Preface

Principles of Taxation for Business and Investment Planning 2010 Edition

Sally M. Jones Professor Emeritus of Accounting McIntire School of Commerce University of Virginia

Shelley C. Rhoades-Catanach Associate Professor of Accountancy School of Business Villanova University

Boston Burr Ridge, IL Dubuque, IA New York San Francisco St. LouisBangkok Bogotá Caracas Kuala Lumpur Lisbon London Madrid Mexico CityMilan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei Toronto

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PRINCIPLES OF TAXATION FOR BUSINESS AND INVESTMENT PLANNING:2010 EDITION

Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY, 10020. Copyright © 2010, 2009, 2008, 2007, 2006, 2005, 2004, 2003, 2002, 2001, 2000, 1999, 1998 by The McGraw-Hill Companies, Inc. All rights reserved. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

Some ancillaries, including electronic and print components, may not be available to customers outside the United States .

This book is printed on acid-free paper.

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ISBN 978-0-07-337964-7 MHID 0-07-337964-6 ISSN 1099-5587

Vice president and editor-in-chief: Brent GordonEditorial director: Stewart MattsonPublisher: Tim VertovecDevelopmental editor II: Daryl HorrocksMarketing manager: Dean KarampelasSenior project manager: Susanne RiedellFull service project manager: Les Chappell, Macmillan Publishing SolutionsProduction supervisor: Gina HangosLead designer: Matthew BaldwinMedia project manager: Balaji Sundararaman, Hurix Systems Pvt. Ltd.Cover design: Matthew BaldwinTypeface: 10/12 Times RomanCompositor: Macmillan Publishing SolutionsPrinter: Quebecor World Dubuque Inc.

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About the Authors Sally M. Jones is professor emeritus of accounting at the McIntire School of Commerce, University of Virginia, where she continues to teach graduate tax courses. Before joining the Virginia faculty in 1992, Professor Jones spent 14 years on the faculty of the Graduate School of Business, University of Texas at Austin. She received her undergraduate degree from Augusta College, her MPA from the University of Texas, and her Ph.D. from the University of Houston. She is also a CPA. Professor Jones was the fi rst editor of Advances in Taxation (JAI Press) and the PriceWaterhouse Case Studies in Taxation. She has pub-lished numerous articles in the Journal of Taxation, The Tax Adviser, and the Journal of the American Taxation Association . Professor Jones is a frequent speaker at tax conferences and symposia, a past president of the American Taxation Association, and the 2000 recipi-ent of the Ray M. Sommerfeld Outstanding Tax Educator Award.

Shelley Rhoades-Catanach is an associate professor of accountancy at Villanova Univer-sity and a CPA. She teaches a variety of tax courses in Villanova’s undergraduate, masters of accounting, and graduate tax programs. Before joining the Villanova faculty in 1998, Profes-sor Rhoades-Catanach spent four years on the faculty of Washington University in St. Louis. She has also served as a visiting faculty member at the Darden Graduate School, Univer-sity of Virginia, and at INSEAD, an international MBA program in Fontaine bleau, France. She received her undergraduate degree in accounting from the University of Nebraska at Lincoln and her Ph.D. from the University of Texas at Austin. Professor Rhoades-Catanach has published articles in numerous journals, including the Journal of the American Taxa-tion Association, the Accounting Review, Issues in Accounting Education, the Journal of Accounting Education, and Review of Accounting Studies . She has served as president, vice president, and trustee of the American Taxation Association and on the editorial boards of the Journal of the American Taxation Association and the Journal of International Account-ing, Auditing and Taxation.

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Brief Contents A Note from the Authors xii

Introduction to Students xxii

PART ONE Exploring the Tax Environment

1 Types of Taxes and the Jurisdictions That Use Them 3

2 Tax Policy Issues: Standards for a Good Tax 21

PART TWO Fundamentals of Tax Planning

3 Taxes as Transaction Costs 47

4 Maxims of Income Tax Planning 69

5 Tax Research 93

PART THREE The Measurement of Taxable Income

6 Taxable Income from Business Operations 115

7 Property Acquisitions and Cost Recovery Deductions 155

Appendix 7–A Midquarter Convention Tables 193

8 Property Dispositions 197

9 Nontaxable Exchanges 237

PART FOUR The Taxation of Business Income

10 Sole Proprietorships, Partnerships, LLCs, and S Corporations 267

11 The Corporate Taxpayer 305

Appendix 11–A Schedule M-3 for Reconciling Book and Taxable Income 337

12 The Choice of Business Entity 341

13 Jurisdictional Issues in Business Taxation 367

PART FIVE The Individual Taxpayer

14 The Individual Tax Formula 401

Appendix 14–A Itemized Deduction Worksheet 435

Appendix 14–B Exemption Amount Worksheet 436

15 Compensation and Retirement Planning 437

16 Investment and Personal Financial Planning 477

Appendix 16–A Comprehensive Schedule D Problem 519

Appendix 16–B Federal Transfer Tax Rates (2009) 523

17 Tax Consequences of Personal Activities 525

Appendix 17–A Social Security Worksheet 556

PART SIX The Tax Compliance Process

18 The Tax Compliance Process 559

APPENDIXES A Present Value of $1 583

B Present Value of Annuity of $1 584

C 2009 Income Tax Rates 585

GLOSSARY 587

INDEX 598

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A Note from the Authors xiiIntroduction to Students xxii

PART ONEEXPLORING THE TAX ENVIRONMENT

Chapter 1Types of Taxes and the Jurisdictions That Use Them 3

Some Basic Terminology 4The Relationship between Base, Rate, and Revenue 5Transaction or Activity-Based Taxes 6Earmarked Taxes 6

The Pervasive Nature of Taxation 6Local Taxes 7State Taxes 8Federal Taxes 10Taxes Imposed by Foreign Jurisdictions 12Jurisdictional Competition 12

Dynamic Nature of Taxation 13Tax Base Changes 13Taxes and the Political Process 14

Sources of Federal Tax Law 14Statutory Authority 15Administrative Authority 15Judicial Authority 16

Conclusion 16Key Terms 16Questions and Problems for Discussion 17Application Problems 18Issue Recognition Problems 19Research Problems 20Tax Planning Cases 20

Chapter 2Tax Policy Issues: Standards for a Good Tax 21

Standards for a Good Tax 22Taxes Should Be Suffi cient 22

The National Debt 23How to Increase Tax Revenues 23

Static versus Dynamic Forecasting 24Behavioral Responses to Rate Changes 25

Taxes Should Be Convenient 28Taxes Should Be Effi cient 28

The Classical Standard of Effi ciency 29Taxes as an Instrument of Fiscal Policy 29Taxes and Behavior Modifi cation 30

Taxes Should Be Fair 32Ability to Pay 32Horizontal Equity 32Vertical Equity 33Distributive Justice 36The Perception of Inequity 37

Conclusion 38Key Terms 39Questions and Problems for Discussion 39Application Problems 40Issue Recognition Problems 42Research Problems 43Tax Planning Case 43

PART TWOFUNDAMENTALS OF TAX PLANNING

Chapter 3Taxes as Transaction Costs 47

The Role of Net Present Value in Decision Making 48

Quantifying Cash Flows 48The Concept of Present Value 48The Issue of Risk 50A Net Present Value Example 51

Taxes and Cash Flows 51The Signifi cance of Marginal Tax Rate 52Net Present Value Example Revisited 53The Uncertainty of Tax Consequences 55

Structuring Transactions to Reduce Taxes 57An Important Caveat 58Transactional Markets 58

Conclusion 62Key Terms 63Questions and Problems for Discussion 63Application Problems 63

Contents

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Issue Recognition Problems 67Tax Planning Cases 68

Chapter 4Maxims of Income Tax Planning 69

Tax Avoidance—not Evasion 70What Makes Income Tax Planning Possible? 70The Entity Variable 71

Income Shifting 72Deduction Shifting 72Constraints on Income Shifting 73

The Time Period Variable 73Income Deferral and Opportunity Costs 75Income Deferral and Rate Changes 76

The Jurisdiction Variable 77 The Character Variable 77

Determining the Value of Preferential Rates 78Constraints on Conversion 79Implicit Taxes 79

Developing Tax Planning Strategies 80Additional Strategic Considerations 81Tax Legal Doctrines 83


Chapter 5Tax Research 93

Developing Tax Research Skills 93The Tax Research Process 94

Step 1: Get the Facts 95Step 2: Identify the Issues 96Step 3: Locate Authority 97

Primary Authorities 97Secondary Authorities 99Strategies for Locating Relevant Authority 100

Step 4: Analyze Authority 102Step 5: Repeat Steps 1 through 4 105Step 6: Communicate your Conclusions 106Conclusion 108Key Terms 108Questions and Problems for Discussion 108Application Problems 109Issue Recognition Problems 111

Research Problems 112Tax Planning Cases 112

PART THREETHE MEASUREMENT OF TAXABLE INCOME

Chapter 6Taxable Income from Business Operations 115

Business Profi t as Taxable Income 116The Taxable Year 117

Changing a Taxable Year 118Annualizing Income on a Short-Period Return 118

Methods of Accounting 120Tax Policy Objectives 121

The Cash Method 123Constructive Receipt 124Prepaid Expenses and Interest 125Merchandise Inventories 126Limitations on Use of the Cash Method by Corporations 127

The Accrual Method 127Contrasting Perspectives on Income Measurement 128Permanent versus Temporary Differences 128Tax Expense versus Tax Payable 130Temporary Book/Tax Accounting Differences 131

Net Operating Losses 137The Problem of Excess Deductions 137Solution: The NOL Deduction 138Valuing an NOL Deduction 139Giving Up an NOL Carryback 140Accounting for NOLs 141

Conclusion 141Sources of Book/Tax Differences 142Key Terms 142Questions and Problems for Discussion 142Application Problems 143Issue Recognition Problems 150Research Problems 152Tax Planning Cases 152

Chapter 7Property Acquisitions and Cost Recovery Deductions 155

Deductible Expense or Capitalized Cost? 156Repairs and Cleanup Costs 157Deductions of Capital Expenditures as Subsidies 158

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The Critical Role of Tax Basis 159Basis, Cost Recovery, and Cash Flow 160Cost Basis 161

Introduction to Cost Recovery Methods 162Inventories and Cost of Goods Sold 163

The Unicap Rules 163Computing Cost of Goods Sold 164

Depreciation of Tangible Business Assets 164Book and Tax Concepts of Depreciation 164The MACRS Framework 165Limited Depreciation for Passenger Automobiles 171Section 179 Expensing Election 172Bonus Depreciation 173Purchase versus Leasing Decision 174

Amortization of Intangible Assets 175Organizational and Start-Up Costs 176Leasehold Costs and Improvements 178Business Acquisition Intangibles 178Comprehensive Example of a Lump-Sum Purchase 180

Depletion of Natural Resources 180Percentage Depletion 181

Conclusion 182Sources of Book/Tax Differences 183Key Terms 183Questions and Problems for Discussion 183Application Problems 184Issue Recognition Problems 190Research Problems 190Tax Planning Cases 191Appendix 7–A Midquarter Convention Tables 193

Chapter 8Property Dispositions 197

Computation of Gain or Loss Recognized 198Sales and Exchanges 199Seller-Financed Sales 201Disallowed Losses on Related Party Sales 204

Tax Character of Gains And Losses 206Capital Asset Defi ned 206Capital Loss Limitation 207Taxation of Capital Gains 209Capital Asset Defi nition Revisited 209

Dispositions of Noncapital Assets 210Inventory 210Business Accounts Receivable and Supplies 211Section 1231 Assets 212Depreciation Recapture 214Comprehensive Example 218

Other Property Dispositions 220Abandonment and Worthlessness 220

Foreclosures 222Casualties and Thefts 222


Chapter 9Nontaxable Exchanges 237

Tax Neutrality for Asset Exchanges 237A Generic Nontaxable Exchange 238

Exchanges of Qualifying Property 238The Substituted Basis Rule 239The Effect of Boot 240Book/Tax Difference from Nontaxable Exchange 241Summary 242

Like-Kind Exchanges 242Exchanges of Mortgaged Properties 245

Involuntary Conversions 247Formations of Business Entities 248

Corporate Formations 248Partnership Formations 250

Wash Sales 251Conclusion 251Sources of Book/Tax Differences 252Key Terms 252Questions and Problems for Discussion 252Application Problems 253Issue Recognition Problems 259Research Problems 260Tax Planning Cases 261Comprehensive Problems for Part Three 262

PART FOURTHE TAXATION OF BUSINESS INCOME

Chapter 10Sole Proprietorships, Partnerships, LLCs, and S Corporations 267

Sole Proprietorships 268Overview of Schedule C 268Employment Taxes 272Self-Employment Tax 274

Partnerships 275

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Forming a Partnership 275Partnership Reporting Requirements 277Tax Consequences to Partners 280Adjusting the Basis of a Partnership Interest 283 Limited Liability Companies 286

Subchapter S Corporations 287Eligible Corporations 289Tax Consequences to Shareholders 291Adjusting the Basis of S Corporation Stock 293


Chapter 11The Corporate Taxpayer 305

Legal Characteristics of Corporations 306Affi liated Groups 306Nonprofi t Corporations 308

Computing Corporate Taxable Income 308The Dividends-Received Deduction 310 Reconciling Book Income and Taxable Income 311

Computing The Regular Corporate Tax 312 Personal Service Corporations 303 Reduced Tax Burden on Domestic Manufacturers 304

Tax Credits 315Rehabilitation Credit 316

Alternative Minimum Tax 317Alternative Minimum Taxable Income 318Calculating AMT 320Minimum Tax Credit 321

Payment and Filing Requirements 322Distributions of Profi ts to Investors 323

Alternatives to Double Taxation 324Incidence of the Corporate Tax 325Conclusion 326Sources of Book/Tax Differences 326Key Terms 326Questions and Problems for Discussion 326Application Problems 327Issue Recognition Problems 333Research Problems 334Tax Planning Problems 335 CPA Exam Simulation 336 Appendix 11–A Schedule M-3 for Reconciling

Book and Taxable Income 337

Chapter 12The Choice of Business Entity 341

Tax Planning with Passthrough Entities 342Tax Benefi t of Start-Up Losses 342Avoiding a Double Tax on Business Income 343Income Shifting among Family Members 344

Partnership or S Corporation? 347Contrasting Characteristics 347Two Planning Cases 349

Tax Planning with Closely Held Corporations 350Getting Cash Out of the Corporation 350Decline of the Corporate Tax Shelter 353Penalty Taxes on Corporate Accumulations 354Controlled Corporate Groups 356

Conclusion 357Key Terms 357Questions and Problems for Discussion 357Application Problems 359Issue Recognition Problems 362Research Problems 363Tax Planning Cases 364CPA Exam Simulation 365

Chapter 13Jurisdictional Issues in Business Taxation 367

State and Local Taxation 368Constitutional Restrictions on State Jurisdiction 368Apportionment of Business Income 370Tax Planning Implications 372

Tax Consequences of International Business Operations 373

Income Tax Treaties 374U.S. Jurisdiction to Tax Global Income 374

Foreign Tax Credit 375Limitation on the Annual Credit 376

Organizational Forms for Overseas Operations 378

Branch Offi ces and Foreign Partnerships 378Domestic Subsidiaries 379Foreign Subsidiaries 379

Deferral of U.S. Tax on Foreign Source Income 381

Controlled Foreign Corporations 383Transfer Pricing and Section 482 386Book/Tax Differences Related to Foreign Operations 387

Conclusion 387

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Sources of Book/Tax Differences 388Key Terms 388Questions and Problems for Discussion 388Application Problems 389Issue Recognition Problems 394Research Problems 395Tax Planning Cases 396Comprehensive Problems for Part Four 397

PART FIVETHE INDIVIDUAL TAXPAYER

Chapter 14The Individual Tax Formula 401

Filing Status for Individuals 402Married Individuals and Surviving Spouses 402Unmarried Individuals 403

Overview of the Taxable Income Computation 403

The Four-Step Procedure 403Step 1: Calculate Total Income 404Step 2: Calculate Adjusted Gross Income 404Step 3: Subtract Standard Deduction or Itemized Deductions 404Step 4: Subtract Exemption Amount 409The Taxable Income Formula 412

Computing Individual Tax 413The Marriage Penalty Dilemma 415The Elusive Marginal Tax Rate 416

Individual Tax Credits 417Child Credit 417Dependent Care Credit 418Earned Income Credit 418Excess Payroll Tax Withholding 419

Alternative Minimum Tax 420The AMT Trap 422

Payment and Filing Requirements 423Conclusion 425Key Terms 425Questions and Problems for Discussion 425Application Problems 427Issue Recognition Problems 432Research Problems 433Tax Planning Cases 433 Appendix 14–A Itemized Deduction Worksheet 435 Appendix 14–B Exemption Amount

Worksheet 436

Chapter 15Compensation and Retirement Planning 437

The Compensation Transaction 438Employee or Independent Contractor? 438

Tax Consequences of Worker Classifi cation 438Worker Classifi cation Controversy 439

Wage and Salary Payments 441Reasonable Compensation 441Foreign Earned Income Exclusion 444

Employee Fringe Benefi ts 445Fringe Benefi ts and Self-Employed Individuals 446Compensation Planning with Fringe Benefi ts 447

Employee Stock Options 448Book/Tax Difference 450Incentive Stock Options 450

Employment-Related Expenses 452Moving Expenses 452

Retirement Planning 453Tax Advantages of Qualifi ed Retirement Plans 453Premature Withdrawals 455

Types of Qualifi ed Plans 456Employer-Provided Plans 456Keogh Plans for Self-Employed Individuals 460Individual Retirement Accounts 461


Chapter 16Investment and Personal Financial Planning 477

Business versus Investment Activities 478Investments in Financial Assets 478

Dividend and Interest Income 478Tax-Exempt Interest 480Deferred Interest Income 482 Life Insurance Policies and Annuity Contracts 484

Gains and Losses from Security Transactions 486Computing Gains and Losses 486

Tax Consequences of Capital Gains and Losses 489Netting Capital Gains and Losses 489Preferential Rates on Long-Term Capital Gains 491

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Policy Reasons for a Preferential Rate 493Capital Loss Limitation 493

Investments in Small Corporate Businesses 494Qualifi ed Small Business Stock 494Section 1244 Stock 495

Investment Expenses 496Investment Interest Expense 496

Investments in Real Property 497Undeveloped Land 497Rental Real Estate 498

Investments in Passive Activities 500Passive Activity Loss Limitation 500Planning with Passive Activity Losses 502

Wealth Transfer Planning 503The Transfer Tax System 503The Gift Tax 503The Estate Tax 506

Conclusion 508Key Terms 508Questions and Problems for Discussion 509Application Problems 510Issue Recognition Problems 515Research Problems 516Tax Planning Cases 517Appendix 16–A Comprehensive Schedule D

Problem 519 Appendix 16–B Federal Transfer Tax Rates

(2009) 523

Chapter 17Tax Consequences of Personal Activities 525

Gross Income from Whatever Source Derived 525Personal Receipts 526Legal Settlements 527Government Transfer Payments 528Gains on Sales of Personal Assets 529

Personal Expenses 530Medical Expenses 531Local, State, and Foreign Tax Payments 531Charitable Contributions 532Tax Subsidies for Education 533

Personal Losses 534Losses on Sales of Personal Assets 534Casualty and Theft Losses 535Hobby and Gambling Losses 536

Tax Consequences of Home Ownership 537Home Mortgage Interest Deduction 538Vacation Homes 539

Exclusion of Gain on Sale of Principal Residence 539

Itemized Deductions as AMT Adjustments 540Conclusion 542Key Terms 542Questions and Problems for Discussion 542Application Problems 543Issue Recognition Problems 549Research Problems 550Tax Planning Cases 551Comprehensive Problems for Part Five 552CPA Exam Simulations 553Appendix 17–A Social Security Worksheet (Adapted from IRS Publication 915) 556

PART SIXTHE TAX COMPLIANCE PROCESS

Chapter 18The Tax Compliance Process 559

Filing and Payment Requirements 560Late-Filing and Late-Payment Penalty 561Return Processing 562

The Audit Process 563Your Rights as a Taxpayer 564Noncompliance Penalties 565Tax Return Preparer Penalties 568

Contesting the Result of an Audit 568Litigation 569A Case History: Lori Williams v. United States 570Making the Legal System More Taxpayer Friendly 571IRS Collection Procedures 572The Innocent Spouse Rule 573

Conclusion 574Key Terms 574Questions and Problems for Discussion 574Application Problems 576Issue Recognition Problems 578Research Problems 579Tax Planning Problems 579

Appendix A Present Value of $1 583

Appendix B Present Value of Annuity of $1 584

Appendix C 2009 Income Tax Rates 585

Glossary 587

Index 598

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Principles of Taxation for Business and Investment Planning is a unique approach to the subject of taxa-tion. This text is designed for use in introductory tax courses included in either undergraduate or graduate business programs. Its objective is to teach students to recognize the major tax issues inherent in business and fi nancial transactions. The text focuses on fundamental concepts, the mastery of which provides a permanent frame of reference for future study of advanced tax top-ics. Unlike traditional introductory texts, Principles of Taxation for Business and Investment Planning down-plays the technical detail that makes the study of taxa-tion such a nightmare for business students. Traditional texts are heavily compliance oriented and convince many students that the tax law is too complex and spe-cialized to be relevant to their future careers. This text attempts to do just the opposite by convincing students that an understanding of taxation is not only relevant but critical to their success in the business world. Principles of Taxation for Business and Investment Planning has its origin in the 1989 White Paper entitled Perspectives on Education: Capabilities for Success in the Accounting Profession, published jointly by the Big Eight public accounting fi rms. The White Paper expressed disenchantment with the narrow technical focus of undergraduate accounting curricula and called for scholastic emphasis on a broad set of business skills necessary for professional success. The Accounting Education Change Commission (AECC), operating under the aegis of the American Accounting Associa-tion, embraced the philosophy refl ected in the White Paper. In September 1990, the AECC published its Po-sition Statement No. One, entitled Objectives of Edu-cation for Accountants. This statement reiterated that an undergraduate business education should provide a base for lifelong learning. Despite these calls for reform, many undergraduate tax courses are taught in a traditional manner based on a paradigm developed a half-century ago. In the mod-ern (postwar) era of business education, the fi rst gen-eration of tax teachers were practitioners: accountants or attorneys hired as adjunct faculty to initiate students into the mysteries of the newly enacted Internal Rev-enue Code of 1954. These practitioners taught their

students in the same way they trained their employees. In doing so, they created a compliance-oriented para-digm. In today’s world, this traditional paradigm is an anachronism. Business students don’t need to learn how to generate tax information. Instead, they must learn how to use tax information to make good busi-ness and fi nancial decisions.

A New Paradigm for the Introductory Tax Course Principles of Taxation for Business and Investment Planning provides a paradigm for meeting the educa-tional needs of tax students in the twenty-fi rst century. This paradigm is based on three postulates:

• Postulate 1: Students should learn the tax law as an integrated component of a complex economic environment. They should be aware of the role taxes play in fi nancial decision making and should under-stand how taxes motivate people and institutions to engage in certain transactions.

• Postulate 2: Students should comprehend the tax law as an organic whole rather than as a frag-mented collection of rules and regulations. They should learn general tax rules rather than the myriad of exceptions that confuse rather than clarify the general rules. They should appreciate how the gen-eral rules apply to all taxpaying entities before they learn how specialized rules apply to only certain en-tities. Finally, they should learn how the law applies to broad categories of transactions rather than to a particular transaction.

• Postulate 3: Students who learn fundamen-tal concepts have a permanent frame of refer-ence into which they can integrate the constant changes in the technical minutiae of the law. The rapid evolution of the tax law results in a short shelf life for much of the detailed information contained in undergraduate tax texts. Yet the key elements of the law—the statutory and judicial bedrock—do not change with each new revenue act. Students who master these key elements truly are prepared for a lifetime of learning.

A Note from the Authors

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The authors know that traditional paradigms die hard and educational reform is diffi cult. Nevertheless, we also believe that change in the way college and univer-sity professors teach tax is both inevitable and worth-while. Our responsibility to our students is to prepare them to cope in a business world with little tolerance for outdated skills or irrelevant knowledge. Our hope is that Principles of Taxation for Business and Investment Plan-ning is a tool that can help us fulfi ll that responsibility.

Using This Text in a First-Semester Tax Course Principles of Taxation for Business and Investment Plan-ning is designed for use in a one-semester (15-week) introductory tax course. Instructors can choose which of the 18 chapters deserve a full week’s coverage and which can be covered in less than a week. Instruc-tors may even decide to omit chapters that seem less rele vant to the educational needs of their students.

Business students who complete a one-semester course based on this text will be well prepared to function in the modern tax environment. If they are required (or may elect) to take a second tax course, they will have a solid, theoretical foundation on which to build. This is the thirteenth annual edition of Principles of Taxation for Business and Investment Planning . This edition incorporates the major tax law changes included in the American Recovery and Reinvestment Act of 2009, which was signed into law by President Obama on February 17, 2009. We’ve been students of the tax law far too long to believe that this edition is free from technical error or includes every relevant topic. Adopters of the text will certainly have many excellent suggestions to improve the next edition. We welcome any and all comments and encourage fellow teachers to e-mail us ( [email protected] and [email protected] ) with their input.

Sally M. Jones

Shelley C. Rhoades-Catanach

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The content and organization of this text are highly compat-ible with the Model Tax Curriculum proposed by the American Institute of Certifi ed Public Accountants. According to the AICPA, the introductory tax course should expose students to a broad range of tax concepts and emphasize the role of taxa-tion in the business decision-making process. Under the model curriculum, students fi rst learn to measure the taxable income from business and property transactions. They are then intro-duced to the different types of business entities and the tax considerations unique to each type. Individual taxation should be one of the last topics covered, rather than the primary focus of the course. Because Principles of Taxation for Business and Investment Planning refl ects this recommended pedagogical approach, the text is ideal for courses based on the AICPA Model Tax Curriculum.

PART ONE Exploring the Tax Environment 1 Types of Taxes and the Jurisdictions That

Use Them 3

2 Tax Policy Issues: Standards for a Good Tax 21

PART TWO Fundamentals of Tax Planning 3 Taxes as Transaction Costs 47

4 Maxims of Income Tax Planning 69

5 Tax Research 93

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Part One consists of two chapters that familiarize students with the global tax environment. Chapter 1 describes the environment in terms of the legal relationship between taxes, taxpayers, and governments. Defi nitions of key terms are developed, and the major taxes are identifi ed. Chapter 2 considers the tax environment from a normative perspective by asking the question: “What are the characteristics of a good tax?” Students are introduced to the notions of tax effi ciency and tax equity and learn how contrasting political beliefs about effi ciency and equity continue to shape the tax environment.

Part Two concentrates on developing a methodology for incorporating tax factors into business decisions. Chapter 3 introduces the pivotal role of net present value of cash fl ows in evaluating fi nancial alternatives. Students learn how to compute tax costs and tax savings and how to interpret them as cash fl ows. Chapter 4 covers the maxims of income tax planning. The characteristics of the tax law that create planning opportunities are explained, and the generic techniques for taking advantage of those opportunities are analyzed. Chapter 5 provides a succinct overview of the tax research process and prepares students to solve the research problems included at the end of each chapter. The chapter explains the six steps in the tax research process and contains a cumulative example of the application of each step to a research case.

Key Features

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PART FOUR The Taxation of Business Income 10 Sole Proprietorships, Partnerships, LLCs,

and S Corporations 267

11 The Corporate Taxpayer 305

12 The Choice of Business Entity 341

13 Jurisdictional Issues in Business Taxation 367

PART FIVE The Individual Taxpayer 14 The Individual Tax Formula 401

15 Compensation and Retirement Planning 437

16 Investment and Personal Financial Planning 477

17 Tax Consequences of Personal Activities 525

PART SIX The Tax Compliance Process 18 The Tax Compliance Process 559

Appendix A Present Value of $1 583 Appendix B Present Value of Annuity of $1 584 Appendix C 2009 Income Tax Rates 585

Part Three focuses on the quantifi cation of business taxable income. Chapter 6 covers the computation of income or loss from ongoing commercial activities, with special emphasis on differences between taxable income and net income for fi nancial statement purposes. Chapters 7 and 8 explore the tax implications of acquisitions and dispositions of business property, while Chapter 9 is devoted to nontaxable exchanges.

Part Four teaches students how to calculate the tax on business income. Chapter 10 describes the function of sole proprietorships, partnerships, LLCs, and S corporations as conduits of income, while Chapter 11 discusses corporations as taxable entities in their own right. Chapter 12 builds on the preceding two chapters by exploring the tax planning implications of the choice of business entity. Chapter 13 broadens the discussion by considering the special problems of businesses operating in more than one tax jurisdiction. This chapter introduces both multistate and international tax planning strategies.

Part Five concentrates on the tax rules and regulations unique to individuals. Chapter 14 presents the individual tax formula and acquaints students with the complexities of computing individual taxable income. Chapter 15 covers compensation and retirement planning. Chapter 16 covers investment and rental activities and introduces wealth transfer planning. Finally, Chapter 17 analyzes the tax consequences of personal activities, with particular emphasis on home ownership.

Part Six consists of Chapter 18 , which presents the important procedural and administrative issues confronting taxpayers. It covers the basic rules for paying tax and fi ling returns, as well as the penalties on taxpayers who violate the rules. Chapter 18 also describes the judicial process through which taxpayers and the IRS resolve their differences.

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PART THREE The Measurement of Taxable Income 6 Taxable Income from Business Operations 115

7 Property Acquisitions and Cost Recovery Deductions 155

8 Property Dispositions 197

9 Nontaxable Exchanges 237

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Key Learning Tools

Learning Objectives The chapters begin with learning objectives that preview the technical content and alert students to the important concepts to be mastered. These objectives appear again as marginal notations marking the place in the chapter where each learning objective is addressed.

Examples and Cases The chapters contain numerous examples and cases illustrating or demonstrating the topic under discussion.

Tax Talk Each chapter includes items of “Tax Talk.” These items highlight new tax planning strategies, tax facts, legislative proposals, or innovative transactions with interesting tax implications reported in the business press.

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Learning Objectives

After studying this chapter, you should be able to:

1. Differentiate between tax avoidance and tax evasion.

2. List the four variables that determine the tax consequences of a transaction.

3. Explain why an income shift or a deduction shift can improve NPV.

4. Explain how the assignment of income doctrine constrains income-shifting strategies.

5. Identify the circumstances in which a tax deferral strategy may not improve NPV.

6. Contrast the tax character of ordinary income and capital gain.

7 Distinguish between an explicit tax and an implicit tax

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Assignment of Income Doctrine The federal courts have consistently held that our income tax system cannot tolecial shifts of income from one taxpayer to another. Over 75 years ago, the Suprdecided that income must be taxed to the person who earns it, even if another pelegal right to the wealth represented by the income. 5 Thus, a business owner wha $10,000 check in payment for services rendered to a client can’t avoid reportinincome by simply endorsing the check over to his daughter. In the picturesque lathe Court, the tax law must disregard arrangements “by which the fruits are attrdifferent tree from that on which they grew.” The Supreme Court elaborated on this theme in the case of a father who degotiable interest coupons from corporate bonds and gave the coupons to his sonWhen the coupons matured, the son collected the interest and reported it as

Objective 4 Explain how the assignment of income doctrine constrains income-shiftingstrategies.

Objective 4 Explain how the assignment of income doctrine constrains income-shiftingstrategies.

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Federal tax cost (Taxable income � 39%) (1,872) (1,755)

After-tax cash fl ow $2,928 $2,745

A comparison of these after-tax cash fl ows gives us our third income tax planim: Tax costs decrease (and cash fl ows increase) when income is generated in a juwith a low tax rate. The comparison between the after-tax cash fl ows of Firms Y and Z would be mplex if these fi rms operate in any foreign country that taxes business income. Cleagers must be aware of the income tax laws of every locality in which their fi rmor plans to operate in the future. Managers should appreciate that they can oftenthe total tax burden by conducting business in jurisdictions with favorable tax climintricacies of tax planning in a multijurisdictional setting are the subject of Chap

Tax Talk The Irish rock band U2 transferred part of its publishing company, U2 Limited, out of Ireland to the same Dutch fi nancial management company used by the Rolling Stones because royalty income is taxed by Ireland but is virtually tax-exempt in the Netherlands.

Tax Talk The Irish rock band U2 transferred part of its publishing company, U2 Limited, out of Ireland to the same Dutch fi nancial management company used by the Rolling Stones because royalty income is taxed by Ireland but is virtually tax-exempt in the Netherlands.

Global The accounting fi rm KPMG has indexed the tax costs imposed by 10 industrialized on businesses operating within the country’s jurisdiction This Total Tax Index uses

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p g p p g

Confl icting Maxims

Firm MN operates as two separate taxable entities, Entity M and Entity N. The fi rm ating a transaction that will generate $25,000 cash in year 0 and $60,000 cash inEntity M undertakes the transaction, taxable income will correspond to cash fl ow (iM will report $25,000 and $60,000 taxable income in years 0 and 1). If Entity N unthe transaction, it must report the entire $85,000 taxable income in year 0. Entity30 percent marginal tax rate while Entity N has a 25 percent marginal tax rate. Firma 9 percent discount rate to compute NPV.

Entity M Entity

Year 0: Before-tax cash fl ow $25,000 Taxable income $25,000 $85,000 .30 .25

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End-of-Chapter Material

Key Terms Key terms are indicated in boldface in the text. A list of key terms is also supplied at the end of the chapter with page references for easy review. Defi nitions of key terms from all the chapters are compiled in a Glossary for the text.

Sources of Book / Tax Differences Chapters 6 , 7 , 8 , 9 , 11 , 13 and 15 provide a list of the sources of book/tax differences introduced in the chapter.

Questions and Problems for Discussion Challenge students to think critically about conceptual and technical issues covered in the chapter. These problems tend to be open-ended and are designed to engage students in debate. Many problems require students to integrate material from previous chapters in formulating their responses.

Sources of Book/Tax Differences

• Interest on state and local bonds • Key-person life insurance proceeds and

premiums • Fines and penalties • Political contributions and lobbying

expense • Meals and entertainment expense • Domestic production activities

deduction

• Prepaid income • Bad debts • Accrued expenses failing

all-events test • Compensation accruals • Related party accruals • NOL carryforwards

Permanent Temporary

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xvii

accrual method of accounting 127

all-events test 132 allowance method 136 annualized income 119 calendar year 117 cash method of

accounting 123 constructive receipt 124 deferred tax asset 130 deferred tax liability 130 direct write-off

economic performance 133

FAS 109 130 fi scal year 117 generally accepted

accounting principles (GAAP) 127

gross income 116 hybrid method of

accounting 126 key-person life insurance

policies 122

NOL carryba NOL carryfo payment liabi permanent di personal serv

corporation prepaid incom realization recognition recurring item

exception short-period r

Key Terms

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1. Discuss the choice of a taxable year for the following businesses.

a. Retail plant and garden center.

b. French bakery.

c. Chimney cleaning business.

d. Moving and transport business.

e. Software consulting business.

2. Corporation DB operates three different lines of business. Can the corpdifferent overall method of accounting for each line or must the corporaoverall method?

3. Firm LK bought a warehouse of used furniture to equip several of its cAn employee discovered a cache of gold coins in a desk drawer. A localFirm LK the rightful owner of the coins, which have a $72,000 FMV. recognize income because of this lucky event?

Questions and Problems for Discussion

Questions and Problems for Discussion

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Issue Recognition Problems Develop students’ ability to recognize the tax issues suggested by a set of facts and to state those issues as questions. The technical issues buried in these problems typically are not discussed in the chapter. Consequently, students must rely on their understanding of basic principles to analyze the problem, spot the tax concern or opportunity, and formulate the question to be resolved. In short, students must take the fi rst steps in the tax research process.

Research Problems Provide further opportunity for students to develop their analytic skills. These problems consist of short scenarios that suggest one or more tax issues. The scenarios conclude with explicit research questions for the students to answer. To fi nd the answers, they need access to either a traditional or an electronic tax library.

Application Problems Give students practice in applying the technical material covered in the chapter. Most of the problems are quantitative and require calculations to derive a numeric solution.

xviii

Identify the tax issue or issues suggested by the following situations, and sin the form of a question.

1. Mr. and Mrs. TR own an investment yielding a 7.2 percent after-taxfriend Ms. K is encouraging them to sell this investment and invest the pbusiness, which takes advantage of several favorable tax preferences.Ms. K’s after-tax return from this business is 8.4 percent.

2. Company QP must decide whether to build a new manufacturing planor Country C. Country B has no income tax. However, its political regiand its currency has been devalued four times in three years. Country20 percent income tax and a stable democratic government.

3. Dr. P is a physician with his own medical practice. For the last several ginal income tax rate has been 35 percent. Dr. P’s daughter, who is a chas no taxable income. During the last two months of the year, Dr. P intients to remit their payments for his services directly to his daughter.

4. Mrs. Y owns 1,800 shares of Acme common stock, which she purchas

IssueRecognitionProblems

IssueRecognitionProblems

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1. Bontaine Publications, an accrual basis, calendar year corporation, pubweekly and monthly magazines to retail bookstores and newsstands. Tment provides that the retailers may return any unsold magazines duringperiod after purchase. Bontaine will refund one-half of the purchasereturned magazine. During December 2009, Bontaine recorded $919zine sales. During January 2010, Bontaine refunded $82,717 to retailermagazines purchased during December. Can Bontaine reduce its 2009refund?

2. CheapTrade, an accrual basis, calendar year corporation, operates a discbrokerage business. CheapTrade accepts orders to buy or sell marketfor its customers and charges them a commission fee for effecting the ttimely, low-cost manner. CheapTrade executes an order on the “trade” dthe securities is not legally transferred and payment to or from the custountil the “settlement date.” In the normal fi ve-day interval between the tment dates CheapTrade performs administrative and accounting func

ResearchProblemsResearchProblems

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1. Refer to the corporate rate schedule in Appendix C.

a. What is the tax liability, the marginal tax rate, and the average tax ratetion with $48,300 taxable income?

b. What is the tax liability, the marginal tax rate, and the average tax ratetion with $615,800 taxable income?

c. What is the tax liability, the marginal tax rate, and the average tax ratetion with $16,010,000 taxable income?

d. What is the tax liability, the marginal tax rate, and the average tax ratetion with $39,253,000 taxable income?

2. Refer to the individual rate schedules in Appendix C.

a. What is the tax liability, the marginal tax rate, and the average tax ratcouple fi ling jointly with $51,900 taxable income?

b Wh t i th t li bilit th i l t t d th t

ApplicationProblemsApplicationProblems

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Tax Planning Cases Give students an opportunity to integrate their tax knowledge into a business planning framework. Most cases involve taxpayers who must decide whether to undertake a certain transaction or who must choose between alternative transactions. Students must assume the role of tax adviser by recommending a course of action to maximize the after-tax value of the transaction.

CPA Exam Simulations Prepare students to sit for the computerized CPA exam by working tax problems in a Web-based interface identical to that used in the exam. Chapters 11 , 12 , and 17 include directions to seven Kaplan CPA Review simulations. Give your students a competitive edge by familiarizing them with the content and structure of tax questions as well as the software by which the CPA exam is administered.

xix

Please visit the text Web site for the online CPA simul mhhe.com/sjones2010. Kimberly Corporation is a calendar year, accrual basis corporation that comtions on January 1, year 1. The following adjusted accounts appear on Kimbethe year ended December 31, year 4. Kimberly is not subject to the uniformrules.

Topics covered in simulation:

• Nontaxable income items

• Nondeductible expense items

• MACRS versus book depreciation

• Dividends-received deduction

• Temporary book/tax differences

• Corporate AMT

CPA Exam Simulation

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p y

1. Firm NS owns 90 percent of Corporation T’s outstanding stock. NS alsorealty that T needs for use in its business. The FMV of the realty is $NS’s adjusted basis is $5.6 million. Both NS and T are in the 35 percenbracket. Discuss the tax implications of each of the following coursesdecide which course you would recommend to NS.

a. NS could exchange the realty for newly issued shares of T stock wor

b. NS could sell the realty to T for $4 million cash.

c. NS could lease the realty to T for its annual fair rental value of $600

2. Firm K, a noncorporate taxpayer, has owned investment land with a $60four years. Two unrelated parties want to acquire the land from K. Party$770,000 cash, and Party B has offered another tract of land with a $72K accepts Party B’s offer, it would hold the new land for no more than twselling it. The FMV of this land should appreciate 10 percent annually. capital gain is 15 percent, and it uses a 7 percent discount rate to compuoffer should K accept to maximize the NPV of the transaction?

3. This year, Corporation EF decides to replace old, outmoded business e

Tax Planning CasesTax Planning Cases

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Supplements

Instructor‘s Manual An Instructor’s Manual includes a course outline, topics for class discussion, and teaching hints for a one-semester introductory tax course. The Instructor’s Manual also provides suggested solutions to all end-of-chapter problems and cases.

Test Bank A Test Bank contains true/false, multiple choice, and application problems in a Windows platform.

These resource supplements are located on the Instructor site on the Online Learning Center.

Online Learning Center A Web Page ( www.mhhe.com/sjones2010 ) includes valuable material for both instructors and students. These include PowerPoint slides and online quizzes for students with solutions and their rationales. All Web page materials are produced by the authors. This Online Learning Center (OLC) can be delivered in multiple ways—professors and students can access it directly through the textbook Web site, through PageOut, or within a course management system (i.e., WebCT, Blackboard, TopClass, or eCollege).

xx

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xxi

Acknowledgments We want to thank the many friends and colleagues who continue to share their ideas for this textbook. We particularly want to acknowledge the contribution of Professor Pat Wilkie (University of Virginia) and Professor Jim Young (Northern Illinois University). Their article entitled “Teaching the Introductory Tax Course: A Template of the Federal Income Tax Formula, Taxpayer Activities, and Taxpayer Entities” in the Journal of the American Taxation Association (Fall 1997) profoundly infl uenced the organization of this book. Thanks also to the individuals who reviewed the 2009 edition of the text. Their ex-pert comments were invaluable, and this edition is signifi cantly improved because of their involvement:

Glenn Alan, University of Arizona

Eugene H. Cantor, University of Maryland

Ernest Carraway, North Carolina State University–Raleigh

Caroline Craig, Illinois State University

Steven E. DeWald, University of Wisconsin–River Falls

Courtney Edwards, University of North Carolina–Chapel Hill

Stephen Gara, Drake University

Gregory Geisler, University of Missouri

Gordon Klein, University of California–Los Angeles

Susan Logorda, Lehigh Carbon Community College

Melanie McCoskey, University of Tennessee

Ken Milani, University of Notre Dame

Arabian Morgan, Los Angeles City College

Tim Murphy, Diablo Valley College

Simon R. Pearlman, California State University–Long Beach

David Randolph, Xavier University

Margaret Reed, University of Cincinnati

John F. Robertson, Arkansas State University

Paul Schloemer, Ashland University

We are grateful to the entire McGraw-Hill/Irwin team for their professional support. In particular, we want to acknowledge Stewart Mattson, Tim Vertovec, Daryl Horrocks, Susanne Riedell, Les Chappell (Macmillan Publishing Solutions), Dean Karampelas, Matthew Baldwin, Debra Sylvester, and Sue Lombardi.

Sally M. Jones University of Virginia

Shelley C. Rhoades-Catanach Villanova University

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Principles of Taxation for Business and Investment Planning explores the role that taxes play in modern life. The book is written for business students who have completed introduc-tory courses in accounting and fi nance and are familiar with basic business concepts. Those of you who fi t this description, regardless of your future career path, will make decisions in which you must evaluate the effect of taxes. At the most fundamental level, all business de-cisions have the same economic objective: maximization of long-term wealth through cash fl ow enhancement. The cash fl ow from any transaction depends on the tax consequences. Therefore, business men and women must appreciate the role of taxes before they can make intelligent decisions, whether on behalf of their fi rm or on their personal behalf.

Taxes as Business Costs

When businesspeople are asked to identify the common goal of all business decisions, their immediate response tends to be that the goal is to increase profi ts. When prompted to think past the current year, most eventually conclude that the long-term goal of business decisions is to maximize the value of the fi rm. In this text, a fi rm is a generic business organization. Firms include sole proprietorships, partnerships, limited liability companies, subchapter S and regular corporations, and any other arrangement through which people carry on a profi t-motivated activity. Firm managers know that short-term profi ts and long-term value are enhanced when operating costs, including taxes, are controlled. Experienced managers never regard taxes as fi xed or unavoidable costs. As you will soon discover, op-portunities abound for controlling the tax cost of doing business. The preceding paragraph suggests that tax planning means reducing tax costs to maximize the value of the fi rm. Firms can reduce taxes by any number of strategies. However, tax cost is only one variable that managers must consider in making business decisions. A strategy that reduces taxes may also have undesirable consequences, such as reducing revenues or increas-ing nontax costs. Because of nontax variables, the strategy with the least tax cost may not be the best strategy. Therefore, tax minimization in and of itself may be a short-sighted objective. This point is so elementary yet so important: Effective tax planning must take into account both tax and nontax factors . When faced with competing strategies, managers should imple-ment the strategy that maximizes fi rm value, even when that strategy has a higher tax cost than the alternatives. In other words, managers should never let the tax tail wag the business dog.

Taxes as Household Expenditures

Principles of Taxation for Business and Investment Planning concentrates on the income taxa-tion of business activities and organizations. This does not mean that the tax rules applying to in-dividuals are ignored. Quite to the contrary. For income tax purposes, individuals and the profi t-making activities in which they engage are entwined. As we will observe over and over again, the ultimate taxpayers in every business are the people who own and operate that business. As you study this text, consider your own role as a lifelong taxpayer. Regardless of who you are, where you live, or how you earn and spend your money, you will pay taxes on a regular basis to any number of governments. In fact, in the United States, taxes are the single largest household expenditure. The above pie chart shows that a person working an eight-hour day spends almost three hours working to pay local, state, and federal taxes.

Introduction to Students

xxii

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Tax Bite in the Eight-Hour Day

Source: Tax Foundation.

Introduction to Students xxiii

Federaltaxes:1 hour,

37 minutes

Allother:

58 minutes

Food: 46 minutes

Housingand

householdoperations:

1 hour,19 minutes

Stateandlocaltaxes:

51 minutes

Transportation:38 minutes

Clothing:17 minutes

Recreation:28 minutes

Healthand

medicalcare:

1 hour,6 minutes

People who are clueless about taxes must take a passive role, participating in a tax system they don’t understand and over which they exercise no control. In contrast, if you under-stand how taxes relate to your life, you can take an active role. You can take positive steps to minimize your personal tax to the fullest extent allowed by law. You can make informed fi nancial decisions to take advantage of tax-saving opportunities. You can draw rational conclusions about the effi ciency and fairness of existing tax laws and can assess the merit of competing tax reform proposals. Finally, you can change the tax system by participating as a voter in the democratic process.

The Text’s Objectives Principles of Taxation for Business and Investment Planning has three objectives that motivate the overall design of the text, the selection and ordering of topics, and the devel-opment of each topic.

Introducing Tax Policy Issues

The fi rst objective is to acquaint you with the economic and social policy implications of the tax systems by which governments raise revenues. Most of the subject matter of the text pertains to today’s tax environment and how successful businesses adapt to and take advantage of that environment. But the text also raises normative issues concerning the effi ciency and equity of many features of the tax environment. You will learn how certain provisions of the tax law are intended to further the government’s fi scal policy goals. You are invited to evaluate these goals and to question whether the tax system is an appropriate mechanism for accomplishing the goals. The text identifi es potentially negative aspects of the tax environment. It explains how taxes may adversely affect individual behavior or cause unintended and undesirable outcomes. You will be asked to consider whether certain provisions of the tax law favor one group of taxpayers over another and whether such favoritism is justifi able on any ethical grounds. After probing both the strengths and weaknesses of the current tax system, you can draw your own conclusions as to how the system can be improved.

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xxiv Introduction to Students

Bridging the Gap between Finance and Tax

The second objective of the text is to bridge the academic gap between the study of fi nancial theory and the study of tax law. Finance courses teach students how to make decisions on the basis of after-tax cash fl ows. However, these courses give only rudimen-tary instruction on determining the tax consequences of transactions and overlook the possibilities for controlling tax costs to maximize cash fl ows. In extreme cases, fi nancial models simply ignore tax consequences by assuming that business decisions are made in a tax-free environment. Traditional tax law courses err in the opposite direction. These courses teach students to apply statutory rules to well-defi ned, closed-fact situations to determine the tax conse-quences. Correct application of the rule is the learning objective. Students are not required to integrate the tax consequences of transactions into a business decision-making frame-work. In other words, they don’t translate tax outcomes into cash fl ows. Traditional law courses may fail to encourage students to consider how closed-fact situations can be re-structured to change the tax outcome and improve fi nancial results. Consequently, students often develop the habit of analyzing transactions from a backward-looking compliance perspective rather than a forward-looking planning perspective. The focus of Principles of Taxation for Business and Investment Planning is the common ground shared by fi nancial theory and tax law. The connecting links between the two disci-plines are stressed throughout the text. You will learn how effective business planning depends on an accurate assessment of relevant tax factors. Tax rules and regulations are presented and illustrated in the context of a decision-making framework. Admittedly, these rules and regulations are tough to master. Two observations should give you reassurance. First, while the tax law is extremely technical and complex, the application of its underly-ing principles to business decision making is relatively straightforward. Second, you can learn to appreciate tax planning strategies without becoming a tax-compliance expert.

Teaching the Framework of the Income Tax

The third objective of Principles of Taxation for Business and Investment Planning is to teach the framework of the federal income tax, the dominant feature of the modern tax en-vironment. This framework has been remarkably stable over time, even though the details of the law change every year. Students who learn the framework needn’t worry that their knowledge will be outdated when Congress enacts its next revenue bill. The federal income tax system has a bad reputation as an impenetrable, intractable body of law. While the income tax law is every bit as complicated as its critics suggest, its frame-work consists of a manageable number of basic principles. The principles are internally consistent and underlie many technical provisions. By concentrating on these principles, you can attain a suffi cient level of tax knowledge in a single introductory course. You will not be a tax expert, but you will be tax literate. You may not be capable of implementing sophisticated tax planning strategies, but you will appreciate how those strategies can im-prove cash fl ows and maximize wealth. Because this text takes a conceptual approach to the tax law, narrowly drawn provisions, exceptions, limitations, and special cases are deemphasized. Details with the potential to confuse rather than clarify tax principles are usually relegated to footnotes. When we do examine a detailed provision of the law, the detail should illuminate an underlying concept. Or we may discuss a thorny technical rule just to emphasize the practical diffi culties en-countered by tax professionals who don’t have the luxury of dealing with concepts. The conceptual approach should sensitize you to the tax implications of transactions and cultivate your ability to ask good tax questions. This approach downplays the importance of

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Introduction to Students xxv

the answers to these questions. Knowing the answers or, more precisely, fi nding the answers to tax questions is the job of accountants and attorneys who devote long hours in their re-search libraries to that end. A tax-sensitive business manager knows when to consult these experts and can help formulate the tax issues for the expert to resolve. The text’s emphasis on issue recognition rather than issue resolution is refl ected in the problems at the end of each chapter. Many of these problems ask you to analyze a fact situation and simply identify any tax concerns or opportunities. Other problems present you with facts suggesting tax issues with no correct solution.

A Word to Accounting Majors Principles of Taxation for Business and Investment Planning is an ideal introductory text for those of you who are concentrating in accounting and who may even plan to specialize in taxation. You will benefi t enormously from mastering the framework of the income tax as the fi rst step in your professional education. This mastery will be the foundation for the future study of advanced topics. You will gain a command of basic principles on which to rely as you develop an instinct for your subject—a facility for diagnosing the tax issues suggested by unfamiliar and unusual transactions. The conceptual approach is appropriate for the fi rst tax course because it concentrates on broad issues concerning most taxpayers instead of narrow problems encountered by only a few taxpayers. If you learn these issues, you will be well prepared to expand and deepen your tax knowledge through professional experience. You will understand that taxes are only one aspect of the economic decision-making process. Because of this understanding, those of you who become tax professionals will be equipped to serve your clients not just as tax specialists but as business advisers.

CPA Exam Preparation

This text provides excellent preparation for the computer-based CPA exam. The text covers approximately 90 percent of the specifi ed federal tax content of the Regulation portion of the exam. The 10 percent remaining content consists of advanced topics usually covered in a second-semester undergraduate tax course. The CPA exam includes a variety of interactive problems designed to test your knowledge of the tax law and your ability to apply the law in realistic situations. Many of the problems are in the form of simulations: short cases in which you must demonstrate your tax research and analytic skills. These are the exact skills that you will learn, practice, and refi ne as you work your way through Principles of Taxation for Business and Investment Planning .

Conclusion The authors hope this introduction has conveyed the message that business men and women who decide on a particular course of action without considering the tax outcomes are mak-ing an uninformed, and possibly incorrect, decision. By proceeding with the course of study contained in this text, you will learn to recognize the tax implications of a whole spectrum of transactions. On entering the business world, you will be prepared to make decisions incorporating this knowledge. You will spot tax problems as they arise and will call in a tax professional before, rather than after, a transaction with profound tax consequences. Finally, you will understand that effective tax planning can save more money than the most diligent tax compliance.

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Documents

Preface