1
Chapter 1
Introduction to Federal Taxation and
Understanding the Federal Tax Law
SUMMARY OF CHAPTER
This chapter presents information on the magnitude of federal taxes collected and on taxpayer obligations. Also,
the history of U.S. federal taxation is briefly summarized followed by a review of the federal legislative process.
Fundamental Aspects of Federal Taxation
¶1101 Sources of Revenue
Types of federal taxes include (1) income taxes on corporations, individuals, and fiduciaries, (2) employment
taxes, (3) estate and gift taxes, and (4) excise and customs taxes. Also, revenues are generated from state and local taxes.
Consideration is given to the attractiveness of alternative systems—the value-added tax and flat tax.
¶1121 Tax Collection and Penalties
Taxes are big business and figures are given to demonstrate just how vast and complex the federal revenue collection
system has become. In 1989, the civil tax penalty provisions were extensively revamped to create a fairer, less complex and
more effective penalty system. Changes were made in the (1) document and information return penalties, (2) accuracy-related
penalties, (3) preparer, promoter, and protester penalties, and (4) penalties for failure to file or pay.
¶1131 Taxpayer Obligations
A clear understanding of tax avoidance versus tax evasion is necessary to achieve good tax planning. Tax avoidance is
legal and a legitimate pursuit of a business entity. Tax evasion requires the presence of a tax liability. There is a legal obligation
to disclose a tax liability based on completed transactions and the refusal to report the tax liability is illegal.
¶1151 Brief History of the Federal Income Tax
The adoption of the Sixteenth Amendment to the Constitution enabled Congress to levy “taxes on income,
from whatever source derived.” A brief chronological history of changes affecting the tax law from 1913 to the present is
presented.
• 16th Amendment (2/15/1913). Congress empowered itself to tax income.
• Revenue Act of 1913. Imposed income tax on individuals, corporations and other entities, effective 3/1/1913.
• Internal Revenue Codes of 1939, 1954 and 1986. Recodified the numerical referencing format of legislative tax
law after significant tax law revisions had occurred.
¶1161 Federal Tax Legislative Process
Steps in the enactment of a revenue bill are (1) origination in the House of Representatives Ways and Means
Committee, (2) passage by the House, (3) passage by the Senate, (4) resolution of differences in House and Senate versions by
the Joint Conference Committee, composed of members of both legislative bodies, (5) approval of the final version by both
the House and the Senate, (6) approval or veto by the President, and (7) incorporation into the Internal Revenue Code. Both
the Senate and the House must vote affirmatively by a two-thirds majority to override a veto.
¶1165 Tax Reform
The Taxpayer Relief Act of 1997 was the most significant tax legislation since the Tax Reform Act of 1986. Major
features of the Act include a reduction in capital gains tax rates, expanded IRAs, education tax incentives, estate tax relief,
and a child tax credit.
Chapter 1
,2 CCH Federal Taxation—Comprehensive Topics
Underlying Rationale of the Federal Income Tax
¶1171 Objectives of the Tax Law
The federal income tax system is comprised of a complicated and continually evolving blend of legislative
provisions, administrative pronouncements, and judicial decisions. The primary purpose of the tax law is obviously to
raise revenue, but social, political, and economic objectives are also important. These various objectives, which frequently
work at cross-purposes with the revenue-raising objective of the law, must be examined and understood to appreciate the
rationale underlying the immense multipurpose body of law known as the federal income tax.
¶1175 Economic Factors
Numerous provisions of the tax law have been employed to help stimulate the economy, to encourage capital
investment, or to direct resources to selected business activities. Examples include the following: MACRS depreciation;
the optional expensing election in lieu of depreciation; percentage depletion; special farming elections to expense rather
than to capitalize expenses for soil and water conservation, land clearing, and fertilizers; the S corporation provisions; the
Section 1244 stock loss provision; and the tax rate structure for regular corporations.
¶1181 Social Factors
Numerous tax provisions can best be explained in light of their underlying social objectives. Examples include the
following: the tax-free status accorded to employees on premiums paid by an employer on group-term insurance, accident
and health plans, and medical benefit plans; and the tax-deferred status accorded to employees’ current income under
deferred compensation plans.
¶1185 Political Factors
Since the tax law is created by Congress, and Congress consists of several hundred elected officials, political factors
play a major role in the development of tax legislation. Additionally, special interest groups and influential constituents
have a definite impact on the legislative process. For example, depletion under the percentage depletion method is limited
to 50% of “taxable net income before depletion” for all natural resource properties except oil and gas properties. For oil
and gas properties, the limit is 100% of taxable net income before depletion.
¶1187 Tax Policy and Reform Measures
Reform of the tax statutes has been a trend through the years. The tax policy implications of the 1986 revision
will be under examination for some time to come. In an effort to further the concept of neutrality in the tax law, the
Revenue Reconciliation Act of 1990 made major changes in the way high-income individuals compute their taxable
income. Also, for 1991 the tax rate schedules were changed to incorporate a third tax bracket: 31 percent. The Revenue
Reconciliation Act of 1993 extended the tax rates to also include a 36 percent bracket and a 39.6 bracket. The Taxpayer
Relief Act of 1997 made major modifications to capital gains. The holding period of capital assets to qualify as long term
was extended from more than 12 months to more than 18 months. Also, the long-term capital gains tax rate for many
items decreased from 28 percent to 20 percent. The IRS Restructuring and Reform Act of 1998 changed the holding
period for long term classification from more than 18 months to more than 12 months. The year 2000 saw the passage
of three important tax bills that contain many provisions impacting taxpayers. The Community Renewal Tax Relief Act
of 2000 was contained in the Consolidated Appropriations Act, 2001. This Act renewed provisions designed to enhance
investment in low- and moderate-income, rural and urban communities. The Act also extended for two years medical
savings accounts (MSAs). Also included was a provision expanding innocent spouse relief. The Installment Tax Correction
Act of 2000 reinstated the availability of the installment method of accounting for accrual basis taxpayers. The year 2001
brought another tax bill, the Economic Growth and Tax Relief Reconciliation Act of 2001. The major provisions of the
Economic Growth and Tax Relief Reconciliation Act of 2001 are: reduction in the individual income tax rates; increased
401(k) and IRA contributions; tax relief for financing higher education, including graduate education; estate and gift
tax relief; and a reduction in the marriage penalty. The highlights of the Jobs and Growth Tax Relief Reconciliation Act
of 2003 are the rate reductions for individuals, the marriage penalty is reduced, the child tax credit is increased, the
maximum tax rate for most long-term capital gains is reduced, the tax rate on dividend income is reduced, additional first-
Chapter 1
, Instructor’s Manual 3
year depreciation is increased, the alternative minimum tax exemption is increased, the accumulated earnings tax rate is
reduced, and the tax on undistributed personal holding company income is reduced. The Working Families Tax Relief Act
of 2004 extended many of the provisions which were set to expire in 2004. The Pension Protection Act of 2006 contains
numerous provisions to strengthen current employer pension plans. Specific reference was given to defined benefit plans.
The Emergency Economic Stabilization Act of 2008 provided $700 billion to stabilize the economy. The Act also extended
numerous tax provisions that were set to expire at the end of 2008. Included in this list is the AMT (alternative minimum
tax). The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 extends the Bush-era tax
cuts for two more years. This includes the capital gains and dividend tax cuts. Further, it cut the payroll tax two percentage
points for the year 2011 and put a patch on the alternative minimum tax for two years.
Basic Tax Concepts
¶1195 Essential Tax Terms Defined
Terms that have definitions peculiar to income taxation and familiarity with which may be of use before proceeding
to the discussion of specific tax topics set out in the chapters are presented for review. Refer to the Glossary of Tax Terms
in the back of the book for a comprehensive listing of the tax terms discussed in the explanatory text.
ANSWER TO KEYSTONE PROBLEM—CHAPTER 1
(¶1101.) There is no question that employing only one form of taxing mechanism would be more efficient. However,
would it be fairer? It is doubtful. Further, taxes are imposed for several reasons: one, to raise revenue to operate the federal
government, and two, for social and economic reasons, such as in the case of the excise or customs taxes.
It would be difficult to think of one tax that could be imposed that would be fair to all citizens and yet raise the
necessary revenue. If there was only the federal income tax, many individuals would completely avoid paying taxes.
ANSWERS TO QUESTIONS—CHAPTER 1
Topical List of Questions
1. Tax Collection (¶1101 and ¶1121)
2. Corporation Taxes (¶1101 and ¶1121)
3. Excise Taxes (¶1181)
4. Value-Added Tax: Disadvantages (¶1101)
5. Value-Added Tax: Advantages (¶1101)
6. Tax Avoidance v. Tax Evasion (¶1131)
7. Tax Avoidance: Investment Strategies (¶1131)
8. Tax Evasion Penalties (¶1131)
9. Fraudulent Acts (¶1131)
10. Tax Policy (¶1121)
11. Tax Planning (¶1131)
12. Tax History (¶1151)
13. Taxing System and Social Influences (¶1165)
14. Tax Collection—Constitutional Authority (¶1151)
15. Income Tax Law—Date of Enactment (¶1151)
16. Revenue Legislation—Origination (¶1161)
17. Revenue Legislation—Congressional Committees (¶1161)
18. Joint Conference Committee Functions (¶1165)
Chapter 1
, 4 CCH Federal Taxation—Comprehensive Topics
Answers to Questions
Tax Collection
1. The government desires corporations to retain large sums of money for capital expansion. Whether or not
individuals and corporations should share the tax burden more equally is a political decision.
Corporation Taxes
2. This relates back to question 1. Some economists believe corporations should be encouraged to expand their
activities as much as possible. Only when an individual receives compensation or dividends from a corporation
should there be a tax.
Excise Taxes
3. There are excise taxes on numerous items, such as alcohol, tobacco, gasoline, and luxury items such as airplanes,
yachts, and expensive automobiles. If the government decides it is in the best interest of the country to control
any of these items, it can raise the excise taxes. As the tax rises, consumer consumption will decrease although, as
is well known, not proportionately.
Value-Added Tax: Disadvantages
4. A value-added tax is like a sales tax. All individuals have certain needs—food, clothing, and shelter. If these items
are taxed, it affects the poor and rich alike. However, the poor spend their income almost totally on these items,
while the rich spend only a small percentage of their salaries on food, shelter, and clothing.
Value-Added Tax: Advantages
5. The VAT has the ability to raise huge sums of money. Certainly, if Congress and the President desired to lower the
deficit, one way to do so would be to impose a VAT. For each 1 percent of VAT over $12 billion is collected.
Tax Avoidance v. Tax Evasion
6. Tax avoidance implies tax planning. An individual arranges affairs to minimize tax liability.
Tax evasion occurs when there is a completed transaction and the taxpayer refuses to pay the tax due.
Tax Avoidance: Investment Strategies
7. With an eye towards tax avoidance, the most logical investment is still tax-exempt municipal bonds. Another
opportunity available to some taxpayers is real estate. The real estate rules have been tightened, but many investment
opportunities still exist.
Tax Evasion Penalties
8. The U.S. has a self-assessed income tax. To be effective, everyone who has a tax obligation must pay a fair share.
An individual enjoying the benefits of the country must help defray the cost. Therefore, individuals convicted of
evading taxes are prosecuted as criminals.
Fraudulent Acts
9. The most common badges of fraud are:
(1) Understatement of income
(2) Claiming fictitious or improper deductions
(3) Accounting irregularities
(4) Allocation of income to related taxpayers in lower income tax brackets
(5) Acts and conduct of the taxpayer, e.g., false statements
Chapter 1
Chapter 1
Introduction to Federal Taxation and
Understanding the Federal Tax Law
SUMMARY OF CHAPTER
This chapter presents information on the magnitude of federal taxes collected and on taxpayer obligations. Also,
the history of U.S. federal taxation is briefly summarized followed by a review of the federal legislative process.
Fundamental Aspects of Federal Taxation
¶1101 Sources of Revenue
Types of federal taxes include (1) income taxes on corporations, individuals, and fiduciaries, (2) employment
taxes, (3) estate and gift taxes, and (4) excise and customs taxes. Also, revenues are generated from state and local taxes.
Consideration is given to the attractiveness of alternative systems—the value-added tax and flat tax.
¶1121 Tax Collection and Penalties
Taxes are big business and figures are given to demonstrate just how vast and complex the federal revenue collection
system has become. In 1989, the civil tax penalty provisions were extensively revamped to create a fairer, less complex and
more effective penalty system. Changes were made in the (1) document and information return penalties, (2) accuracy-related
penalties, (3) preparer, promoter, and protester penalties, and (4) penalties for failure to file or pay.
¶1131 Taxpayer Obligations
A clear understanding of tax avoidance versus tax evasion is necessary to achieve good tax planning. Tax avoidance is
legal and a legitimate pursuit of a business entity. Tax evasion requires the presence of a tax liability. There is a legal obligation
to disclose a tax liability based on completed transactions and the refusal to report the tax liability is illegal.
¶1151 Brief History of the Federal Income Tax
The adoption of the Sixteenth Amendment to the Constitution enabled Congress to levy “taxes on income,
from whatever source derived.” A brief chronological history of changes affecting the tax law from 1913 to the present is
presented.
• 16th Amendment (2/15/1913). Congress empowered itself to tax income.
• Revenue Act of 1913. Imposed income tax on individuals, corporations and other entities, effective 3/1/1913.
• Internal Revenue Codes of 1939, 1954 and 1986. Recodified the numerical referencing format of legislative tax
law after significant tax law revisions had occurred.
¶1161 Federal Tax Legislative Process
Steps in the enactment of a revenue bill are (1) origination in the House of Representatives Ways and Means
Committee, (2) passage by the House, (3) passage by the Senate, (4) resolution of differences in House and Senate versions by
the Joint Conference Committee, composed of members of both legislative bodies, (5) approval of the final version by both
the House and the Senate, (6) approval or veto by the President, and (7) incorporation into the Internal Revenue Code. Both
the Senate and the House must vote affirmatively by a two-thirds majority to override a veto.
¶1165 Tax Reform
The Taxpayer Relief Act of 1997 was the most significant tax legislation since the Tax Reform Act of 1986. Major
features of the Act include a reduction in capital gains tax rates, expanded IRAs, education tax incentives, estate tax relief,
and a child tax credit.
Chapter 1
,2 CCH Federal Taxation—Comprehensive Topics
Underlying Rationale of the Federal Income Tax
¶1171 Objectives of the Tax Law
The federal income tax system is comprised of a complicated and continually evolving blend of legislative
provisions, administrative pronouncements, and judicial decisions. The primary purpose of the tax law is obviously to
raise revenue, but social, political, and economic objectives are also important. These various objectives, which frequently
work at cross-purposes with the revenue-raising objective of the law, must be examined and understood to appreciate the
rationale underlying the immense multipurpose body of law known as the federal income tax.
¶1175 Economic Factors
Numerous provisions of the tax law have been employed to help stimulate the economy, to encourage capital
investment, or to direct resources to selected business activities. Examples include the following: MACRS depreciation;
the optional expensing election in lieu of depreciation; percentage depletion; special farming elections to expense rather
than to capitalize expenses for soil and water conservation, land clearing, and fertilizers; the S corporation provisions; the
Section 1244 stock loss provision; and the tax rate structure for regular corporations.
¶1181 Social Factors
Numerous tax provisions can best be explained in light of their underlying social objectives. Examples include the
following: the tax-free status accorded to employees on premiums paid by an employer on group-term insurance, accident
and health plans, and medical benefit plans; and the tax-deferred status accorded to employees’ current income under
deferred compensation plans.
¶1185 Political Factors
Since the tax law is created by Congress, and Congress consists of several hundred elected officials, political factors
play a major role in the development of tax legislation. Additionally, special interest groups and influential constituents
have a definite impact on the legislative process. For example, depletion under the percentage depletion method is limited
to 50% of “taxable net income before depletion” for all natural resource properties except oil and gas properties. For oil
and gas properties, the limit is 100% of taxable net income before depletion.
¶1187 Tax Policy and Reform Measures
Reform of the tax statutes has been a trend through the years. The tax policy implications of the 1986 revision
will be under examination for some time to come. In an effort to further the concept of neutrality in the tax law, the
Revenue Reconciliation Act of 1990 made major changes in the way high-income individuals compute their taxable
income. Also, for 1991 the tax rate schedules were changed to incorporate a third tax bracket: 31 percent. The Revenue
Reconciliation Act of 1993 extended the tax rates to also include a 36 percent bracket and a 39.6 bracket. The Taxpayer
Relief Act of 1997 made major modifications to capital gains. The holding period of capital assets to qualify as long term
was extended from more than 12 months to more than 18 months. Also, the long-term capital gains tax rate for many
items decreased from 28 percent to 20 percent. The IRS Restructuring and Reform Act of 1998 changed the holding
period for long term classification from more than 18 months to more than 12 months. The year 2000 saw the passage
of three important tax bills that contain many provisions impacting taxpayers. The Community Renewal Tax Relief Act
of 2000 was contained in the Consolidated Appropriations Act, 2001. This Act renewed provisions designed to enhance
investment in low- and moderate-income, rural and urban communities. The Act also extended for two years medical
savings accounts (MSAs). Also included was a provision expanding innocent spouse relief. The Installment Tax Correction
Act of 2000 reinstated the availability of the installment method of accounting for accrual basis taxpayers. The year 2001
brought another tax bill, the Economic Growth and Tax Relief Reconciliation Act of 2001. The major provisions of the
Economic Growth and Tax Relief Reconciliation Act of 2001 are: reduction in the individual income tax rates; increased
401(k) and IRA contributions; tax relief for financing higher education, including graduate education; estate and gift
tax relief; and a reduction in the marriage penalty. The highlights of the Jobs and Growth Tax Relief Reconciliation Act
of 2003 are the rate reductions for individuals, the marriage penalty is reduced, the child tax credit is increased, the
maximum tax rate for most long-term capital gains is reduced, the tax rate on dividend income is reduced, additional first-
Chapter 1
, Instructor’s Manual 3
year depreciation is increased, the alternative minimum tax exemption is increased, the accumulated earnings tax rate is
reduced, and the tax on undistributed personal holding company income is reduced. The Working Families Tax Relief Act
of 2004 extended many of the provisions which were set to expire in 2004. The Pension Protection Act of 2006 contains
numerous provisions to strengthen current employer pension plans. Specific reference was given to defined benefit plans.
The Emergency Economic Stabilization Act of 2008 provided $700 billion to stabilize the economy. The Act also extended
numerous tax provisions that were set to expire at the end of 2008. Included in this list is the AMT (alternative minimum
tax). The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 extends the Bush-era tax
cuts for two more years. This includes the capital gains and dividend tax cuts. Further, it cut the payroll tax two percentage
points for the year 2011 and put a patch on the alternative minimum tax for two years.
Basic Tax Concepts
¶1195 Essential Tax Terms Defined
Terms that have definitions peculiar to income taxation and familiarity with which may be of use before proceeding
to the discussion of specific tax topics set out in the chapters are presented for review. Refer to the Glossary of Tax Terms
in the back of the book for a comprehensive listing of the tax terms discussed in the explanatory text.
ANSWER TO KEYSTONE PROBLEM—CHAPTER 1
(¶1101.) There is no question that employing only one form of taxing mechanism would be more efficient. However,
would it be fairer? It is doubtful. Further, taxes are imposed for several reasons: one, to raise revenue to operate the federal
government, and two, for social and economic reasons, such as in the case of the excise or customs taxes.
It would be difficult to think of one tax that could be imposed that would be fair to all citizens and yet raise the
necessary revenue. If there was only the federal income tax, many individuals would completely avoid paying taxes.
ANSWERS TO QUESTIONS—CHAPTER 1
Topical List of Questions
1. Tax Collection (¶1101 and ¶1121)
2. Corporation Taxes (¶1101 and ¶1121)
3. Excise Taxes (¶1181)
4. Value-Added Tax: Disadvantages (¶1101)
5. Value-Added Tax: Advantages (¶1101)
6. Tax Avoidance v. Tax Evasion (¶1131)
7. Tax Avoidance: Investment Strategies (¶1131)
8. Tax Evasion Penalties (¶1131)
9. Fraudulent Acts (¶1131)
10. Tax Policy (¶1121)
11. Tax Planning (¶1131)
12. Tax History (¶1151)
13. Taxing System and Social Influences (¶1165)
14. Tax Collection—Constitutional Authority (¶1151)
15. Income Tax Law—Date of Enactment (¶1151)
16. Revenue Legislation—Origination (¶1161)
17. Revenue Legislation—Congressional Committees (¶1161)
18. Joint Conference Committee Functions (¶1165)
Chapter 1
, 4 CCH Federal Taxation—Comprehensive Topics
Answers to Questions
Tax Collection
1. The government desires corporations to retain large sums of money for capital expansion. Whether or not
individuals and corporations should share the tax burden more equally is a political decision.
Corporation Taxes
2. This relates back to question 1. Some economists believe corporations should be encouraged to expand their
activities as much as possible. Only when an individual receives compensation or dividends from a corporation
should there be a tax.
Excise Taxes
3. There are excise taxes on numerous items, such as alcohol, tobacco, gasoline, and luxury items such as airplanes,
yachts, and expensive automobiles. If the government decides it is in the best interest of the country to control
any of these items, it can raise the excise taxes. As the tax rises, consumer consumption will decrease although, as
is well known, not proportionately.
Value-Added Tax: Disadvantages
4. A value-added tax is like a sales tax. All individuals have certain needs—food, clothing, and shelter. If these items
are taxed, it affects the poor and rich alike. However, the poor spend their income almost totally on these items,
while the rich spend only a small percentage of their salaries on food, shelter, and clothing.
Value-Added Tax: Advantages
5. The VAT has the ability to raise huge sums of money. Certainly, if Congress and the President desired to lower the
deficit, one way to do so would be to impose a VAT. For each 1 percent of VAT over $12 billion is collected.
Tax Avoidance v. Tax Evasion
6. Tax avoidance implies tax planning. An individual arranges affairs to minimize tax liability.
Tax evasion occurs when there is a completed transaction and the taxpayer refuses to pay the tax due.
Tax Avoidance: Investment Strategies
7. With an eye towards tax avoidance, the most logical investment is still tax-exempt municipal bonds. Another
opportunity available to some taxpayers is real estate. The real estate rules have been tightened, but many investment
opportunities still exist.
Tax Evasion Penalties
8. The U.S. has a self-assessed income tax. To be effective, everyone who has a tax obligation must pay a fair share.
An individual enjoying the benefits of the country must help defray the cost. Therefore, individuals convicted of
evading taxes are prosecuted as criminals.
Fraudulent Acts
9. The most common badges of fraud are:
(1) Understatement of income
(2) Claiming fictitious or improper deductions
(3) Accounting irregularities
(4) Allocation of income to related taxpayers in lower income tax brackets
(5) Acts and conduct of the taxpayer, e.g., false statements
Chapter 1
