Solution Manual for McGraw-Hill’s Essentials of Federal Taxation 2024 Edition, 15th Edition By Brian Spilker-stamped

Solutions Manual—Essentials of Federal Taxation, by Spilker et al. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 1 Chapter 1 An Introduction to Tax SOLUTIONS MANUAL Discussion Questions (1) [LO 1] Jessica’s friend Zachary once stated that he couldn’t understand why someone would take a tax course. Why is this a rather naïve view? Taxes are a part of everyday life and have a financial effect on many of the major personal decisions that individuals face (e.g., investment decisions, evaluating alternative job offers, saving for education expenses, gift or estate planning, etc.). (2) [LO 1] What are some aspects of business that require knowledge of taxation? What are some aspects of personal finance that require knowledge of taxation? Taxes play an important role in fundamental business decisions such as the following: • What organizational form should a business use? • Where should the business locate? • How should business acquisitions be structured? • How should the business compensate employees? • What is the appropriate mix of debt and equity for the business? • Should the business rent or own its equipment and property? • How should the business distribute profits to its owners? One must consider all transaction costs (including taxes) to evaluate the merits of a transaction. Common personal financial decisions that taxes influence include: choosing investments, retirement planning, choosing to rent or buy a home, evaluating alternative job offers, saving for education expenses, and doing gift or estate planning. (3) [LO 1] Describe some ways in which taxes affect the political process in the United States. U.S. presidential candidates often distinguish themselves from their opponents based upon their tax rhetoric. Likewise, the major political parties generally have very diverse views of the appropriate way to tax the public. Determining who is taxed, what is taxed, and how much is taxed are difficult questions. Voters must have a basic understanding of taxes to evaluate the merits of alternative tax Solutions Manual—Essentials of Federal Taxation, by Spilker et al. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 2 proposals offered by opposing political candidates and their political parties. (4) [LO 2] Courtney recently received a speeding ticket on her way to the university. Her fine was $200. Is this considered a tax? Why or why not? The $200 speeding ticket is not considered a tax. Instead, it is considered a fine or penalty. Taxes differ from fines and penalties because taxes are not intended to punish or prevent illegal behavior. (5) [LO 2] Marlon and Latoya recently started building a house. They had to pay $300 to the county government for a building permit. Is the $300 payment a tax? Why or why not? The building permit is not considered a tax because $300 payment is directly linked to a benefit that they received (i.e., the ability to build a house). (6) [LO 2] To help pay for the city’s new stadium, the city of Birmingham recently enacted a 1 percent surcharge on hotel rooms. Is this a tax? Why or why not? The 1 percent surcharge is a tax. The 1 percent surcharge is an earmarked tax – i.e., collected for a specific purpose. The surcharge is considered a tax because the tax payments made by taxpayers do not directly relate to the specific benefit received by the taxpayers. (7) [LO 2] As noted in Example 1-2, tolls, parking meter fees, and annual licensing fees are not considered taxes. Can you identify other fees that are similar? There are several possible answers to this question. Some common examples include entrance fees to national parks, tag fees paid to local/state government for automobiles, boats, etc. (8) [LO 2] If the general objective of our tax system is to raise revenue, why does the income tax allow deductions for charitable contributions and retirement plan contributions? In addition to the general objective of raising revenue, Congress uses the federal tax system to encourage certain behavior and discourage other behavior. The charitable contribution deduction is intended to encourage taxpayers to support the initiatives of charitable organizations, whereas deductions for retirement contributions are intended to encourage retirement savings. Another objective of the tax system is to redistribute wealth. (9) [LO 2] One common argument for imposing so-called sin taxes is the social goal of reducing demand for such products. Using cigarettes as an example, is there a Solutions Manual—Essentials of Federal Taxation, by Spilker et al. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 3 segment of the population that might be sensitive to price and for whom high taxes might discourage purchases? The most obvious segment sensitive to price may be teenagers and younger adults that typically have less disposable income, although price sensitivity or elasticity will vary by taxpayer. (10) [LO 3] Dontae stated that he didn’t want to earn any more money because it would “put him in a higher tax bracket.” What is wrong with Dontae’s reasoning? Although earning additional taxable income may increase Dontae’s marginal tax rate (i.e., put him in a higher tax bracket), the additional income earned does not affect the taxes that Dontae will pay on his existing income. Moving to a higher tax bracket simply means that Dontae will pay a higher tax rate on the additional income earned (not on the income that he already has). (11) [LO 3] Describe the three different tax rates discussed in the chapter and how taxpayers might use them. The marginal tax rate is the tax rate that applies to the taxpayer’s additional taxable income or deductions that the taxpayer is evaluating in a decision. Specifically, Δ ( ) Δ ( ) Tax NewTotalTax OldTotalT M ax TaxableIncome N l argin n al o Tax ewTaxab eI c me OldTaxableIncom Rate e − − = = The marginal tax rate is particularly useful in tax planning because it represents the rate of taxation or savings that would apply to additional taxable income or tax deductions. The average tax rate represents the taxpayer’s average level of taxation on each dollar of taxable income. Specifically, Average Tax Rate = TotalTax TaxableIncome The average tax rate is often used in budgeting tax expense as a portion of income (i.e., what percent of taxable income earned is paid in tax). The effective tax rate represents the taxpayer’s average rate of taxation on each dollar of total income (i.e., taxable and nontaxable income). Specifically, Solutions Manual—Essentials of Federal Taxation, by Spilker et al. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 4 Effective Tax Rate = Total Tax Total Income The effective tax rate provides a depiction of a taxpayer’s tax burden because it depicts the taxpayer’s total tax paid as a ratio of the sum of both taxable and nontaxable income earned. (12) [LO 3] Which is a more appropriate tax rate to use to compare taxpayers’ tax burdens – the average or the effective tax rate? Why? Relative to the average tax rate, the effective tax rate provides a better depiction of a taxpayer’s tax burden because it depicts the taxpayer’s total tax paid as a ratio of the sum of both taxable and nontaxable income earned. (13) [LO 3] Describe the differences between a proportional, progressive, and regressive tax rate structure. A proportional (flat) tax rate structure imposes a constant tax rate throughout the tax base. In other words, as the tax base increases, the taxes paid increases, but the marginal tax rate remains constant. Because the marginal tax rate is constant across all levels of the tax base, the average tax rate remains constant across the tax base and always equals the marginal tax rate. Common examples of proportional taxes include sales taxes and excise taxes (i.e., taxes based on quantity such as gallons of gas purchased). A progressive tax rate structure imposes an increasing marginal tax rate as the tax base increases. In other words, as the tax base increases, both the marginal tax rate and the taxes paid increase. Common examples of progressive tax rate structures include federal and most state income taxes and federal estate and gift taxes. A regressive tax rate structure imposes a decreasing marginal tax rate as the tax base increases. In other words, as the tax base increases, the taxes paid increases, but the marginal tax rate decreases. Regressive tax rate structures are not common. In the United States, the Social Security tax and the federal employment tax employ a regressive tax rate structure. However, there are other regressive taxes when the tax is viewed in terms of effective tax rates. For example, a sales tax by definition is a proportional tax – i.e., as taxable purchases increase, the sales tax rate (i.e., the marginal tax rate) remains constant. Nonetheless, when you consider that the proportion of your total income spent on taxable purchases likely decreases as your total income increases, you can see the sale tax as a regressive tax. (14) [LO 3] Arnold and Lilly recently had a discussion about whether a sales tax is a proportional tax or a regressive tax. Arnold argued that a sales tax is regressive. Lilly countered that the sales tax is a flat tax. Who was correct? Solutions Manual—Essentials of Federal Taxation, by Spilker et al. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 5 Arnold and Lilly were both correct. A sales tax by definition is a proportional tax – i.e., as taxable purchases increase, the sales tax rate (i.e., the marginal tax rate) remains constant. For this reason, Arnold was correct. Nonetheless, when you consider that the proportion of one’s total income spent on taxable purchases likely decreases as total income increases, the sales tax may be considered a regressive tax. A good example of this is food. Although higher-income taxpayers may pay more for food than lower-income taxpayers, higher-income taxpayers spend a smaller percentage of their income on food—this is why many states exempt food from the sales tax base—because of its regressive nature. For this reason, Lilly was correct. (15) [LO 4] Which is the largest tax collected by the U.S. government? What types of taxpayers are subject to this tax? The federal income tax is the largest tax collected by the U.S. government. Currently, federal income taxes are levied on individuals, corporations, estates, and trusts. (16) [LO 4] What is the tax base for the Social Security and Medicare taxes for an employee or employer? What is the tax base for Social Security and Medicare taxes for a self-employed individual? Is the self-employment tax in addition to or in lieu of federal income tax? Employee wages is the tax base for the Social Security and Medicare taxes. Net earnings from self-employment is the tax base for the self-employment tax. The self-employment tax is in addition to the federal income tax. The same is true for employment taxes—they are in addition to the federal income tax. (17) [LO 4] What are unemployment taxes? Employers are required to pay federal and state unemployment taxes, which fund temporary unemployment benefits for individuals terminated from their jobs without cause. The tax base for the unemployment taxes is wages or salary. (18) [LO 4] What is the distinguishing feature of an excise tax? Excise taxes differ from other taxes in that the tax base on excise taxes is typically based on the quantity of an item or service purchased. The federal government imposes a number of excise taxes on goods such as alcohol, diesel fuel, gasoline, tobacco products and services such as telephone services. In addition, states also often impose excise taxes on these same items. Solutions Manual—Essentials of Federal Taxation, by Spilker et al. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 6 (19) [LO 4] What are some of the taxes that currently are unique to state and local governments? What are some of the taxes that the federal, state, and local governments each utilize? The sales, use, and property (personal, real, intangible) taxes are unique to state and local governments. Taxes that are common among the federal, state, and local governments include income taxes, excise taxes, and estate and gift taxes. (20) [LO 4] The state of Georgia recently increased its tax on a pack of cigarettes by $2. What type of tax is this? Why might Georgia choose this type of tax? The cigarette tax is both considered an excise tax (i.e., a tax based on quantity purchased) and a “sin” tax (i.e., a tax on goods that are deemed to be socially undesirable). Georgia may choose this type of tax to discourage smoking and because sin taxes are often viewed as acceptable ways of increasing tax revenues. (21) [LO 4] What is the difference between a sales tax and a use tax? The tax base for sales taxes is retail sales of goods (and some services). 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 (e.g., goods purchased over the internet). The prevalence of the use tax has significantly declined since economic nexus for sales taxes was found to be constitutional (see State and Local Taxes chapter for a discussion). (22) [LO 4] What is an ad valorem tax? Name an example of this type of tax. An ad valorem tax is a tax based on the fair market value of property. Real and personal property taxes are examples of ad valorem taxes. (23) [LO 4] What are the differences between an explicit and an implicit tax? An explicit tax is a tax that is directly imposed by a government unit and easily quantified. Implicit taxes are the reduced rates of pretax return that a tax-favored asset produces (e.g., the lower pretax rate of return earned by tax exempt municipal bonds). Although implicit taxes are real and equally important in understanding our tax system, they are difficult to quantify. (24) [LO 4] When we calculate average and effective tax rates, do we consider implicit taxes? What effect does this have on taxpayers’ perception of equity? Implicit taxes are very difficult to quantify and thus, are generally not considered when calculating average and effective tax rates. Since implicit taxes are ignored in these calculations, taxpayers may conclude that groups of taxpayers investing Solutions Manual—Essentials of Federal Taxation, by Spilker et al. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 7 in tax advantaged assets (subject to implicit tax) do not pay their fair share of tax as represented by a low effective tax rate. (25) [LO 4] Benjamin recently bought a truck in Alabama for his business in Georgia. What different types of federal and state taxes may affect this transaction? Benjamin will have to pay state sales tax in Alabama for the truck purchased. However, some states only charge sales tax when the purchased vehicle is registered. Assuming Alabama sales tax was charged, when the vehicle is registered in Georgia, Benjamin will have to pay use tax on the purchase at a rate representing any difference in the Alabama sales tax rate and the Georgia use tax rate. Benjamin will also have to pay personal property tax annually on the truck. Finally, since the vehicle is used in Benjamin’s business, he will be able to depreciate the truck for federal income tax purposes. (26) [LO 5] Kobe strongly dislikes SUVs and is appalled that so many are on the road. He proposes to eliminate the federal income tax and replace it with a $50,000 annual tax per SUV. Based on the number of SUVs currently owned in the United States, he estimates the tax will generate exactly the amount of tax revenue currently collected from the income tax. What is wrong with Kobe’s proposal? What type of forecasting is Kobe likely using? Kobe’s forecast is based on static forecasting (i.e., he is ignoring how taxpayers may alter their activities in response to the tax law change). Given that taxpayers are likely to substitute purchases of other vehicles for SUVs (i.e., the substitution effect), Kobe’s proposal is likely to result in a large discrepancy in projected and actual tax revenues since taxpayers will likely purchase fewer SUVs that are subject to the tax. (27) [LO 5] What is the difference between the income and substitution effects? For which types of taxpayers is the income effect more likely descriptive? For which types of taxpayers is the substitution effect more likely descriptive? The income effect predicts that when taxpayers are taxed more (e.g., tax rate increases from 22 to 24 percent), they will work harder to generate the same after-tax dollars. The substitution effect predicts that when taxpayers are taxed more, they will substitute nontaxable activities (e.g., leisure activities) for taxable activities because the marginal value of taxable activities has decreased. The income effect is likely to be more descriptive for taxpayers with insufficient income to meet their necessities, etc. for their desired standard of living. The substitution effect is likely to be more descriptive for taxpayers with sufficient income to meet their necessities and to sustain their desired standard of living. Solutions Manual—Essentials of Federal Taxation, by Spilker et al. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 8 (28) [LO 5] What is the difference between horizontal and vertical equity? How do tax preferences affect people’s view of horizontal equity? Horizontal equity means that two taxpayers in similar situations pay the same tax. Vertical equity is achieved when taxpayers with greater ability to pay tax, pay more tax relative to taxpayers with a lesser ability to pay tax. One can view vertical equity in terms of tax dollars paid or in terms of tax rates. Governmental units provide tax preferences for a variety of reasons – e.g., encourage investment, social objectives, etc. For example, a deduction for mortgage interest paid which encourages home ownership. Whether one views these tax preferences as appropriate or not, greatly influences whether one considers a tax system to be fair in general and specifically, horizontally equitable. Specifically, if one views a tax preference as being inappropriate, this would adversely affect one’s view of horizontal equity. (29) [LO 3, LO 5] Montel argues that a flat income tax rate system is vertically equitable. Oprah argues that a progressive tax rate structure is vertically equitable. How do their arguments differ? Who is correct? Vertical equity is achieved when taxpayers with greater ability to pay tax, pay more tax relative to taxpayers with a lesser ability to pay tax. One can view vertical equity in terms of tax dollars paid or in terms of tax rates. Proponents of a flat income tax or sales tax (i.e., proportional tax rate structures) are more likely to argue that vertical equity is achieved when taxpayers with a greater ability to pay tax, pay more in tax dollars. Proponents of a progressive tax system are more likely to argue that taxpayers with a greater ability to pay should be subject to a higher tax rate. This view is based upon the argument that the relative burden of a flat tax rate decreases as a taxpayer’s income (e.g., disposable income) increases. Which is the correct answer? There is no correct answer. Nonetheless, many feel very strongly regarding one view or the other. (30) [LO 3, LO 5] Discuss why evaluating vertical equity simply based on tax rate structure may be less than optimal. Although tax rate structures can be used, in part, to assess vertical equity, focusing on the tax rate structure solely ignores the role that the tax base plays in determining vertical equity. Indeed, focusing on the tax rate structure in evaluating a tax system is appropriate only if the tax base chosen (e.g., taxable income, purchases, property owned, etc.) accurately portrays a taxpayer’s ability to pay. This can be a rather strong assumption. Consider the sales tax. Although taxable purchases typically increase as taxpayers’ total incomes increase, total incomes typically increase at a much faster rate than taxable purchases. Thus, the gap between taxable purchases and total income widens as total income Solutions Manual—Essentials of Federal Taxation, by Spilker et al. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 9 increases. The end result is that the effective tax rates for those with a greater ability to pay are lower than those taxpayers with a lesser ability to pay. Regressive tax rate structures are generally considered not to satisfy vertical equity (unless one is a strong advocate of the belief that those with a greater ability to pay simply should be paying a higher tax, albeit at a lower rate). In sum, evaluating vertical equity in terms of effective tax rates may be much more informative than simply an evaluation of tax rate structures. (31) [LO 4, LO 5] Compare the federal income tax to sales taxes using the “certainty” criterion. Certainty means that taxpayers should be able to determine when to pay the tax, where to pay the tax, and how to determine the tax. It is relatively easy to determine when and where to pay the federal income tax and sales taxes. For example, individual federal income tax returns and the remaining balance of taxes owed must be filed with the Internal Revenue Service each year on or before April 15th (or the first business day following April 15th if the 15th falls on a weekend). Likewise, sales taxes are paid to retailers when items are purchased, and property taxes are typically paid annually to local governments. The ease of “how to determine the tax,” however, varies by tax system. Sales taxes are determined with relative ease – i.e., they are based on the value of taxable purchases. In contrast, income taxes are often criticized as being complex. What are taxable/nontaxable forms of income? What are deductible/nondeductible expenses? When should income or expense be reported? For many taxpayers (e.g., wage earners with few investments), the answers to these questions are straightforward. For other taxpayers (e.g., business owners, individuals with a lot of investments), the answers to these questions are nontrivial. Constant tax law changes enacted by Congress also add to the difficulty in determining the proper amount of income tax to pay. These changes can make it difficult to determine a taxpayer’s current tax liability much less plan for the future. (32) [LO 5] Many years ago a famous member of Congress proposed eliminating federal income tax withholding. What criterion for evaluating tax systems did this proposal violate? What would likely have been the result of eliminating withholding? Eliminating withholding would violate the convenience criterion – i.e., a tax system should be designed to facilitate the collection of tax revenues without undue hardship on the taxpayer or the government (i.e., a tax system should make collection as easy as possible). Eliminating withholding would most likely have slowed collection of taxes and increased taxpayer aggressiveness (or tax evasion). Prior research suggests that taxpayers are more likely to take more aggressive tax positions when they owe additional taxes when filing their return. Solutions Manual—Essentials of Federal Taxation, by Spilker et al. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 10 (33) [LO 5] “The federal income tax scores very high on the economy criterion because the current IRS budget is relatively low compared to the costs of a typical collection agency.” Explain why this statement may be considered wrong. This statement ignores the economy criterion from the taxpayer’s perspective. The income tax is often criticized for the compliance costs imposed on the taxpayer. Indeed, for certain taxpayers, record-keeping costs, accountant fees, attorney fees, etc. can be quite substantial. Advocates of alternative tax systems often challenge the income tax on this criterion. Problems (34) [LO 3] Chuck, a single taxpayer, earns $75,000 in taxable income and $10,000 in interest from an investment in City of Heflin bonds. Using the U.S. tax rate schedule, how much federal tax will he owe? What is his average tax rate? What is his effective tax rate? What is his current marginal tax rate? Chuck will owe $11,808 in federal income tax this year computed as follows: $11,808 = $5,147 + 22% ($75,000 $44,725) − —rounded up to the nearest dollar. Chuck’s average tax rate is 15.74 percent. Average Tax Rate = Total Tax ∕ Taxable Income = $11,808 ∕ $75,000 = 15.74% Chuck’s effective tax rate is 13.89 percent. Effective tax rate = Total Tax/Total Income = $11,808/($75,000 + $10,000) = 13.89% Chuck is currently in the 22 percent tax rate bracket. His marginal tax rate on increases in income up to $20,375 and deductions from income up to $30,275 is 22 percent. (35) [LO 3] Using the facts in problem 34, if Chuck earns an additional $40,000 of taxable income, what is his marginal tax rate on this income? What is his marginal rate if, instead, he had $40,000 of additional deductions? If Chuck earns an additional $40,000 of taxable income, his marginal tax rate on the income is 22.98 percent. Solutions Manual—Essentials of Federal Taxation, by Spilker et al. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 11 Marginal Tax Rate = Change in Tax/Change in Taxable Income = ($21,000 $11,808)/($115,000 $75,000) = − − 22.98% Where $21,000 for the revised tax is computed as follows: $21,000 = $16,290 + 24% ($115,000 $95,375). − If Chuck instead had $40,000 of additional tax deductions, his marginal tax rate on the deductions would be 19.57 percent. Marginal Tax Rate = Change in Tax/Change in Taxable Income = $3, ( 980 − $11,808 ($35,000 $75,000) = 19.57% )/ − Where $3,980 for the revised tax is computed as follows: $3,980 = $1,100 + 12% (35,000 $11,000) − . Solutions Manual—Essentials of Federal Taxation, by Spilker et al. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 12 (36) [LO 3] Campbell, a single taxpayer, earns $400,000 in taxable income and $2,000 in interest from an investment in State of New York bonds. Using the U.S. tax rate schedule, how much federal tax will she owe? What is her average tax rate? What is her effective tax rate? What is her current marginal tax rate? Campbell will owe $111,895 in federal income tax this year computed as follows: $111,895 = $52,832 + 35% ($400,000 $231,250)  − —rounded up to the nearest dollar. Campbell’s average tax rate is 27.97 percent. Average Tax Rate = Total Tax ∕ Taxable Income = $111,895 ∕ $400,000 = 27.97% Campbell’s effective tax rate is 27.83 percent. Effective tax rate = Total Tax/Total Income = $111,895/($400,000 + $2,000) = 27.83% Campbell is currently in the 35 percent tax rate bracket. Her marginal tax rate on deductions up to $168,750 will be 35 percent. However, her marginal tax rate on the next $178,125 of income will be 35%, and income earned over $578,125 will be taxed at 37 percent. (37) [LO 3] Using the facts in problem 36, if Campbell earns an additional $15,000 of taxable income, what is her marginal tax rate on this income? What is her marginal rate if, instead, she had $15,000 of additional deductions? If Campbell earns an additional $15,000 of taxable income, her marginal tax rate on the income is 35 percent. Marginal Tax Rate = Change in Tax ∕ Change in Taxable Income = ($117,145− $111,895 ($415,000 $400,000)= 35.00% )/ − Where $117,145 for the revised tax is computed as follows: $117,145 = $52,832 + 35% ($415,000 $231,250). − If Campbell instead had $15,000 of additional tax deductions, her marginal tax rate on the deductions would be 35.00 percent. Marginal Tax Rate = Change in Tax ∕ Change in Taxable Income = ($106 645 , − $111,895 ($385,000 0 )/ − $400,0 0) = 35.00% Where $106,645 for the revised tax is computed as follows: $106,645 = $52,832+35% ($385,000 $231,250). − Solutions Manual—Essentials of Federal Taxation, by Spilker et al. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 13 (38) [LO 3] Jorge and Anita, married taxpayers, earn $150,000 in taxable income and $40,000 in interest from an investment in City of Heflin bonds. Using the U.S. tax rate schedule for married filing jointly (see Example 1-3), how much federal tax will they owe? What is their average tax rate? What is their effective tax rate? What is their current marginal tax rate? Jorge and Anita will owe $23,615 in federal income tax this year computed as follows: $23,615 = $10,294 + 22% ($150,000 $89,4 − 50). Jorge and Anita’s average tax rate is 15.74 percent. Average Tax Rate = Total Tax ∕ Taxable Income = $23,615 ∕ $150,000 = 15.74% Jorge and Anita’s effective tax rate is 12.43 percent. Effective tax rate = Total Tax/Total Income = $23,615/($150,000 + $40,000) = 12.43% Jorge and Anita are currently in the 22 percent tax rate bracket. Their marginal tax rate on increases of income up to $40,750 and deductions up to $60,550 is 22 percent. (39) [LO 3] Using the facts in problem 38, if Jorge and Anita earn an additional $100,000 of taxable income, what is their marginal tax rate on this income? What is their marginal rate if, instead, they reported an additional $100,000 in deductions? If Jorge and Anita earn an additional $100,000 of taxable income, their marginal tax rate on the income is 23.19 percent. Marginal Tax Rate = Change in Tax ∕ Change in Taxable Income = ($46, 00 8 − $23,615 /($250,000 0 ) − $150,0 0) = 23.19% Where $46,800 for the revised tax is computed as follows: $46,800 = $32,580 + 24% ($250,000 $190,750). − If Jorge and Anita instead had $100,000 of additional tax deductions, their marginal tax rate on the deductions would be 18.06 percent. Marginal Tax Rate = Change in Tax ∕ Change in Taxable Income = ($5, 60 5 − $23,615 /($50,000 0 ) − $150,0 0) = 18.06% Where $5,560 for the revised tax is computed as follows: $5,560 = $2,200 + 12% $50,000 $22,000 ( ). − Solutions Manual—Essentials of Federal Taxation, by Spilker et al. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 14 (40) [LO 3] Scot and Vidia, married taxpayers, earn $240,000 in taxable income and $5,000 in interest from an investment in City of Tampa bonds. Using the U.S. tax rate schedule for married filing jointly (see Example 1-3), how much federal tax will they owe? What is their average tax rate? What is their effective tax rate? What is their current marginal tax rate? Scot and Vidia will owe $44,400 in federal income tax this year computed as follows: $44,400 = $32,580 + 24% ($240,000 $190, − 750). Scot and Vidia’s average tax rate is 18.50 percent. Average Tax Rate = Total Tax ∕ Taxable Income = $44,400 ∕ $240,000 = 18.50% Scot and Vidia’s effective tax rate is 18.12 percent. Effective tax rate = Total Tax ∕ Total Income = $44,400/($240,000 + $5,000) = 18.12% Scot and Vidia are currently in the 24 percent tax rate bracket. Their marginal tax rate on increases in income up to $124,200 and deductions up to $49,250 is 24 percent. (41) [LO 3] Using the facts in problem 40, if Scot and Vidia earn an additional $80,000 of taxable income, what is their marginal tax rate on this income? How would your answer differ if they, instead, had $80,000 of additional deductions? If Scot and Vidia earn an additional $80,000 of taxable income, their marginal tax rate on the income is 24.00 percent. Marginal Tax Rate = Change in Tax ∕ Change in Taxable Income = ($63, 00 6 − $44,400 /($320,000 0 ) − $240,0 0) = 24.00% Where $63,600 for the revised tax is computed as follows: $63,600 = $32,580 + 24% ($320,000 $190,750). − If Scot and Vidia instead had $80,000 of additional tax deductions, their marginal tax rate on the deductions would be 23.23 percent. Marginal Tax Rate = Change in Tax ∕ Change in Taxable Income = ($25, 15 8 − $44,400 /($160,000 0 ) − $240,0 0) = 23.23% Solutions Manual—Essentials of Federal Taxation, by Spilker et al. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 15 Where $25,815 for the revised tax is computed as follows: $25,815 = $10,294 + 22% ($160,000 $89,450). − (42) [LO 3, LO 4] Melinda invests $200,000 in a City of Heflin bond that pays 6 percent interest. Alternatively, Melinda could have invested the $200,000 in a bond recently issued by Surething Inc. that pays 8 percent interest and has risk and other nontax characteristics similar to the City of Heflin bond. Assume Melinda’s marginal tax rate is 25 percent. a. What is her after-tax rate of return for the City of Heflin bond? Since the City of Heflin bond is a tax-exempt bond, Melinda’s after-tax rate of return on the bond is equal to its pretax rate of return (6 percent). b. How much explicit tax does Melinda pay on the City of Heflin bond? Since the City of Heflin bond is a tax-exempt bond, Melinda pays no explicit tax on the interest earned from the City of Heflin bond. c. How much implicit tax does she pay on the City of Heflin bond? Melinda earns $12,000 of interest on the City of Heflin bond (i.e., 6% × $200,000). A similar priced taxable bond (i.e., the Surething Inc. bond) would pay $16,000 of taxable interest (i.e., 8% × $200,000). Melinda pays $4,000 of implicit tax on the City of Heflin bond (i.e., the difference between the pretax interest earned from a similar taxable bond ($16,000) and the pretax interest earned from the City of Heflin bond ($12,000)). d. How much explicit tax would she have paid on the Surething Inc. bond? Since Melinda’s marginal tax rate is 25 percent, she would have paid $4,000 of explicit tax (i.e., 25% × $16,000) on the interest earned from the Surething, Inc. bond. e. What is her after-tax rate of return on the Surething Inc. bond? Her after-tax income from the Surething Inc. bond is $12,000 $16,00 ( 0 interest income $4,000 tax − ). Thus, her after-tax return from the Surething Inc. bond would be 6 percent (after-tax income of $12,000 divided by her $200,000 investment). (43) [LO 3, LO 4 PLANNING] Hugh has the choice between investing in a City of Heflin bond at 6 percent or investing in a Surething Inc. bond at 9 percent. Solutions Manual—Essentials of Federal Taxation, by Spilker et al. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 16 Assuming that both bonds have the same nontax characteristics and that Hugh has a 40 percent marginal tax rate, in which bond should he invest? Hugh’s after tax rate of return on the tax-exempt City of Heflin bond is 6 percent. The Surething bond pays taxable interest of 9 percent. Hugh’s after-tax rate of return on the Surething bond is 5.4 percent (i.e., 9% interest income (9% × 40%) tax = 5.4% − ). Hugh should invest in the City of Heflin bond. (44) [LO 3, LO 4 PLANNING] Using the facts in problem 43, what interest rate does Surething Inc. need to offer to make Hugh indifferent between investing in the two bonds? To be indifferent between investing in the two bonds, the Surething Inc. bond should provide Hugh the same after-tax rate of return as the City of Heflin bond (6 percent). To solve for the required pretax rate of return we can use the following formula: After tax return = Pretax return × 1 Mar - . ( − ginal Tax Rate) Surething Inc. needs to offer a 10 percent interest rate to generate a 6 percent after-tax return and make Hugh indifferent between investing in the two bonds – i.e., 6% = Pretax return × (1 40%); Pretax return = 6% / (1 40%) = 10% − − (45) [LO 3, LO 4 PLANNING] Fergie has the choice between investing in a State of New York bond at 5 percent and a Surething Inc. bond at 8 percent. Assuming that both bonds have the same nontax characteristics and that Fergie has a 30 percent marginal tax rate, in which bond should she invest? Fergie’s after tax rate of return on the tax-exempt State of New York bond is 5 percent. The Surething bond pays taxable interest of 8 percent. Fergie’s after-tax rate of return on the Surething bond is 5.6 percent (i.e., 8% interest income (8% × 30%) tax = 5.6% . − ) Fergie should invest in the Surething bond. (46) [LO 3, LO 4 PLANNING] Using the facts in Problem 45, what interest rate does the State of New York bond need to offer to make Fergie indifferent between investing in the two bonds? To be indifferent between investing in the two bonds, the State of New York bond should provide Fergie the same after-tax rate of return as the Surething bond. Fergie’s after-tax rate of return on the Surething bond is 5.6 percent (i.e., 8% interest income (8% × 30%) ta − x = 5.6%). The state of New York needs to Solutions Manual—Essentials of Federal Taxation, by Spilker et al. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 17 offer a 5.6 percent interest rate to generate a 5.6 percent after-tax return to make Fergie indifferent between investing in the two bonds. (47) [LO 3] Given the following tax structure, what minimum tax would need to be assessed on Shameika to make the tax progressive with respect to average tax rates? Taxpayer Salary Muni-Bond Interest Total Tax Mihwah 10,000 10,000 600 Shameika 50,000 30,000 ??? Mihwah’s average tax rate is 6 percent. $600 $10,000 TotalTax Ta % xableIncome Average Tax Rate 6 = = = A 6 percent average tax rate on Shameika’s $50,000 taxable income would result in $3,000 of tax (i.e., 6% × $50,000 = $3,000). Thus, Shameika must pay more than $3,000 tax (e.g., $3,001) for the tax structure to be progressive with respect to average tax rates. (48) [LO 3] Using the facts in Problem 47, what minimum tax would need to be assessed on Shameika to make the tax progressive with respect to effective tax rates? Mihwah’s effective tax rate is 3 percent. Effective tax rate = TotalTax TotalIncome = $600 ($10,000 $10,000) + = 3% A 3 percent effective tax rate on Shameika’s $80,000 total income would result in $2,400 of tax (i.e., 3% × $80,000 = $2,400). Thus, Shameika must pay more than $2,400 tax (e.g., $2,401) for the tax structure to be progressive with respect to effective tax rates. (49) [LO 3, LO 5] Song earns $100,000 taxable income as an interior designer and is taxed at an average rate of 20 percent (i.e., $20,000 of tax). If Congress increases the income tax rate such that Song’s average tax rate increases from 20 percent to 25 percent, how much more income tax will she pay assuming that the income effect is descriptive? What effect will this tax rate change have on the tax base and tax collected? Under the current income tax, Song has $80,000 of income after tax. If the income Solutions Manual—Essentials of Federal Taxation, by Spilker et al. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 18 effect is descriptive and Congress increases tax rates so that Song’s average tax rate is 25 percent, Song will need to earn to $106,666.67 to continue to have $80,000 of income after tax. After-tax income = Pretax income (1 − tax rate) $80,000 = Pretax income (1 −.25) Pretax income = $106,666.67 Song will pay $26,666.67 in tax ($106,666.67 × .25). Accordingly, if the income effect is descriptive, the tax base and the tax collected will increase. The additional income tax is $26,666.67 − $20,000 = $6,666.67 (50) [LO 3, LO 5] Using the facts from Problem 49, what will happen to the government’s tax revenues if Song chooses to spend more time pursuing her other passions besides work in response to the tax rate change and therefore earns only $75,000 in taxable income? What is the term that describes this type of reaction to a tax rate increase? What types of taxpayers are likely to respond in this manner? If Song only earns $75,000 of taxable income, she would pay only $18,750 of tax under the new tax structure (i.e., $75,000 × .25). Thus, the government’s tax revenues would decrease by $1,250 (i.e., $18,750 − $20,000). This is an example of the substitution effect, which may be descriptive for taxpayers with more disposable income. (51) [LO 5] Given the following tax structure, what tax would need to be assessed on Venita to make the tax horizontally equitable? Taxpayer Salary Total Tax Mae 10,000 600 Pedro 20,000 1,500 Venita 10,000 ??? Horizontal equity means that two taxpayers in similar situations pay the same tax. Thus, to make the tax structure horizontally equitable, Venita should pay $600 in tax. (52) [LO 5] Using the facts in Problem 51, what is the minimum tax that Pedro should pay to make the tax structure vertically equitable based on the tax rate paid? This would result in what type of tax rate structure? Mae’s average tax rate is 6 percent. Solutions Manual—Essentials of Federal Taxation, by Spilker et al. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 19 Average Tax Rate = Total Tax Tax able Income = $600 $10,000 = 6% To be vertically equitable with respect to tax rates, Pedro should pay a tax rate higher than 6 percent. A 6 percent tax rate on Pedro’s $20,000 taxable income would result in $1,200 of tax (i.e., 6% × $20,000 = $1,200). Thus, Pedro must pay more than $1,200 tax (e.g., $1,201) for the tax structure to be vertically equitable (i.e., to generate a tax rate more than 6 percent). This would be a progressive structure since the structure imposes an increasing marginal tax rate as the tax base increases. (53) [LO 5] Using the facts in Problem 51, what is the minimum tax that Pedro should pay to make the tax structure vertically equitable with respect to the amount of tax paid? This would result in what type of tax rate structure? To be vertically equitable with respect to the amount of tax paid, Pedro should pay more in tax dollars than Mae because he earns more taxable income than her. A strict interpretation of this definition would suggest that the tax is vertically equitable if Pedro pays 1 more dollar in tax than Mae (i.e., $601). However, this would result in a regressive tax structure (which most people would argue is not vertically equitable). A less strict interpretation of vertical equity (based on dollar amounts) is that Pedro should pay more tax than Mae but at the same tax rate (i.e., a proportional or flat tax rate structure). (54) [LO 5] Consider the following tax rate structure. Is it horizontally equitable? Why or why not? Is it vertically equitable? Why or why not? Taxpayer Salary Total Tax Rajiv 10,000 600 LaMarcus 20,000 600 Dory 10,000 600 The tax rate schedule is horizontally equitable because those taxpayers in the same situation (Rajiv and Dory) pay the same tax ($600). The tax is not vertically equitable because the taxpayer with a greater ability to pay (LaMarcus) does not pay more tax, nor does he pay a higher tax rate. (55) [LO 5] Consider the following tax rate structure. Is it horizontally equitable? Why or why not? Is it vertically equitable? Why or why not? Solutions Manual—Essentials of Federal Taxation, by Spilker et al. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 20 Taxpayer Salary Total Tax Marilyn 10,000 600 Kobe 20,000 3,000 Alfonso 30,000 6,000 We cannot evaluate whether the tax rate structure is horizontally equitable because we are unable to determine if taxpayers in similar situations pay the same tax (i.e., the problem does not give data for two taxpayers with the same income). The tax rate structure would be considered vertically equitable because taxpayers with higher income pay more tax and at a higher rate. Specifically, Marilyn’s, Kobe’s, and Alfonso’s average tax rates are 6 percent, 15 percent, and 20 percent, respectively. (56) [LO 5] Consider the following tax rate structure. Is it horizontally equitable? Why or why not? Is it vertically equitable? Why or why not? Taxpayer Salary Total Tax Rodney 10,000 600 Keisha 10,000 600 The tax rate structure is horizontally equitable because taxpayers in similar situations (Rodney and Keisha) pay the same tax. We cannot evaluate whether the tax is vertically equitable because we are unable to determine if taxpayers with a greater ability to pay (higher income) pay more tax. (57) [LO 1, LO 4 PLANNING] Lorenzo is considering starting a trucking company either in Texas or Oklahoma. He will relocate his family, which includes his wife, children, and parents, to reside in the same state as his business. What types of taxes may influence his decision of where to locate his business? Taxes will affect several aspects of Lorenzo’s decision. Lorenzo should consider differences in Texas and Oklahoma for (1) business taxes (e.g., corporate taxes), (2) individual income taxes, (3) excise taxes on gasoline, (4) real estate taxes (business and personal), (5) estate taxes (e.g., for wealth transfers from his parents), and (6) sales taxes. (58) [LO 3, LO 5 PLANNING] Congress would like to increase tax revenues by 10 percent. Assume that the average taxpayer in the United States earns $65,000 and pays an average tax rate of 15 percent. If the income effect is in effect for all taxpayers, what average tax rate will result in a 10 percent increase in tax Solutions Manual—Essentials of Federal Taxation, by Spilker et al. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 21 revenues? This is an example of what type of forecasting? This analysis is an example of dynamic forecasting. Based on the information above, the average taxpayer pays $9,750 of tax (i.e., $65,000 × 15%), leaving $55,250 of income after tax. A 10 percent increase in revenues would mean that the average taxpayer pays $10,725 in tax ($9,750 × 1.10). With this new tax amount, we can solve for the tax rate that would generate this tax amount. After-tax income = Pretax income × (1 tax rate) − After-tax income = Pretax income (Pretax income × tax rate − ) After-tax income = Pretax income − Tax Substituting information from the problem results in: $55,250 = Pretax income − $10,725 Pretax income = $65,975 We can use the above formula to solve for the new tax rate. After-tax income = Pretax income × (1 tax rate) − $55,250 = $65,975 × (1 tax rate) − Tax rate = $10,725 ∕ $65,975 = 16.26% (59) [LO 5 RESEARCH] Locate the IRS Web site at the IRS collected, how much was spent on the IRS collection efforts? What tax system criterion does this information help you to evaluate with respect to the current U.S. tax system? The IRS’ budget for exam and collections as a percentage of revenue collected is about .33 percent. Currently, the IRS collects over $4.11 trillion annually with a budget of $13.7 billion. Thus, for every $100 collected, about .35 cents is spent on collection efforts. This data is useful in evaluating “economy.” See: (60) [LO 4 RESEARCH] Using the Internet, find a comparison of income tax rates across states. What state currently has the highest income tax rate? In considering individual tax burdens across states, what other taxes should you consider? Solutions Manual—Essentials of Federal Taxation, by Spilker et al. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 22 California currently has the highest individual income tax rate (13.3%). To compare tax burdens across states, one should also consider real estate and other property taxes, excise taxes (gasoline taxes), and sales taxes. Solutions Manual—Essentials of Federal Taxation, by Spilker et al. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 1 Chapter 2 Tax Compliance, the IRS, and Tax Authorities SOLUTIONS MANUAL Discussion Questions (1) [LO1] Name three factors that determine whether a taxpayer is required to file a tax return. Filing status (e.g., single, married filing joint, etc.), age, and the taxpayer’s gross income. (2) [LO1] Benita is concerned that she will not be able to complete her tax return by April 15. Can she request an extension to file her return? By what date must she do so? Assuming she requests an extension, what is the latest date that she could file her return this year without penalty? Benita can file an automatic six-month extension to file her tax return – form 4868, Application for Automatic Extension of Time To File U.S. Individual Income Tax Return. This extension must be filed by April 15th. October 15th is the latest date she can file her return without penalty. If October 15th falls on a Saturday, Sunday, or holiday, the extended due date will be the 1st day after October 15th that is not a Saturday, Sunday, or holiday. (3) [LO1] Agua Linda Inc. is a calendar-year corporation. What is the original due date for the corporate tax return? What happens if the original due date falls on a Saturday? The original due date for Agua Linda Inc.’s corporate tax return is April 15th. If the 15th falls on a Saturday, Sunday, or holiday, the due date will be the 1st day after April 15th that is not a Saturday, Sunday, or holiday. In this example, Agua Linda Inc.’s due date is April 17th (i.e., the Monday after Saturday the 15th). (4) [LO2] Approximately what percentage of tax returns does the IRS audit? What are the implications of this number for the IRS’s strategy in selecting returns for audit? Currently, less than 1 percent of all tax returns are audited. The IRS must be strategic in selecting returns for audit in an effort to promote the highest level of voluntary taxpayer compliance. (5) [LO2] Explain the difference between the DIF system and the National Research Program. How do they relate to each other? Solutions Manual—Essentials of Federal Taxation, by Spilker et al. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 2 The DIF system is basically a scoring system that assigns a score to each tax return that represents the probability that the tax liability on the return has been underreported (i.e., a higher score, a higher likelihood of underreporting). The IRS derives the weights assigned to specific tax return attributes from historical IRS audit adjustment data from the National Research Program (NRP). The NRP analyzes randomly selected returns to ensure that the DIF scorings are representative of the population of tax returns. The DIF system then uses these (undisclosed) weights to score each tax return based on the tax return’s characteristics. Returns with higher DIF scores are then reviewed to determine if an audit is the best course of action. (6) [LO2] Describe the differences between the three types of audits in terms of their scope and taxpayer type. The three types of IRS audits consist of correspondence, office, and field examinations. Correspondence examinations are the most common. These audits (as the name suggests) are conducted by mail and generally are limited to one or two items on the taxpayer’s return. Among the three types of audits, correspondence audits are generally the narrowest in scope and least complex. Office examinations are the second most common audit. As the name suggests, the IRS conducts these audits at the local IRS office. These audits are typically broader in scope and more complex than correspondence examinations. Small businesses, taxpayers operating sole proprietorships, and middle to high-income individual taxpayers are likely candidates for office examinations. In these examinations, the taxpayer receives a notice that identifies the items subject to audit, requests substantiation for these items as necessary, and notifies the taxpayer of the date, time, and location of the exam. Taxpayers may attend the examination alone, or simply let their tax adviser or attorney attend on the taxpayer’s behalf. Field examinations are the least common audit. The IRS conducts these audits at the taxpayer’s office (i.e., place of business), or the location where the taxpayer’s books, records and source documents are maintained. Field examinations are generally the broadest in scope and most complex of the three audit types. They can last many months to multiple years and generally are limited to business returns and the most complex individual returns. (7) [LO2] Simon just received a 30-day letter from the IRS indicating a proposed assessment. Does he have to pay the additional tax? What are his options? Solutions Manual—Essentials of Federal Taxation, by Spilker et al. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 3 Simon does not have to pay the additional tax at this time. The 30-day letter instructs the taxpayer that they have 30 days (1) to request a conference with an appeals officer, who is independent (resides in a separate IRS division) from the examining agent or (2) to agree to the proposed adjustment. If the taxpayer chooses to go to the appeals conference and reaches an agreement with the IRS at the appeals conference, the taxpayer can then sign the Form 870. If the taxpayer and IRS do not agree on the proposed adjustment at the appeals conference, or the taxpayer chooses not to request an appeals conference, the IRS will then send the taxpayer a 90-day letter (statutory notice of deficiency). (8) [LO2] Compare and contrast the three trial-level courts. The U.S. District Court is the only court that provides for a jury trial; the U.S. Tax Court is the only court that allows tax cases to be heard before the taxpayer pays the disputed liability and the only court with a small claims division (hearing claims involving disputed liabilities of $50,000 or less); the U.S. Tax Court judges are tax experts, whereas the U.S. District Court and U.S. Court of Federal Claims judges are generalists. Both the U.S. Tax Court and local U.S. District Court cases appeal to the specific circuit court based on the taxpayer’s residence. In contrast, all U.S. Court of Federal Claims cases appeal to the U.S. Circuit Court of Appeals for the Federal Circuit. (9) [LO3] Compare and contrast the three types of primary tax law sources and give examples of each. The three types of tax law sources include statutory authority issued by Congress (e.g., the Internal Revenue Code, committee reports), judicial authority (i.e., rulings by the U.S. district court, U.S. Tax Court, U.S. Court of Federal Claims, U.S. circuit court of appeals, or U.S. Supreme Court), and administrative authority (e.g., regulations, revenue rulings, and revenue procedures). In addition to being issued by different groups, the format and purposes of each of these authorities are different. Whereas statutory authorities are tax laws enacted by Congress, judicial and administrative authorities generally interpret enacted tax laws. (10) [LO3] The U.S. Constitution is the highest tax authority but provides very little in the way of tax laws. What are the next highest tax authorities beneath the U.S. Constitution? The Internal Revenue Code of 1986 and Supreme Court decisions represent the highest tax authority beneath the U.S. Constitution. However, the Supreme Court does not establish law, but instead, simply interprets and applies the Code (and other authorities). Solutions Manual—Essentials of Federal Taxation, by Spilker et al. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 4 (11) [LO3] Jackie has just opened her copy of the Code for the first time. She looks at the table of contents and wonders why it is organized the way it is. She questions whether it makes sense to try and understand the Code’s organization. What are some reasons why understanding the organization of the Internal Revenue Code may prove useful? One must understand the organization of a code section (i.e., into subsections, paragraphs, subparagraphs, and clauses) to be able to cite the respective law correctly (e.g., § 162(b)(2)). Many provisions in the Code apply only to specific parts of the Code. If one does not understand what laws are encompassed in the chapter, it would be very difficult to interpret the code section and determine its applicability to a research question. Finally, the Code has been arranged such that, in general, similar code sections are grouped together. Understanding this organization allows the researcher to be much more efficient in locating relevant code sections. (12) [LO3] Laura Li, a U.S. resident, works for three months this summer in China. What type of tax authority may be especially useful in determining the tax consequences of her foreign income? The tax treaty between the U.S. and China. (13) [LO3] What are the basic differences between regulations, revenue rulings, and private letter rulings? Regulations are the Treasury Department’s official interpretation of the Internal Revenue Code and have the highest authoritative weight among regulations, revenue rulings, and private letter rulings. Regulations are issued in three different forms: proposed, temporary, and final. In addition to being issued in three different forms, regulations also serve three basic purposes: interpretative, procedural, and legislative. Unlike regulations, revenue rulings address the specific application of the Code and regulations to a specific factual situation. Thus, while revenue rulings have less authoritative weight, they provide a much more detailed interpretation of the Code as it applies to a specific transaction and fact pattern. Private letter rulings (also known as letter rulings) are less authoritative but more specific than revenue rulings and regulations. Letter rulings generally may not be used as precedent by taxpayers. However, they may be cited as authority to avoid the substantial understatement of tax penalty under § 6662 imposed on taxpayers and related tax practitioner penalty under § 6694. Private letter rulings represent the IRS’s application of the Code and other tax authorities to a specific transaction and taxpayer. Private letter rulings are issued in response to a taxpayer request and are common for proposed transactions with potentially large tax implications. Solutions Manual—Essentials of Federal Taxation, by Spilker et al. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 5 (14) [LO3] Under what circumstances would the IRS issue an acquiescence? A nonacquiescence? An action on decision? Except for Supreme Court cases, whenever the IRS loses, it may issue an acquiescence or nonacquiescence as guidance for how the IRS intends to respond to the loss. Although an acquiescence indicates that the IRS has decided to “follow” the court’s adverse ruling in the future, it does not mean that the IRS agrees with the court’s ruling. Instead, it simply means that the IRS will no longer litigate this issue. A nonacquiescence has the exact opposite implications. A nonacquiescence alerts taxpayers that the IRS plans to continue to litigate this issue. Finally, the IRS also issues actions on decisions, which explain the background reasoning behind an IRS acquiescence or nonacquiescence. (15) [LO3] Carlos has located a regulation that appears to answer his tax research question. He is concerned because the regulation is a temporary regulation. Evaluate the authoritative weight of this type of regulation. Should he feel more or less confident in his answer if the regulation is a proposed regulation? Temporary regulations, as the name suggests, have a limited life (three years for regulations issued after November 20, 1988). Nonetheless, during their “life,” they carry the same authoritative weight as final regulations. Thus, Carlos should be confident in his answer. Proposed regulations are, as the name suggests, “proposed,” and thus do not carry the same authoritative weight as temporary or final regulations. Carlos should feel less confident in his answer if it was based on a proposed regulation. (16) [LO3] Tyrone recently read a regulation that Congress specifically requested the IRS to issue. What type of regulation is this? How does this regulation’s authoritative weight compare to other regulations? Legislative regulation. Legislative regulations are rare and are issued when Congress specifically directs the Treasury Department to issue regulations to address an issue in an area of law. In these instances, the Treasury is actually writing the law instead of interpreting the Code. Because legislative regulations actually represent the tax law instead of an interpretation, legislative regulations generally have been viewed to have more authoritative weight than interpretative and procedural regulations. However, in Mayo Foundation for Medical Education & Research v. U.S., 131 S.Ct. 704 (2011), the Supreme Court held (subject to specific conditions) that all Treasury regulations warrant deference. (17) [LO3] In researching a tax question, you find only one authority (a trial-level court opinion) that is directly on point. Which court would you least prefer to have heard this case, and why? Solutions Manual—Essentials of Federal Taxation, by Spilker et al. © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 6 The U.S. district court because these decisions are often considered less authoritative and are likely rendered by a district court outside of the taxpayer’s jurisdiction (versus the U.S. Tax Court or U.S. Court of Federal Claims which have jurisdiction over all taxpayers regardless of their residence). U.S. district court decisions are often considered to have the lowest authoritative weight because the U.S. district court hears a much broader spectrum of issues compared to the U.S. Tax Court or U.S. Court of Federal Claims. Thus, U.S. district court judges are considered generalists relative to U.S. Tax Court or U.S. Court of Federal Claims judges. (18) [LO3] What is stare decisis, and how does it relate to the Golsen rule? Stare decisis means that a court will rule consistently with (a) its previous rulings (i.e., unless they decide to overrule the decision) and (b) the rulings of higher courts with appellate jurisdiction (i.e., the courts their cases are appealed to). The doctrine of stare decisis presents a special problem for the tax court because it appe