Medium X X X P3-37 15 min. Medium X X X P3-38 20 min. Medium X X X P3-39 20 min. Medium X X X P3-40 20 min. Medium X X X P3-41 20 min. Medium X X X P3-42 20 min. Medium X X X P3-43 20 min. Medium X X X P3-44 20 min. Medium X X X P3-45 20 min. Medium X X X P3-46 10 min. Medium X P3-47 10 min. Medium X X P3-48 10 min. Medium X X P3-49 10 min. Medium X X P3-50 10 min. Medium X X P3-51 25 min. Hard X X P3-52 25 min. Hard X X P3-53 25 min. Hard X X P3-54 20 min. Hard X X P3-55 20 min. Medium X X X P3-56 20 min. Medium X X X P3-57 20 min. Medium X X P3-58 20 min. Medium X X P3-59 20 min. Hard X X P3-60 15 min. Easy X P3-61 30 min. Medium X X P3-62 30 min. Medium X X P3-63 60 min. Hard X X P3-64 15 min. Medium X P3-65 15 min. Medium X P3-66 60 min. Medium X X X X X P3-67 45 min. Medium X X P3-68 45 min. Medium X X Lecture Notes 1) Basic Tax Planning Overview a) Effective tax planning i) Goal of tax planning: Maximizing the taxpayer’s after-tax wealth while achieving the taxpayer’s nontax goals. ii) Three parties to every transaction: Taxpayer, other transacting party, and the government. iii) Astute tax planning requires understanding the tax and nontax costs from the taxpayer’s and other party’s perspective. iv) Three basic tax planning strategies: Timing, income shifting, and conversion. 2) Timing Strategies a) Timing i) When income is taxed or expense is deducted affects the associated “real” tax costs or savings. ii) The time when income is taxed or an expense is deducted affects the present value of the taxes paid on income or the tax savings on deductions. iii) The tax costs of income and tax savings income vary as tax rates change. The tax costs on income are higher when tax rates are higher and lower when tax rates are lower. Likewise, the tax savings on deductions are higher when tax rates are higher and lower when tax rates are lower. b) Present value of money i) $1 today will be worth more than $1 in the future. ii) The implication of the time value of money for tax planning is that the timing of a cash inflow or a cash outflow affects the present value of the income or expense. iii) When considering cash inflows, higher present values are preferred; when considering cash outflows, lower present values are preferred. iv) Future Value = Present Value × (1 + r)n v) Present Value = Future Value / (1 + r)n vi) Exhibit 3-1 provides discount rates for a single payment received in n periods using various rates of return. vii) Work through Example 3-2. c) The timing strategy when tax rates are constant i) Two basic tax-related timing strategies ii) Accelerating deductions: Essentially accelerating a current cash inflow. iii) Deferring income: Essentially deferring a current cash outflow. iv) Work through Example 3-3. d) The timing strategy when tax rates change i) When tax rates are increasing, the taxpayer must calculate the optimal tax strategies for deductions and income. Why? ii) The taxpayer must calculate whether the benefit of accelerating deductions outweighs the disadvantage of recognizing deductions in a lower-tax-rate year. iii) The taxpayer must calculate whether the benefit of deferring income outweighs the disadvantage of recognizing income in a higher-tax-rate year. iv) When tax rates are decreasing, taxpayers should accelerate tax deductions into earlier years and defer taxable income to later years. Why? v) Accelerating deductions maximizes the present value of tax savings from deductions due to the acceleration of the deductions into earlier years with a higher tax rate. vi) Deferring income minimizes the present value of taxes paid due to the deferral of the income to later years with a lower tax rate. vii) Work through Example 3-5. e) Limitations to timing strategies i) (1) Tax deductions often cannot be accelerated without also accelerating the actual cash outflow that generates the deduction. (2) Tax law generally requires taxpayers to continue their investment to defer income. (3) A deferral strategy may not be optimal if the taxpayer has severe cash flow needs, if continuing the investment would generate a low rate of return compared to other investments, if the current investment would subject the taxpayer to unnecessary risk, and so on. (4) Constructive receipt doctrine: taxpayer must recognize income when it is actually or constructively received. 3) Income-Shifting Strategies a) Income shifting exploits the differences in tax rates across taxpayers by shifting income from high-tax-rate taxpayers (or jurisdictions) to low-tax-rate taxpayers (or jurisdictions) or shifting deductions from low-tax-rate taxpayers (or jurisdictions) to high-tax-rate taxpayers (or jurisdictions). b) Transactions between family members i) Children generally have lower marginal tax rates, and therefore parents may shift income to children so it will be taxed at the child’s tax rate. ii) Assignment of income, IRS scrutiny of related-party transactions, and the kiddie tax limit this strategy. c) Transactions between owners and their businesses i) Incorporating a business and thus shifting income from an individual to the corporation may result in lower current taxation of the business income. [See Example 3-8] ii) Shifting income from a corporation to an owner through tax-deductible expenses (e.g., compensation, interest, rent) allows the owners to avoid double taxation on corporate profits. iii) IRS scrutiny of related-party transactions limits this strategy. d) Income shifting across jurisdictions i) Income earned in different jurisdictions—whether in the United States or abroad, and for state income tax purposes, income earned in different states—is often taxed very differently. With a proper understanding of the differences in tax laws across jurisdictions, taxpayers can use these differences to maximize their after-tax wealth. ii) IRS scrutiny of transfer pricing, implicit taxes, and negative publicity (e.g., for moving operations abroad) limits this strategy. 4) Conversion Strategies a) Tax rates can vary across different activities ; ordinary income is taxed at ordinary rates; long-term capital gains are taxed at preferential rates; some income is tax-exempt. b) The conversion strategy is based on the understanding that the tax law does not treat all types of income or deductions the same. c) To implement the conversion strategy, you must be aware of the underlying differences in tax treatment across various types of income, expenses, and activities and have some ability to alter the nature of the income or expense to receive the more advantageous tax treatment. d) Work through Example 3-10 e) When the investment period is longer than one year, taxpayers can receive benefits from combining the timing strategy and the conversion strategy. f) Work through Example 3-11. g) Limitations of conversion strategies i) The Code itself contains provisions to prevent a taxpayer from changing the nature of expenses and income. ii) Implicit taxes may also reduce or eliminate the advantages of conversion strategies. 5) Additional Limitations to Tax Planning Strategies: Judicially Based Doctrines a) The IRS also has several other doctrines at its disposal for situations where it expects taxpayer abuse. These doctrines apply across a wide variety of transactions and planning strategies (timing, income shifting, and conversion). b) Business purpose doctrine: IRS has the power to disallow business expenses for transactions that don’t have a business purpose. c) Step-transaction doctrine: IRS has the power to collapse a series of transactions into one to determine tax liability. d) Substance-over-form doctrine: IRS can reclassify a transaction according to its substance (instead of its form). e) Economic substance doctrine: Transactions must meet two criteria 1) the transaction must meaningfully change a taxpayer’s economic position (excluding any federal income tax effects) and 2) the taxpayer must have a substantial purpose (other than tax avoidance) for engaging in the transaction. 6) Tax Avoidance versus Tax Evasion a) Tax avoidance is the legal act of arranging one’s transactions to minimize taxes paid. b) Tax evasion is the willful attempt to defraud the government by not paying taxes legally owed. c) Tax evasion falls outside the confines of legal tax avoidance. Class Activities 1. Suggested class activities ○ Let’s make a deal: This chapter provides a great opportunity for students to research tax planning in the real world. As a game, you can assign students to locate via Internet research a discussion of a transaction in which tax planning played a major role (i.e., the Disney-Marvel acquisition). Split the students into groups and have them add up the dollar value of the related transactions (one per group member) that they located in their research. The group with the aggregated largest value of transactions receives bonus participation points. As part of this game, the students should be required to print documentation regarding the transaction, describe the specific tax planning strategy, and classify it based on the tax strategies discussed in the text. ○ One versus the class: Have one student volunteer as the “one” with the other class members being the “group.” Use the key facts boxes in the text to develop basic multiple-choice questions (A, B, C answers) and then quiz the volunteer and the class on the questions. The volunteer and each class member will need to write the letters A, B, and C on separate sheets of paper and then hold up their appropriate response to the question. Once a student (either the “one” or a member of the “group”) misses a question, her or she is eliminated from the competition. After six (or some other number) of questions, those students left standing receive bonus participation points for the day. 2. Research activities ○ This chapter provides a good opportunity to get students to form the habit of identifying tax planning strategies using available resources (Internet, tax services, etc.). As an ongoing class exercise, you can instruct the class that they will receive a certain specified number of points for every tax article (maximum of X points for the course) they submit that discusses a tax planning idea relating to the material covered in class. For every article submitted, students should classify the type of tax planning strategy (timing, income shifting, conversion) and be ready to provide a brief overview of the tax planning strategy to the class with a three to five minute presentation (for additional points as deemed appropriate). This exercise is a great way to stress the importance and relevance of tax planning and to get students actively engaged in applying the material discussed in class. To the extent short class presentations are utilized, this exercise should also enhance students’ presentation skills. 3. Ethics discussion From page 3-14: Discussion points: • Agnes would like to reduce her overall tax burden. • One way to accomplish this would be to shift income to her lower-taxed children. • One issue to discuss is whether the salary paid to the children represents reasonable compensation for the services they provide. It may be questionable as to whether children of these ages can perform enough janitorial and clerical services to reach this standard. Chapter 4 Individual Income Tax Overview, Dependents, and Filing Status Learning Objectives 4-1. Describe the formula for calculating an individual taxpayer’s taxes due or refund. 4-2. Explain the requirements for determining who qualifies as a taxpayer’s dependent. 4-3. Determine a taxpayer’s filing status. Teaching Suggestions The first part of this chapter dealing with the individual income tax formula (Learning Objective 4-1) was designed to provide students with an overview of individual taxation. The tax formula changed slightly under the tax law passed as part of the TCJA by including a deduction for qualified business income that is a from AGI deduction but is not an itemized deduction. Also, personal and dependency exemption amounts are no longer deductible as they were prior to the TCJA. It is important that students understand that this part of the chapter is introducing, at a high level, material that they will be learning in more depth in subsequent chapters (and later in this chapter). The objective is to help students understand the big picture. Students should come away from this portion of the chapter with enough understanding of individual taxation to be able to answer the following types of questions: What is gross income? Why is all realized income not included in gross income? What is the difference between an exclusion item and a deferral item? What is the character of income and why is income character important? What is the difference between a “for” and a “from” AGI deduction? What is an itemized deduction? What is a standard deduction? At a general level, how do you compute taxable income? At a general level, how do you compute a taxpayer’s tax liability given taxable income? What is a tax credit? How do taxpayers pay their tax liabilities? The section “Character of Income” is intended to discuss in general terms the rates at which different types of income are taxed in the current year. Further, this section introduces capital assets and capital gains and losses. Because these concepts come up in several chapters of the text, it is important to introduce them early in the chapter sequence. The chapter describes (in exhibits) common income items (and their character), common for AGI deductions, the deduction for qualified business income, and the main categories of itemized deductions. The chapter also provides the amounts of the standard deduction by filing status (which were increased significantly under the TCJA). Students should understand that this information provided under the first learning objective is to give them a general sense of what they will learn in more detail in later chapters. Students should not feel like they need to know the technical nuances of the items listed in these exhibits at this point. They should, however, be able to recognize common income and deduction items. Students should also understand that only income that is not excluded or deferred is reported on and affects taxable income on the tax return. In terms of the reporting on the actual tax return, gross income is the starting point for determining taxable income. Finally, note that the tax forms changed between the 2018 and the 2019 versions. More information is included on page 1 of the Form 1040. The last line on page 1 is now taxable income. The second and third parts of the chapter dealing with who qualifies as a taxpayer’s dependent (Learning Objective 4-2) and filing status (Learning Objective 4-3) were designed to provide the technical details on these topics. That is, the technical detail on these topics is not provided elsewhere in the text. Because filing status may depend on a taxpayer’s dependents, the chapter discusses who qualifies as a taxpayer’s dependent before discussing filing status. Students should understand why it is important to determine who qualifies as the taxpayer’s dependents even though taxpayers are no longer allowed to deduct dependency amounts. The chapter discusses the tests for qualifying children and qualifying relatives. Exhibit 4-8 provides a framework for students to use when evaluating whether someone qualifies as a dependent. It is important to help students understand that someone can meet the relationship test for a qualifying relative even if that person is not actually related to the taxpayer as long as that person lives with the taxpayer for the entire year. In the “Filing Status” section, it is important that students understand that from a tax perspective that it would be unusual for a couple to gain a tax advantage by filing separately. Couples who file separately usually do so for nontax purposes. Students generally have the most difficulty understanding the rules for qualifying for head of household status. This is especially true when the taxpayer’s dependent is a qualifying relative, not a qualifying child. In order for the taxpayer to qualify for head of household status, the dependent must have a qualifying family relationship with the taxpayer (taxpayer’s descendant or ancestor, sibling, stepmother, stepfather, stepbrother, or sister, nephews, nieces, aunts, uncles, or in-laws) and not be considered a relative just because the dependent lives with the taxpayer for the entire year. The text includes detail and discussion of the requirements for the head of household filing status. Finally, students may need extra help understanding the abandoned spouse rule and its implications for head of household status. Assignment Matrix Learning Objectives Text Feature Problem Time Difficulty LO1 LO2 LO3 Research Planning Tax Forms DQ4-1 10 min. Medium X DQ4-2 10 min. Medium X DQ4-3 10 min. Medium X DQ4-4 10 min. Medium X DQ4-5 10 min. Medium X DQ4-6 10 min. Medium X DQ4-7 10 min. Medium X DQ4-8 10 min. Medium X DQ4-9 10 min. Medium X DQ4-10 10 min. Medium X DQ4-11 10 min. Medium X DQ4-12 10 min. Medium X DQ4-13 10 min. Medium X DQ4-14 10 min. Medium X DQ4-15 10 min. Medium DQ4-16 10 min. Medium X DQ4-17 10 min. Medium X DQ4-18 10 min. Medium X DQ4-19 10 min. Medium X DQ4-20 10 min. Medium X DQ4-21 10 min. Medium X DQ4-22 10 min. Medium X DQ4-23 10 min. Hard X DQ4-24 10 min. Medium X DQ4-25 5 min. Medium X DQ4-26 5 min. Hard X DQ4-27 10 min. Medium X DQ4-28 5 min. Easy X P4-29 20 min. Medium X P4-30 5 min. Easy X P4-31 20 min. Medium X X P4-32 15 min. Hard X X P4-33 15 min. Hard X X P4-34 15 min. Medium X X P4-35 20 min. Medium X P4-36 20 min. Medium X P4-37 15 min. Medium X P4-38 15 min. Medium X P4-39 15 min. Hard X P4-40 20 min. Hard X X P4-41 20 min. Hard X X P4-42 20 min. Hard X X P4-43 10 min. Medium X X P4-44 15 min. Hard X X P4-45 10 min. Medium X P4-46 5 min. Easy X P4-47 15 min. Medium X P4-48 20 min. Hard X P4-49 20 min. Medium X P4-50 25 min. Medium X X P4-51 25 min. Medium X X P4-52 5 min. Easy X P4-53 30 min. Medium X X P4-54 15 min. Medium X X CP4-55 25 min. Medium X CP4-56 30 min. Medium X CP4-57 30 min. Medium CP4-58 10 min. Easy Lecture Notes 1) The Individual Income Tax Formula a) Reporting taxable income i) Income tax Form 1040 generally used to report taxable income. ii) Refer to Exhibit 4-1 for Individual Tax Formula (but note that what is included on the tax return generally starts with gross income). iii) Refer to Exhibit 4-2 for Form 1040. The exhibit provides the 2019 tax forms, which are a little different from the 2018 tax forms. The text includes the 2019 forms because the 2020 forms were not available at press time. b) Realized income, exclusions, deferrals, and gross income i) Realized income (1) All-inclusive income concept (a) Realized income is income generated in a transaction with a second party in which there is a measurable change in property rights between parties. (i) Refer to Exhibit 4-3 for common income items (including character). (b) Discuss concept of deferral versus exclusion. (i) Refer to Exhibit 4-4 for common exclusions and deferrals. c) Character of income i) Determines rate at which income will be taxed for the year ii) Tax-exempt iii) Tax-deferred iv) Ordinary v) Capital (1) Capital gain or loss from selling capital assets (2) Capital asset (a) Accounts receivable (b) Inventory (c) Property used in trade or business, including supplies (3) Long-term capital gains (a) Generally taxed at 0 percent, 15 percent, or 20 percent (net long-term gains in excess of net short-term losses). The IRS provides a separate schedule to that gives the break points for the different rates (see Appendix D). May mention, but don’t discuss, 25 percent and 28 percent long-term capital gains. (4) Short-term capital gains (a) Generally taxed at ordinary rates (5) Net capital losses (a) Deduct $3,000 against ordinary income. (b) Carryover excess loss to future years (indefinite carryover). vi) Qualified dividend (1) Taxed at 0 percent, 15 percent, or 20 percent. Break points for the different rates are provided by the IRS (see Appendix D). d) Deductions: Taxpayers are not allowed to deduct anything unless a specific tax provision allows them to do so. i) Deductions for AGI (1) Above the line (2) Refer to Exhibit 4-5 for Partial Listing of Common for AGI Deductions. ii) Deductions from AGI (1) Below the line (2) New deduction for qualified business income (from AGI deduction but not itemized deduction). Equal to qualified business income × 20%. (3) Refer to Exhibit 4-6 for Primary Categories of Itemized Deductions. (4) Refer to Exhibit 4-7 for Standard Deduction Amounts by Filing Status. e) Income tax calculation i) Taxpayers generally calculate their income tax liability using either a tax table or a tax rate schedule, depending on their filing status and income level. This chapter covers the tax tables but does not deal directly with the tax tables. (You could pull up a tax table to show students.) The current tax rates range from 10 percent to 37 percent. f) Other taxes i) Alternative minimum tax and the self-employment tax (both covered in the Individual Income Tax Computation and Tax Credits chapter). ii) The 3.8 percent net investment income tax (on unearned income) and the .9 percent additional Medicare tax (on earned income) are covered in the Individual Income Tax Computation and Tax Credits chapter. g) Tax credits i) Individual taxpayers may reduce their tax liabilities by tax credits to determine their total taxes payable. h) Tax prepayments i) Income taxes withheld from the taxpayer’s salary or wages by the employer; ii) Estimated tax payments the taxpayer makes for the year; and iii) Taxes overpaid in the previous year that the taxpayer elects to apply as an estimated payment for the current year. 2) Dependents of the Taxpayer a) Dependency requirements i) To qualify as a dependent of another, an individual: (1) Must be a citizen of the United States or a resident of the United States, Canada, or Mexico. (2) Must not file a joint return with the individual’s spouse unless there is no tax liability on the couple’s joint return and there would not have been any tax liability on either spouse’s tax return if they had filed separately. (3) Must be considered either a qualifying child of the taxpayer or a qualifying relative of the taxpayer. ii) Qualifying child (1) Relationship test (2) Age test (3) Residence test (4) Support test (5) Tiebreaking rules iii) Qualifying Relative (1) Relationship test (2) Support test (3) Gross income test iv) Refer to Exhibit 4-8 for Summary of Dependency Requirements. v) Refer to Appendix A of this chapter for flowchart to determine who qualifies as the taxpayer’s dependent. 3) Filing Status a) Each year taxpayers determine their filing status according to their marital status at year-end and whether they have any dependents. b) Married filing jointly i) Taxpayers must be legally married as of the last day of the year. ii) When one spouse dies during the year, the surviving spouse is still considered to be married for tax purposes during the year of the spouse’s death. iii) Both spouses are ultimately responsible for paying the joint tax. c) Married filing separately i) Each spouse files his or her own tax return. ii) Generally, there is no tax advantage for filing separately. iii) Each spouse is ultimately responsible for paying own tax. iv) Generally, for nontax reasons, couples may choose to file separately. (1) Limit liability for other spouse’s taxes. d) Qualifying widow or widower (surviving spouse) i) Generally treated as married filing jointly. ii) When the taxpayer’s spouse dies, the surviving spouse can file as qualifying widow or widower for two years after the year of the spouse’s death if the surviving spouse remains unmarried and maintains a household for a dependent child. e) Single i) Unmarried taxpayers who do not qualify for head of household status file as single taxpayers. f) Head of household i) Unmarried or considered to be unmarried at year-end ii) Not a qualifying widow or widower iii) Pay more than half the costs of maintaining home during year iv) Lived in taxpayer’s home with a qualifying person for more than half the year (1) See exception for parents who qualify as taxpayer’s dependents. (2) Qualifying person (a) Qualifying child (b) Qualifying relative must live with taxpayer for more than half the year, be taxpayer’s dependent, and must have qualifying family relationship. (c) Parent, even if parent doesn’t live with taxpayer, if parent qualifies as taxpayer’s dependent. (d) See Exhibit 4-9 for description of who is a qualifying person for purposes of the head of household test. See Appendix B to this chapter for a flowchart to use to determine who is a qualifying person for head of household filing status. v) Requirements for married taxpayers to be treated as unmarried at end of year (also known as abandoned spouse rules) Qualifies if: (a) Taxpayer not legally separated from spouse. (b) Taxpayer does not file joint return with spouse. (c) Spouse has not lived in taxpayer’s home at all during last six months of year (excluding temporary absences due to illness, military, etc.). (d) Taxpayer pays more than half the costs of maintaining a home that is principal place of abode for qualifying child. 4) Summary of Income Tax Formula a) Refer to Exhibit 4-10 for summary of the Halls’ taxable income. 5) Appendix A: Flowchart for determining who qualifies as a dependent. 6) Appendix B: Flowchart for determining who is a qualifying person for head of household status. 7) Appendix C: Flowchart for determining filing status. Class Activities 1. Suggested class activities ○ Movie clip: As a way to introduce individual income taxes, you could show a clip from The Simpsons episode “The Trouble with Trillions” (the twentieth episode of the ninth season). See the episode’s Wikipedia article for information on the episode. The individual income tax portion runs through about 7 minutes and 40 seconds of the episode (the introduction runs about the first 54 seconds). ○ Relate general concepts to first two pages and Schedule 1 of Form 1040: Have students identify where the items in Exhibit 4-1 show up on page two and Schedule 1 of Form 1040. Gross income (realized income from whatever source derived minus excluded or deferred income) is found somewhere in lines 1–7, inclusive, and Schedule 1 lines 1–8; for AGI deductions don’t show up directly on page 1 but they generally show up in lines 10–20 of Schedule 1, inclusive. However, for AGI deductions could also show up on line 3 (Schedule C), line 4 (Form 4797), or line 5 (Schedule E) of Schedule 1 and/or Line 6 of page 1 (Schedule D) of Form 1040. Students could work on this individually or work on it in groups. This could be a competition for bonus points or simply a learning activity. ○ Research activity: Have students download the first two pages and Schedule 1 of Form 1040 from the IRS website. Students can use this form in the second class activity suggested above. ○ Comprehensive problems: Have students work in groups (two to four students) to complete a comprehensive problem. Make yourself available to students to answer questions, but try to get them to work together to resolve their questions. You could choose one question (what is taxable income? or what are taxes due?) for students to report to you. You can write the answer from each group on the board and then reveal the correct answer. Give credit to the group(s) that is (are) correct/closest. ○ Elimination: Develop several multiple-choice questions (A, B, C answers) relating to important topics from the chapter. You could also draw questions from the test bank. Have each class member write the letters A, B, and C on separate sheets of paper. Have the entire class stand up. When you ask a question, have each class member hold up their appropriate response to the question (A, B, or C). Those who miss must sit down. Continue until you have asked all your questions or until all but one student has been eliminated. Award bonus points (or acknowledgment of a job well done) to those still standing. 2. Ethics discussion From page 4-17: Blake was 21 years of age at the end of the year. During the year, he was a full-time college student. He also worked part-time and earned $8,000, which he used to pay all $6,000 of his living expenses. Blake’s parents, Troy and Camille, claimed him as a dependent on their joint tax return. After filing the return, Troy told Blake they owed him $3,001 for his annual living expenses. What do you think of Troy and Camille’s strategy to claim Blake as a dependent? Discussion points: • For Blake to qualify as his parents’ dependent, he must do so as a qualifying child because he has too much income to qualify as a qualifying relative. • To qualify as a qualifying child, Blake must not have provided his own support. • During the year, Blake provided all his own support, but Blake’s father, Troy, informed Blake that Troy and Camille (Blake’s parents) owed Blake enough money such that Blake’s parents would have provided more than half the support for Blake. • Since this was done after the fact, who has provided Blake’s living expenses? Did Blake provide all of his own support or did his parents provide more than half? • Are Blake’s parents going to actually transfer the money to Blake? What was the nature of the arrangement? Is this simply a ploy to justify claiming Blake as a dependent in order to secure a tax benefit such as the (expanded) child tax credit or the American opportunity credit, or is there something more to it? Instructor Manual for McGraw-Hill's Taxation of Individuals and Business Entities 2021 Brian C. Spilker, Benjamin C. Ayers, John A. Barrick, Troy Lewis, John Robinson, Connie Weaver, Ronald G. Worsham 9781260247138, 9781260432534