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Tax Research: Process (Third Edition)

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Tax Research: Process (Third Edition) 1

Welcome Welcome to the Tax Research: Process (Third Edition) course. This course, developed by David Gibberman, an attorney specializing in business, estate, and tax planning, discusses the steps involved in researching a tax question. It is one in a series of courses on tax research.

To help you do additional research on this topic, links are provided from each statutory provision, court case, and IRS interpretation cited in the course to the full text of that cited item.

You must be a subscriber to the CCH Tax Research NetWork to take advantage of these links.

Visit cchgroup.com for more information about the CCH Tax Research NetWork and how to subscribe.

Tax Research: Process (Third Edition) 2

Course Structure

How the Course is Organized

This course is designed to provide you with an engaging learning experience. It consists of self-paced reading materials, study questions, and graphics. Tax Research: Process (Third Edition) is divided into the following chapters:

• Introduction • How Research Goals Influence the Research Process • Overview of the Steps in the Tax Research Process • Gathering Relevant Facts • Identifying Tax Questions • Locating Primary Sources Relevant to a Tax Question • Analyzing and Evaluating Primary Sources • Obtaining Additional Facts and Applying the Relevant Primary Sources to Those Facts • Drawing Conclusions and Developing Recommendations • Communicating Research Results to Other Professionals and Clients • IRS Standards for Tax Research • Special Ethical Duties for Accountants in Conducting Tax Research • Conclusion

Why Do I Need to Complete Learning Activities

Set forth throughout the course are study questions. By answering these questions, you can test your understanding of the material presented and prepare yourself for the Final Exam.

What Do I Find in the Glossary

A glossary provides definitions of the terms used in the text. It is universal for all CCH Learning Center online courses. Terms are listed in alphabetical order.

How to Navigate the Site

The Back arrow ( ) and Next arrow ( ) allow you to navigate linearly through the course. The drop down list in the upper left allows you to select which lesson you want to view. When you select a lesson, the topics and pages within that lesson appear in the left navigation frame. After you have visited a page, the title in the left navigation frame will be grayed out. The Course Outline in the menu bar lists all lessons, topics, and subtopics and allows you to link directly to any page in the course.

CCH Tax Research NetWork

This course includes links to the CCH Tax Research NetWork, which provides access to judicial decisions, tax statutes, and IRS interpretations mentioned in the course. Direct links to the selections are provided. You will need to use your personal CCH Tax Research NetWork User ID and Password.

There are different ways you can use the CCH Tax Research NetWork in this course:

Tax Research: Process (Third Edition) 3

• Read the material online • Print the pages, read the hard copy, and take notes • Keep the CCH Tax Research NetWork open during the course and toggle back to it when

necessary

NOTE: You need to login to the CCH Tax Research NetWork only once. Each time you click on a link, a new Internet Explorer window will open. You can have several code sections and regulations open at once, each in its own window.

Tax Research: Process (Third Edition) 4

Course Objectives

After completing this course, you should be able to:

• Identify the steps required to research a tax question

• Determine the difference between research for tax compliance and research for tax planning

• Determine what types of facts need to be gathered when researching a tax question

• Take a factual situation presented by a client and identify tax questions that need to be researched

• Distinguish between primary and secondary sources

• Locate primary sources relevant to a tax question being researched

• Analyze and evaluate primary sources related to a tax question

• Draw conclusions and make recommendations regarding a tax question

• Communicate research results to other professionals and clients

• Identify the professional standards applicable to tax research

Tax Research: Process (Third Edition) 5

Tools and Resources In addition to helpful planning pointers and citations linked throughout this course, Tools and Resources are provided to:

• Help you understand of the tax research process

• Keep you abreast of developments related to the tax research process

• Help you utilize the knowledge gained in this course in your practice

Download:

You will need Adobe Acrobat Reader® to view or print the Portable Documents Format (.pdf) files below. If you need to install it, download the free plugin from Adobe's website.

Download: The IRS to the Rescue?

Debra J. Bennett provides information on a series of Notices issued by the IRS over the last few months.

Download: Notice 2008-111: Revised Intermediary Transaction Guidance

Debra J. Bennett discusses Notice 2008-111, which supersedes Notice 2008-20.

Tax Research: Process (Third Edition) 6

Introduction You have to navigate many dangerous shoals when attempting to give a client the correct answer to a question about taxes. For example:

• Your client may have misperceived or misstated the facts. • An overlooked fact may change the answer to a tax question.

• The answer to a question may require an understanding of the interrelationships among multiple

Code provisions, Treasury regulations, IRS rulings, and judicial decisions.

• There may be no clear-cut answer to a question.

• The applicable tax law may be different than current tax law.

• You may not be familiar with all of the issues that must be resolved before a tax question can be answered.

• Your client may not understand your answer to a question.

The consequences of a wrong answer or a misunderstood answer can be costly for your client, you, and your firm. Your client may have to pay thousands of dollars, perhaps millions of dollars or more, in additional taxes and interest. Dissatisfied with that result, the client may sue both you and your firm for malpractice.

When the Tribune Co. acquired the Times Mirror Co. in June 2000 for $8.3 billion, it inherited a tax dispute: Times Mirror claimed that it did not have to recognize any gain from its disposition of its Matthew Bender and Mosby subsidiaries because each transaction qualified as a tax-free reorganization. The Tribune treated Times Mirror’s tax position as uncertain but felt that a $180 million tax reserve to cover the Tribune’s exposure was adequate.

The U.S. Tax Court decided that the transactions were taxable sales Tribune Co., 125 TC 110, Dec. 56,151 (2005)(Matthew Bender); Tribune Co., 91 TCM 678, Dec. 56,418(M), TC Memo. 2006-12 (2006)(Mosby). The Tribune paid the approximately $1 billion in taxes and interest that the IRS said it owed and appealed the Tax Court’s decision. On October 1, 2007, the Tribune announced that it had settled its dispute with the IRS and would receive a $344 million refund of the approximately $1 billion in taxes and interest that it had paid. The bottom line: the Tribune’s interpretation of the tax consequences of the Matthew Bender and Mosby dispositions cost it hundreds of millions of dollars.

You can minimize the possibility of errors by establishing procedures for conducting, reviewing, and communicating the results of research to clients. This course describes such procedures. It focuses on federal taxes. However, the same procedures followed when researching federal tax law can be followed when researching state and international tax laws.

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How Research Goals Influence the Research Process Sometimes a tax adviser is asked to determine how income already received, an expenditure already made, or a transaction already completed should be reported on a tax return. This type of research is referred to as tax compliance research. When you do this type of research, you can tell your client how the income, expenditure, or transaction should be reported for tax purposes but cannot make any recommendation that can reduce the amount of tax payable.

Sarracino Sound Control Enclosures, Inc. told Arie Wissler, its tax adviser, that it had sold one parcel of land with an adjusted basis of $100,000 for $500,000 and used that $500,000 to purchase another parcel of land better suited for a new manufacturing plant. The company asked Arie how it should report the transaction.

Arie told the company that it had a gain of $400,000 (the $500,000 amount realized minus the company's $100,000 adjusted basis in the property), which the company had to include in its taxable income for the year.

Other times, a tax adviser is asked how best to plan for income not yet received, an expenditure not yet made, or a transaction that has not yet occurred to achieve the most favorable tax consequences. This type of research is referred to as tax planning research. When you do this type of research, you have an opportunity to alter the facts to achieve the most favorable tax outcome.

The facts are the same as in the previous example except that instead of selling one parcel of land for $500,000 and using the $500,000 to purchase a more desirable parcel of land, Sarracino Sound Control Enclosures asked Arie how the company could minimize its taxes on the transaction. Because the company came to Arie before selling one parcel of land and purchasing another, Arie could recommend that the company exchange the parcels of land and not pay any tax on the transaction (Code Sec. 1031).

When doing tax planning research, you need to consider how changes in the timing of the receipt of income, the making of an expenditure, or the structure of a transaction can affect a client's taxes. You also have to be aware of imminent changes in the tax law that could affect your recommendations.

Whether research is for tax compliance or tax planning, the basic goal is the same: to locate, analyze, and evaluate all relevant primary sources of tax law (such as Code provisions, Treasury regulations, IRS rulings, and judicial decisions) to determine what the tax law is and how it affects your client.

Tax Avoidance Versus Tax Evasion

A legitimate goal of tax planning is tax avoidance, which is the taking advantage of legal opportunities to reduce a taxpayer's tax liability. Sometimes these legal opportunities to reduce tax liability are referred to as "tax loopholes." However, that term more often has the negative connotation of an unintentional omission or ambiguity in the tax law that permits a reduction in tax liability not intended by Congress.

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Kuilan Fabrics, Inc. had a manufacturing plant that was destroyed by a hurricane. The company's adjusted basis in the manufacturing plant was $100,000, and it received $500,000 of insurance proceeds as compensation for the destruction of its manufacturing plant.

If the company does nothing, it will have to include in its taxable income the $400,000 of gain ($500,000 of insurance proceeds - $100,000 adjusted basis) that it realized on the destruction of the plant, which is considered an involuntary conversion. However, if the company reinvests the $500,000 of insurance proceeds in another manufacturing plant, it legally can avoid having to recognize any of that gain (Code Sec. 1033).

Tax avoidance should be distinguished from tax evasion, which involves illegally paying less federal income tax than one should.

Randal McCanna reduced his income tax liability by taking deductions for expenditures he did not make and not reporting income that he did receive. He is guilty of tax evasion and may be subject to civil and criminal penalties.

Study Questions 1. Which one of the following is an example of tax planning research?

Christin Torchia spent $20,000 to purchase a motor vehicle. He asked his tax adviser, Ilene Hartvigsen, whether he could take a tax deduction for his expenditure.

Lynn Brevig asked her tax adviser, Moises Grappe, whether she could do anything to save taxes when she sold her home.

Jayna Lewark did research to determine the tax consequences of a client’s sale of one parcel of land used as an office and use of the proceeds to purchase another parcel of land better suited for a new office.

Hue Halat did research to determine how a client would be taxed on the receipt of a $1 million lottery prize.

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Overview of the Steps in the Tax Research Process There is no one "right way" to research a tax question. However, there are some time-tested guidelines to ensure that research is as complete as possible.

The basic steps in researching a tax question should include:

1. Gathering relevant facts.

2. Identifying tax questions.

3. Locating primary sources relevant to identified tax questions.

4. Analyzing and evaluating the primary sources that have been located.

5. Obtaining additional facts found to be needed after an analysis and evaluation of primary sources.

6. Applying relevant primary sources to the additional facts.

7. Drawing conclusions and developing recommendations.

8. Communicating research and results to colleagues for review and to the client for implementation.

Study Question 1. Put the following steps in the research process in the correct order.

(Type the appropriate number, 1 through 4, in the boxes to the left of the statement.)

Identifying tax questions.

Gathering relevant facts.

Locating primary sources relevant to tax questions that have been identified.

Obtaining additional facts.

Tax Research: Process (Third Edition) 10

Gathering Relevant Facts The first step in tax research is to gather relevant facts about the taxpayer and the transaction with respect to which the taxpayer needs tax advice.

What Is a Relevant Fact? A fact is "relevant" if it affects how the tax laws are applied.

The age of an individual is relevant when determining whether distributions must be made from the individual's traditional IRA but not when determining whether the individual can take a medical deduction for certain expenditures.

It is important to distinguish between facts and conclusions when you gather information about a taxpayer and the situation giving rise to the taxpayer's need for tax advice.

You need to obtain facts, not conclusions.

Facts Distinguished from Conclusions A "fact" is a condition that actually exists or has existed or an event that actually has occurred. By contrast, a "conclusion" is a judgment based on facts and/or law.

The amount of salary paid an employee is an example of a fact. However, a judgment that the salary is "reasonable" is a c onclusion.

The importance of gathering relevant facts should not be underestimated. What may seem like an irrelevant fact may alter the tax consequences of a transaction.

Brendan Earthman asked his tax adviser, Isidra Tartaglione, whether he will be able to take a child and dependent care credit in 2009 for amounts he pays a sitter to watch over his teenage daughter Carol when he has to work on the weekends. Before answering Brendan's question, Isidra asked Brendan how old Carol will be in 2009 and was told that Carol will turn 13 on August 1.

Normally that would make Carol too old to qualify Brendan for the credit. However, Isidra then asked Brendan whether Carol is physically or mentally incapable of caring for herself and was told that she is mentally incapable of caring for herself. Because of that additional fact, Isidra told Brendan that he will be able to take the child and dependent care credit.

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Carrie Zarzycki asked her tax adviser, Aracelis Baken, whether she will be able to take a child and dependent care credit in 2009 for amounts she pays to have someone watch over her daughter Meggan during the time that Meggan is home from school but Carrie is still at work. Aracelis asked Carrie how old Meggan will be in 2007 and was told that she will turn 11 that year.

Normally that would make Meggan a qualifying individual and permit Carrie to take a credit for her employment-related expenses to care for Meggan. However, Aracelis then asked Carrie who will care for Meggan and was told that Meggan will be cared for by Carrie's other daughter, Sherry, who will turn 16 in 2009. Because of that additional fact, Aracelis told Carrie that she will not qualify for the credit.

Knowing what questions should be asked can be a daunting task, particularly if you are inexperienced at doing tax research, because it is not until you have identified all of the tax questions and researched the tax law relating to those tax questions that you will have a complete understanding as to which facts are relevant and which are not.

Planning Pointer: You should realize that it is perfectly understandable that you may have to request additional information from a client after you have analyzed and evaluated the primary sources relevant to a tax question.

You cannot rely on clients to know which facts are relevant and which or not (or, for that matter, what are facts and what are conclusions). It is your responsibility to ask whatever questions are necessary, and to examine whatever documents are needed, to obtain relevant facts.

Some preliminary facts that need to be established when doing tax research for a business can be determined by asking the following questions:

• What type of legal entity is the business (i.e., a C corporation, S corporation, partnership, limited liability company taxed as a partnership, limited liability company taxed as a corporation, or sole proprietorship)?

• Is the business a U.S. or foreign business? Are the owners U.S. citizens and residents or foreign citizens and residents?

• What is the business' tax year and method of accounting?

• Are the business and the person paying it income, selling it goods or services, or involved in the transaction being researched considered "related" for tax purposes? A corporation and an individual will be considered related for tax purposes, for example, if the individual directly or indirectly owns more than 50 percent in value of the corporation's outstanding stock. A corporation and a partnership will be considered related if the same persons own more than 50 percent in value of the outstanding stock of the corporation and more than 50 percent of the capital or profits interest in the partnership.

• If the research involves tax planning, what is the business' marginal income tax rate expected to be for its current tax year and subsequent tax years? If the business is a sole proprietorship or a pass-through entity (such as an S corporation, partnership, or limited liability company taxed as a partnership), what is the marginal income tax rate for each of its owners expected to be for the current tax year and subsequent tax years?

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A business asked its tax adviser, Dominick Dulude, how it would be taxed if it distributed $10,000 of its earnings for the year to its owners. Dominick needs to know whether the business is a C corporation, sole proprietorship, or pass-through entity because different tax rules apply to distributions by C corporations than to distributions by sole proprietorships and pass-through entities.

For example, a distribution by a C corporation to its shareholders may be treated as a dividend includible in its shareholders' gross income. By contrast, a distribution by an S corporation may be treated as a nontaxable return of capital to the S corporation's shareholders.

McNay Flavoring Extracts, Inc. asked its tax adviser, Randal Heeralall, how it should report its purchase of an advertisement in a trade publication for tax purposes. The company told Randal that it purchased the advertisement on November 20, 2008 but did not pay for the advertisement until January 5, 2009. To be able to answer the company's tax question, Randal needs to know the company's tax year and method of accounting.

For example, if the company uses the calendar year as its tax year and the accrual method of accounting, it can deduct the cost of the advertisement for its 2008 tax year. If the company uses the calendar year as its tax year and the cash method of accounting, it cannot deduct the cost of the advertisement until its 2009 tax year. If the company uses the cash method of accounting but its tax year begins February 1 and ends January 31, it can deduct the cost of the advertisement for its 2008 tax year.

Some preliminary facts that need to be established when doing tax research for an individual can be obtained by asking the following questions:

• Is the individual married or unmarried? If married, is the individual living with his or her spouse or separated and living apart?

• What is the individual's filing status (i.e., married filing jointly, married filing separately, qualifying surviving spouse, head of household, or unmarried)?

• Can the individual be claimed as a dependent of another taxpayer?

• Does the individual have any dependents? If so, what are their ages?

• Is the individual a U.S. citizen, U.S. resident alien, or nonresident alien? If the individual is married, is the individual’s spouse a U.S. citizen, U.S. resident alien, or nonresident alien?

• What is the individual's tax year and method of accounting?

• Is the individual related to the person paying the individual income, selling the individual goods or services, or otherwise involved in the transaction being researched?

• If the research involves tax planning, what is the individual's marginal income tax rate expected to be for the individual's current tax year and subsequent tax years?

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Elijah Pierson sold 1,000 shares of stock for $18,000. He had purchased the stock for $20,000. He asked his tax adviser, Jan Nardelli, how he should report the transaction for tax purposes. Before Jan can answer Elijah's tax question, she needs to know who purchased the stock from Elijah.

For example, if Elijah sold the stock to his daughter, he cannot deduct his $2,000 loss (i.e., the difference between the amount he received for selling the stock, $18,000, and the amount that he paid to purchase the stock, $20,000) (Code Sec. 267). However, Elijah can deduct his loss if he sold the stock to an unrelated person.

Randal Winski asked his tax adviser, Ariane Lozeau, whether he qualified for the earned income credit. Before Ariane can answer Randal's tax question, she needs to know whether he was a nonresident alien at any time during his tax year. If he was, he can be eligible for the earned income credit only if he was married at the end of his tax year to a U.S. citizen or resident and if he and his wife elected to treat him as a U.S. resident for the entire tax year (Code Sec. 32).

Once you have obtained preliminary facts about a client, you need to learn about the factual situation giving rise to the client's tax question. Does the client want to know whether an amount already received or to be received has to be included in the client's taxable income, whether a deduction or tax credit is available for an expenditure already made or to be made, how a transaction already completed has to be reported for tax purposes, or how a contemplated transaction can be structured to the client's tax advantage?

If a tax question involves an amount of money or property that a client has received, some of the facts that you need to learn can be obtained by asking the following questions:

• On what date was the money or other property transferred to the client?

• Who transferred the money or other property to the client?

• What is the relationship between the transferor and the client (e.g., is the transferor an employer, customer, family member, state or federal government, insurance company, or the seller of a product or service that the client has purchased)?

• Why was the money or other property transferred to the client?

• If property other than money was received by the client, what is the value of the property?

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Jan Ursini told her tax adviser, Emmett Pu, that she received a check for $1,000 and wanted to know whether she had to include that $1,000 in her gross income. To answer that question, Emmett needs to know who paid Jan the $1,000 and why the payment was made.

For example, if Jan tells Emmett that she received the $1,000 from her employer as a bonus, then Emmett knows that Jan has to include the $1,000 in her gross income as compensation.

If Jan tells Emmett that she received the $1,000 from her aunt's estate as a bequest, then Emmett knows that Jan can exclude the $1,000 from her gross income because bequests are not included in a taxpayer's gross income (Code Sec. 102).

Jen Gutknecht received a check for $750 and asked her tax adviser, Devora Dulek, whether she had to include the $750 in her gross income. To answer that question, Devora needs to know who paid Jen the $750 and why that payment was made. For example, if Jen tells Devora that she received the $750 from the U.S. Treasury Department as a refund of federal income tax that Jen overpaid, Devora knows that Jen does not have to include the $750 in her gross income.

However, if Jen tells Devora that she received the $750 from her state government as a refund of state income tax that Jen overpaid, then Devora will need to find out whether Jen previously took an itemized deduction on her federal income tax return for that $750. If not, then Jen can exclude the $750 from her gross income. However, if Jen did take an itemized deduction for that $750, then she has to include the $750 in her gross income.

If you determine that a tax question involves a disposition of property, some of the facts that you need to learn can be obtained by asking the following questions:

• When did the disposition occur?

• How was the disposition structured (e.g., as a sale, exchange, or reorganization)?

• Who made the disposition?

• Is the person who made the disposition an individual, C corporation, S corporation, partnership, limited liability company taxed as a corporation, limited liability company taxed as a partnership, or sole proprietorship?

• Who received the property?

• Are the transferor and transferee related?

• What type of property was disposed?

• When did the transferor acquire the property disposed?

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• For what purpose was the disposed property being held (e.g., business, investment, or personal use)?

• Was any money transferred as part of the disposition?

• Was any money or other property received by the transferor as part of the disposition? If so, how much money was received, and what was the fair market value of the other property received?

• Did the transferee assume any liability as part of the disposition or take the property subject to any liability? If so, what was the amount of the liability?

• Did the transferor receive the property from a related person?

• What was the adjusted basis of the property?

• Was any depreciation taken with respect to the property disposed? If so, how much was taken and how was the depreciation deduction calculated?

• Was any portion of the disposed property expensed? If so, what amount was expensed?

• Were any amortization deductions taken with respect to the property disposed? If so, what amount was deducted?

Aubrey Tufo asked his tax adviser, Domingo Dulude, how much tax he has to pay on the sale of his home. To answer that question, Domingo first needs to determine whether Aubrey can exclude any gain from the sale under Code Sec. 121 because the home was Aubrey's principal residence. Domingo needs to ask Aubrey whether he used and owned the home as his principal residence during the 5-year period ending on the date of the sale and, if so, on what dates.

If Aubrey is married, Domingo needs to ask Aubrey when they married, whether Aubrey's spouse used and owned the home as her principal residence during the 5-year period ending on the date of the sale, and, if so, on what dates. Domingo also needs to know whether Aubrey took advantage of the exclusion at any time during the 2 years preceding the date of the sale.

Armanda Sucharski asked her tax adviser, Jerald Leaser, how much tax she would have to pay on the sale of 100 shares of stock that she had held for more than 5 years. She purchased the shares for $5,000 and sold them for $8,000.

Without further investigation, a tax adviser might conclude that Armanda has to include $3,000 ($8,000 - $5,000 = $3,000) in her gross income as capital gain. However, Jerald asked Armanda who sold her the stock and learned that the seller was her father. He also learned that her father's $4,000 loss on the sale was disallowed by Code Sec. 267. With this additional information, Jerald could tell Armanda that she did not have to report any gain or loss from the sale (Code Sec. 267(d)).

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Relevant facts are not limited to those needed to determine the tax consequences of the tax matter being researched. They also include constraints on what tax strategies a tax researcher can recommend for a client.

Sole proprietor Devorah Hulslander asked her tax adviser, Emanuel Wanat, how she could minimize the amount of tax she would have to pay on the sale of certain equipment she used in her business. She told Emanuel that her adjusted basis in the equipment was $0 and that she expected to be able to sell the equipment for $2,000.

If Emanuel relied only on facts relating to the tax consequences of disposing the equipment, he might have recommended that she exchange the equipment for like-kind equipment so that she would not have to recognize any gain (Code Sec. 1031).

However, because Emanuel knew that Devorah wanted to concentrate on the service side of her business and would not need any equipment, he recommended that she make an installment sale of the equipment so that she could delay reporting the gain (Code Sec. 453) and offset gain she had to recognize by selling any business or investment property she had that had depreciated in value (such as stock selling for less than what she had paid for it).

Reliance on Information Furnished by a Client

If you advise a client to take a position on a tax return, document, affidavit, or other paper submitted to the IRS or prepare or sign a tax return as a preparer, you generally may rely in good faith upon (and not have to verify) information furnished by your client. However, you may not ignore the implications of information furnished to you or actually known by you and must make reasonable inquiries if the information as furnished appears to be incorrect, inconsistent with an important fact or another factual assumption, or incomplete (31 C.F.R. §10.34(d)).

Emmett Cardo sold his Illinois home during the year. He told his tax adviser, Fae Oesterle, that he had used and owned the home as his principal residence for at least 2 years during the 5 years prior to the sale. However, Fae knew that Emmett spent most of his time in Michigan at another home and that Emmett's daughter had been paying in-state tuition while attending the University of Michigan for the past 4 years.

Fae has an obligation to make additional inquiries to determine whether Emmett actually owned and used his Illinois home as his principal residence for at least 2 years during the 5 years prior to its sale.

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Emanuel Renton told his tax adviser, Waltraud Denzel, that the $30,000 he paid his teenage son Darrin to work summers at Emanuel's business was reasonable compensation for the work performed.

Waltraud should make reasonable inquiries to determine whether the compensation paid Darrin would be considered reasonable by other businesses in the same industry for the work performed.

Study Questions 1. Troilo Metal Corrugating, Inc. asks you whether it can take a tax deduction for an expenditure that

it made during its 2009 tax year. Which one of the following questions do you NOT have to ask when gathering facts needed to answer the company's tax question?

Is the company a C corporation or an S corporation?

What does the company expect its marginal tax rate to be for its 2010 tax year?

What is the company's method of accounting?

Is the company related to the person to whom it incurred the expense?

2. Which one of the following statements is NOT correct?

An example of a fact is that a company will be building a new manufacturing plant.

An example of a conclusion is that the amount of compensation paid was reasonable.

An example of a relevant fact is the age of a person asking whether he or she has to withdraw any money from a traditional IRA.

A tax adviser cannot always rely on information furnished by a client without verification.

3. Elijah Gubler said that he received some money and wants to know whether he has to include it in

his gross income for 2009. Which one of the following questions do you NOT have to ask when gathering information to answer Elijah's question?

Did he receive the money in dollars or in a foreign currency?

Who gave Elijah the money?

Why was the money transferred to Elijah?

What is the relationship between Elijah and the transferor?

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Identifying Tax Questions Once you have gathered the relevant facts, you need to identify which tax questions need to be researched. Being able to identify those questions is the most difficult step in the tax research process.

As a preliminary matter, you should determine whether you have been asked about an item of income, an expenditure for which a deduction or credit may be available, or a transaction that may or may not trigger the recognition of gain or loss.

If you determine that there is a question about an item of income, you must determine what type of income is involved, whether it is includible in gross income, and, if so, when it has to be recognized under the taxpayer's method of accounting.

Deboard Picture Frames, Inc. received interest on a bond and wants to know whether the interest has to be included in the company's gross income. The tax questions are whether the interest is the type of interest that can be excluded from gross income and, if not, when it has to be taken into account under the company's method of accounting.

If you determine that there is a tax question about an expenditure, you must determine whether a deduction or credit is available for the expenditure and when it can be taken into account under the taxpayer's method of accounting.

Skokan Gems, Inc., a calendar year taxpayer, purchased machinery in 2008 but did not pay for the machinery until 2010. The tax questions are whether the company is entitled to a deduction or credit for its purchase and, if so, for which year a deduction or credit is available.

If you determine that there is a question about a disposition of property, you must determine how much gain or loss was realized on the disposition, whether any or all of the gain or loss realized may or must be deferred, for what tax year any gain or loss that must be recognized has to be taken into account, and how any gain or loss recognized has to be characterized (i.e., as capital gain or loss or ordinary income or loss).

Dominick Weare, a sole proprietor, exchanged one piece of equipment plus $20,000 for another piece of equipment.

The tax questions are: (1) How much gain or loss was realized on the exchange? (2) May or must recognition of any gain or loss realized be deferred to another tax year? (3) For which tax year must any gain or loss that must be recognized be taken into account? (4) Will any gain or loss that must be recognized be characterized as capital gain or loss or ordinary income or loss for federal income tax purposes?

You should be prepared to modify the tax questions that you initially identified and add additional tax questions as you research the tax law.

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Study Question 1. Shery Hickam tells you that she made an expenditure during the year. Which one of the following

is NOT a tax question that you might have about the expenditure?

Can Shery take a deduction for the expenditure?

Can Shery take a tax credit for the expenditure?

What is Shery's method of accounting?

Where did Shery get the money to make the expenditure?

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Locating Primary Sources Relevant to a Tax Question Once you have gathered the relevant facts and identified which tax questions need to be researched, you need to locate the primary sources relevant to the tax issues you are researching.

Primary Sources Distinguished from Secondary Sources

Tax information is classified as a primary source or as a secondary source. A primary source emanates from the legislative, executive, or judicial branch of the government and constitutes part of the tax law.

Examples of primary sources include:

• Statutory authority, such as the Internal Revenue Code (the Code), statutes outside the Code, tax treaties, and Congressional reports.

• Administrative authority, such as Treasury regulations and IRS rulings.

• Judicial authority (i.e., court decisions).

Because primary sources are not readily accessible in official versions, constitute a large amount of material, and are not well-organized, researchers usually rely on secondary sources to locate primary sources relevant to their tax questions.

A secondary source is a reference that sets forth unofficial versions of primary sources (such as Code provisions, Treasury regulations, IRS rulings, and/or judicial decisions), explains and comments on primary sources, and/or describe the current legal status of primary sources.

Examples of secondary sources include:

• Tax reporters: Organized by Code provision, a tax reporter typically includes the full text of each Code provision and each Treasury regulation interpreting the Code provision and provides annotations of other primary sources (such as IRS rulings and judicial decisions).

• Tax services and treatises: Organized by topic, tax services and treatises explain and comment on primary sources. Tax services usually are updated more frequently than treatises.

• Citators: Describe the current legal status of primary sources. For example, a citator may discuss whether a particular judicial decision is still good law or has been overruled by another court. A citator also may discuss whether an IRS ruling has been modified, amplified, clarified, revoked, superseded, or declared obsolete.

• Legal periodicals: Include articles explaining and commenting on particular tax questions. Some legal periodicals are devoted entirely to articles about tax questions.

• Tax institute publications: Some universities (such as New York University, the University of Chicago, and the University of Miami) sponsor institutes on tax topics and then publish papers presented at the institute.

• Tax newsletters: Many newsletters explain and comment about tax questions and discuss current developments in the tax law.

• Tax opinions: A tax adviser may have access to opinions on tax questions prepared by other tax advisers.

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The courses entitled Tax Research: Primary Sources of Federal Tax Law – The Internal Revenue Code and IRS Interpretations and Tax Research: Primary Sources of Federal Tax Law – Judicial Interpretations discuss in detail what primary sources are and how they are used. The course entitled Tax Research: Secondary Sources of Federal Tax Law discusses secondary sources and how they are used.

Use of Secondary Sources to Identify Relevant Primary Sources

You may feel overwhelmed by the vast number of pages of Code provisions, Treasury regulations, IRS rulings, and court decisions. It is the great quantity of such material that makes secondary sources so important for tax researchers.

Secondary sources organize primary sources for readers and ideally explain the tax law in a straightforward manner.

Without secondary sources, you would have to read all cases and rulings to determine which ones, if any, applied to a client's situation.

Using computers to identify relevant primary sources is no substitute for secondary sources. By using computers to identify relevant primary sources, you can narrow the amount of material that you need to read, but computerized searches may pick up much irrelevant material if the search expression is defined too broadly, or exclude relevant material if the search expression is defined too narrowly.

If you totally rely on primary sources, you will be denied the benefit of the insight into a tax question that a secondary source can provide.

Planning Pointer: Before using a secondary source, you should determine when the secondary source last was updated. If the secondary source sets forth the full text of the Code, you should determine how it handles Code provisions

that have been revoked or modified. Some secondary sources include such provisions but indicate when they were modified or revoked. Others exclude such provisions.

Usually it is advisable for you to start researching a tax question by referring to a secondary source covering the tax question you are researching. Both Code-oriented and topic-oriented secondary sources have a place in the research process. Topic-oriented secondary sources are a good place to start if you do not know which Code provisions apply to the tax issue or if you need the special insight that a topic-oriented secondary source can provide about a tax question.

If you know which Code provisions apply to a tax question and expect a straightforward answer, you may save time by using a Code-oriented secondary source to determine whether their tax question has been answered by the Code itself or by a particular Treasury regulation, IRS ruling, or judicial decision.

Determining Whether a Primary Source Reflects Current Law

As part of your research, you should consult a citator to determine whether IRS rulings and judicial decisions identified as relevant reflect current law. By consulting a citator, you can determine whether an IRS ruling has been modified, amplified, clarified, revoked, superseded, or declared obsolete. You also can determine whether a judicial decision has been affirmed or reversed and whether other courts have commented favorably or unfavorably on the decision.

You cannot rely on an authority to the extent that it has been implicitly or explicitly overruled or modified.

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A district court opinion is not an authority if overruled or reversed by the U.S. Court of Appeals for that district. However, a U.S. Tax Court opinion is not considered overruled or modified by a Court of Appeals to which the taxpayer does not have a right of appeal unless the Tax Court adopts the holding of that Court of Appeals.

Planning Pointer: Before relying on a Code provision, be sure to check the date it became effective and whether it is scheduled for termination. Before relying on a Treasury regulation, determine whether the

regulation reflects recent changes in the Code.

Study Questions 1. Each one of the following is a primary source EXCEPT:

The Internal Revenue Code.

A tax opinion written by a tax adviser.

A decision by a U.S. district court.

An IRS revenue ruling.

2. Each one of the following is a secondary source EXCEPT:

A tax reporter that publishes the full text of the Internal Revenue Code and the Treasury regulations.

A treatise on corporations.

A citator.

An IRS technical advice memorandum.

3. As part of the process of identifying primary sources relevant to a tax question, you should NOT

do which one of the following?

Consult a treatise discussing the tax question.

Make a computerized search of a database containing the Internal Revenue Code and Treasury regulations.

Refer to a citator.

Telephone the IRS and ask a representative for the answer to the tax question.

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Analyzing and Evaluating Primary Sources Once you have identified the primary sources relevant to a tax question, you should assess what those primary sources say about the tax question.

Some primary sources are more important than others. The importance accorded a particular primary source depends on the similarity of the pertinent facts relied on by the primary source to the facts involved in the tax question and from whom the primary source emanates.

You should give the greatest weight to primary sources that involve a factual situation with the greatest similarities to the factual situation involved in your tax question. The greater the similarity between the facts involved in a primary source and the facts involved in your tax question, the more important that primary source is in answering the tax question.

Planning Pointer: At the same time that you review a judicial decision or IRS interpretation for facts similar to those involved in a client's tax question, you should consider whether there is any different fact that could cause the court or IRS to come to a different conclusion

with respect to your tax question.

Jenice Larona asked her tax adviser whether she could deduct as a medical expense the cost of food she purchased for a special low-salt diet prescribed by her physician to lower her blood pressure. Her tax adviser found a U.S. Tax Court case, J.W. Harris, 46 TC 672, Dec. 28,084 (1966), which decided that J. Willard Harris, a diabetic, could not deduct the cost of certain low-salt and reduced sugar foods prescribed as a diet by the taxpayer's physician because the prescribed foods were a substitute for foods that the taxpayer ordinarily consumed.

Because the facts of the Tax Court case are similar to those of Jenice's situation, the case must be given great weight in determining whether Jenice can deduct the cost of her special diet.

Because Darrin Nute was allergic to a variety of chemicals found in pesticides and herbicides, his doctor required him to limit his diet to organic foods. Based on J.W. Harris, discussed in the previous example, it would seem that Darrin could not deduct the cost of those organic foods because they were a substitute for foods that he ordinarily consumed. However, there is an additional fact present in this case that was not present in J.W. Harris: the organic foods that Darrin purchased cost significantly more money than the foods for which they substituted.

This additional fact made the difference in T.G. Randolph, 67 TC 481, Dec. 34,152 (1976), where the U.S. Tax Court decided that Theron G. Randolph and Janet M. Randolph, both allergic to pesticides, herbicides, and certain other chemicals, could deduct as a medical expense the amount by which the cost of chemically uncontaminated organic food that they purchased exceeded what it would have cost them to purchase foods exposed to pesticides, herbicides, and other chemicals.

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Sometimes a tax question is answered clearly by a Code provision.

Devorah Kaplun asked her tax adviser, Jen Bedrosian, whether she had to include in her gross income the unemployment compensation that she received from her state. A secondary source referred Jen to Code Sec. 85, which requires individuals to include unemployment compensation in their gross income.

Darrin Groff asked his tax adviser, Alishia Leather, whether he had to include in his gross income $1,000 gifted to him by his father. Alishia found that Code Sec. 102 permits taxpayers to exclude the value of property acquired by gift from their gross income.

Other times a Code provision does not answer a tax question but a Treasury regulation does.

Aubrey Tanis got into a car accident as a result of her faulty driving, and her car sustained $3,000 in damages, $2,000 of which was covered by insurance. Aubrey asked her tax adviser, Abel Deoliveira, whether she could take a tax deduction for the $1,000 in damages not covered by insurance. After consulting a secondary source, Abel read Code Sec. 165(c)(3), which permits individuals to deduct a loss of property if the loss arose from a fire, storm, shipwreck, or other casualty.

This Code section did not tell him whether a car accident qualifies as a casualty, but Reg. §1.165-7 did. Reg. §1.165-7(a)(3) specifically provides that damage to an automobile owned by a taxpayer can qualify as a casualty loss if it results from the faulty driving of the taxpayer or another person operating the automobile.

Elois Popoff asked his tax adviser, Carrie Turcott, whether he would have to recognize any gain if he exchanged unimproved land for an apartment building. Carrie found that Code Sec. 1031 would permit Elois to avoid having to recognize gain if the unimproved land and apartment building could be considered "like-kind property." However, Code Sec. 1031 does not define what constitutes "like-kind property." Referring to Reg. §1.1031(a)-1(c), Carrie found that unimproved land and an apartment building are considered like-kind property.

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Planning Pointer:

That a Treasury regulation answers a tax question does not preclude a taxpayer from arguing that the answer given is wrong. The IRS is bound by its regulations; courts are not. However, the regulations command a court's respect because Congress has

delegated to the Secretary of the Treasury, not the courts, the task of administering the tax laws.

The amount of deference that a court is required to give a regulation depends on whether the regulation is a legislative or interpretive regulation. A "legislative regulation" is a regulation promulgated pursuant to a specific grant of authority by Congress to define a statutory term or prescribe a method for implementing a Code provision. An "interpretive regulation" is a regulation promulgated pursuant to the IRS' general authority to issue regulations.

A legislative regulation is given the force and effect of law unless it is arbitrary, capricious, or manifestly contrary to the statute.

An interpretive regulation is accorded less deference than a legislative regulation and can be set aside if it is not a reasonable interpretation of the Code.

When no clear answer is provided by the Code or a Treasury regulation, you should look at IRS revenue rulings and procedures for guidance. A taxpayer can rely on the conclusion drawn by a revenue ruling or revenue procedure unless the revenue ruling or revenue procedure has been revoked, superseded, declared obsolete, or modified in a way that affects its conclusion regarding the taxpayer's tax question.

Latashia Stockfisch asked her tax adviser, Erminia Delacy, whether she could deduct as medical expenses her expenditures for a program she took to help her stop smoking, prescription drugs to help alleviate the effects of nicotine withdrawal, nicotine gum, and patches. Erminia found nothing in the Code or regulations that specifically answered this tax question.

However, she found Rev. Rul. 99-28, 1999-1 CB 1269, which decided that taxpayers can deduct as medical expenses expenditures for a stop-smoking program and prescription drugs to help alleviate the effects of nicotine withdrawal but not expenditures for nonprescription drugs such as nicotine gum and nicotine patches.

You should look at IRS letter rulings and technical advice memoranda (TAM) for guidance as to how the IRS will answer a tax question. However, taxpayers cannot rely on the conclusion of a letter ruling or TAM unless it was issued to them.

Diflorio Pet Remedies, Inc. asked the IRS for a letter ruling regarding a planned transaction and received a letter ruling explaining how the transaction would be taxed. If the company carries out the transaction as the transaction is described in the letter ruling, the company can report the transaction for tax purposes as detailed by the IRS in the letter ruling without worry that its treatment of the transaction will be challenged by the IRS.

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Timmy Ciccarelli, the tax adviser for Tapija Pet Supplies, Inc., researched the tax consequences of a planned transaction by the company and came across the letter ruling issued to Diflorio Pet Remedies. The letter ruling issued to Diflorio Pet Remedies describes a transaction almost identical to the transaction planned by Tapija Pet Supplies and explains how that transaction will be taxed. Although the transaction described in the letter ruling is almost identical to the transaction planned by Tapija Pet Supplies, Tapija Pet Supplies cannot rely on that letter ruling issued to Diflorio Pet Remedies.

If Tapija Pet Supplies goes through with the transaction and reports the tax consequences the same way the IRS told Diflorio Pet Remedies to report its transaction there is no guarantee that the IRS will agree that Tapija Pet Supplies reported its transaction properly. To avoid risk of a contrary result, Tapija Pet Supplies should request that the IRS issue a letter ruling to Tapija Pet Supplies.

If a conclusion reached by the IRS does not benefit a taxpayer, you should look for any court decisions that have come to a conclusion favorable to the taxpayer. If such a decision was made by the U.S. Supreme Court, then a taxpayer can rely on that decision without worry of challenge by the IRS. Although the starting point for answering a tax question is the Code, the U.S. Supreme Court has the final say as to the meaning of Code provisions. Its answer to a tax question is the answer unless Congress amends the Code to reverse the court's interpretation of the Code.

In D. A. Gitlitz, SCt, 2001-1 USTC §50,147, 531 US 206, 121 SCt 701, 148 LE2d 613, the U.S. Supreme Court was asked to construe the meaning of two Code provisions and to explain their interaction with respect to S corporation shareholders. Its decision became the final word on that tax question and was binding on taxpayers and the IRS until Congress, as part of the Job Creation and Worker Assistance Act of 2002 (P.L. 107-147), amended Code Sec. 108 to reverse the Supreme Court's decision.

If a decision favorable to a taxpayer has been made by the U.S. Court of Appeals with jurisdiction over the taxpayer (because the taxpayer resides or has its place of business in one of the states governed by the court), the taxpayer can rely on that decision without worry of challenge by the IRS because the IRS is required to follow a decision by a Court of Appeals with respect to taxpayers subject to that court's jurisdiction. If a decision not favoring a taxpayer has been made by the U.S. Court of Appeals with jurisdiction over the taxpayer, the taxpayer must follow that decision unless the taxpayer is prepared to try to convince the Court of Appeals to reconsider its decision or try to convince the U.S. Supreme Court to reverse the Court of Appeals' decision.

Simley Coin Machines, Inc., whose principal place of business is in Illinois, was unsure whether an expenditure it made during its tax year was a capital expenditure (deductible over a number of years) or a business expense (deductible in the year paid or incurred). According to an IRS revenue ruling, the expenditure was a capital expenditure. The 9th Circuit Court of Appeals agreed with the IRS, but the 7th Circuit Court of Appeals did not. Because the 7th Circuit Court of Appeals has jurisdiction over Illinois taxpayers, the company can deduct its expenditure currently as a business expense.

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The facts are the same as in the previous example except that Simley Coin Machines' principal place of business is in California instead of Illinois. Because the 9th Circuit Court of Appeals has jurisdiction over California taxpayers, the company should treat its expenditure as a capital expenditure instead of as a currently deductible business expense unless it is confident that: (1) the 9th Circuit will reverse its decision or the U.S. Supreme Court will reverse the 9th Circuit's decision and; (2) the company's tax savings will outweigh the substantial legal costs that it is likely to incur if it has to litigate the issue.

If a U.S. Court of Appeals without jurisdiction over a taxpayer has made a decision favorable to that taxpayer, that decision can indicate how the U.S. Court of Appeals with jurisdiction over the taxpayer will rule on the tax question. However, such a decision does not protect a taxpayer outside the court's jurisdiction from challenge by the IRS.

Meck Marine Engines, Inc., whose principal place of business is in Massachusetts, governed by the 1st Circuit Court of Appeals, was unsure whether an expenditure it made during its tax year was a capital expenditure (deductible over a number of years) or a business expense (deductible in the year paid or incurred). According to an IRS revenue ruling, the expenditure was a capital expenditure.

The 9th Circuit Court of Appeals agreed with the IRS, but the 7th Circuit Court of Appeals did not. Under these circumstances, the company must decide whether the 1st Circuit Court of Appeals is more likely to follow the decision made by the 7th Circuit or the decision made by the 9th Circuit, and whether its tax savings will outweigh the substantial legal costs it is likely to incur in challenging the IRS.

Planning Pointer: Courts prohibit taxpayers from relying on opinions that they have designated as "not for publication."

Decisions made by the U.S. Tax Court, a U.S. district court, or the U.S. Court of Federal Claims bind the taxpayer who participated in the legal proceedings if the time for appealing that decision to a Court of Appeals has passed. For other taxpayers, such decisions are not the final authority on a tax question but are important because they can indicate how a Court of Appeals is likely to rule. The IRS is not required to follow a decision made by any of those courts and may force a taxpayer in a similar situation to relitigate the tax question.

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Hoyles Cooling Systems, Inc., whose place of business is in New York City, planned to exchange certain equipment for other equipment but was unsure whether the two types of equipment could be characterized as "like-kind" for purposes of Code Sec. 1031. The U.S. District Court for the Southern District of New York, one of the courts to which the company could appeal an adverse determination by the IRS, has decided that the two types of equipment are like kind. However, the IRS has said that it will not acquiesce to that decision.

If the company decides to treat the two types of equipment as like kind, it can expect the IRS to rule against it despite the favorable decision by the U.S. District Court for the Southern District of New York. The company must weigh the potential tax savings against the legal costs of litigating the tax question before the district court (where it can expect to prevail) and possibly the Court of Appeals for the Second Circuit.

Because the U.S. Tax Court and U.S. Court of Federal Claims are national courts, a taxpayer litigating in either forum can rely on a decision made by that court, no matter where the taxpayer lives in the country, unless the Court of Appeals to which the Tax Court's or Court of Federal Claims' decision can be appealed has ruled otherwise.

Frames Data Processing Equipment, Inc., whose place of business was in Oklahoma, received insurance proceeds following the destruction of machinery by a hurricane and wanted to avoid having to recognize gain on the conversion by investing the insurance proceeds in property "similar or related in service or use" to the property converted. However, it was unsure whether the machinery it wanted to purchase qualified as "similar or related in service or use" to the property converted.

In a case involving a Florida business, the U.S. Tax Court ruled that the type of machinery Frames Data Processing Equipment wanted to purchase was similar or related in service or use to the company's machinery that was destroyed.

If the IRS rules against the company, the company can be confident that the U.S. Tax Court will rule favorably to the company, even though Frames Data Processing Equipment's place of business is in a different state. However, the company has to consider the possibility that the IRS will appeal the Tax Court's decision to the 10th Circuit Court of Appeals, which has jurisdiction over Frames Data Processing Equipment.

The facts are the same as in the previous example, except that the 10th Circuit Court of Appeals, which has jurisdiction over Frames Data Processing Equipment, ruled the opposite of the Tax Court. The company cannot rely on the Tax Court's decision in favor of the Florida business because the Tax Court will follow the 10th Circuit Court of Appeals' decision in any litigation involving the company.

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The facts are the same as in the previous example except that it was the 11th Circuit Court of Appeals, which has jurisdiction over the Florida business, not the 10th Circuit Court of Appeals, that ruled in favor of the IRS. Under the Tax Court's Golsen rule (J. E. Golsen, 54 TC 742, Dec. 30,049, aff'd CA-10, 71-2 USTC §9497, 445 F2d 985), the Tax Court will follow the 11th Circuit's decision only in states subject to that court's jurisdiction. Because Frames Data Processing Equipment is not subject to the 11th Circuit's jurisdiction, it may rely on the Tax Court's decision involving the Florida business.

Planning Pointer: Because the U.S. Tax Court handles only tax cases, its judges are considered specialists in the tax law. Their decisions tend to carry more weight than decisions made by U.S. district courts or the U.S. Court of Federal Claims.

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Study Questions 1. You have been asked to determine whether a client can deduct the cost of a weight-loss program

as a medical expense. Which one of the following authorities is most important in answering this tax question?

A U.S. Tax Court decision that permitted a taxpayer to deduct the cost of a stop-smoking program.

A U.S. Supreme Court decision that ruled that the cost of medical care to treat an illness can be deducted as a medical expense.

An IRS revenue ruling deciding that the cost of a weight-loss program can be deducted as a medical expense.

A U.S. Court of Appeals decision that the cost of an exercise program prescribed for heart patients can be deducted as a medical expense.

2. Assuming that all of the following provide an answer to a tax question, which one of the following sources provides the most authoritative answer?

The U.S. Supreme Court.

The Internal Revenue Code.

The U.S. Circuit Court of Appeals with jurisdiction over the taxpayer.

A Treasury regulation.

3. Which one of the following statements is NOT correct?

Congress can overrule a U.S. Supreme Court decision regarding the interpretation of a tax law by changing the tax law.

Potential legal costs to challenge an IRS' determination should not be considered when answering a tax question.

The IRS may deny a taxpayer a deduction even though it issued a letter ruling to another taxpayer that permitted such a deduction.

If the IRS says that a taxpayer cannot deduct a particular expenditure but the U.S. Court of Appeals for the taxpayer's state permits such a deduction, the taxpayer can take the deduction.

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Obtaining Additional Facts and Applying the Relevant Primary Sources to Those Facts While analyzing and evaluating primary sources, you may find that additional facts have to be obtained from a client to determine whether an item of income has to be included in the client's gross income, whether an expenditure can be deducted or used to obtain a credit, or how a transaction will be taxed. After obtaining that additional information, you will have to analyze and evaluate the relevant primary sources in light of those additional facts.

Melanie Sluka was asked whether Elwood Zillmer could exclude from his gross income any of the gain he realized when he sold his home. During the 5 years preceding the sale, Elwood had owned and used the home as his principal residence for 18 months. The other months he was serving abroad on active duty in the U.S. military. After reading Code Sec. 121, Melanie realized that the $250,000 exclusion usually applies only if an individual has owned and used property as the individual’s principal residence for at least 2 years during the 5-year period ending on the date of the sale.

However, Melanie noticed that the 5-year period can be suspended while an individual is on active duty in the U.S. military. Melanie asked Elwood whether he used the home as his principal residence prior to his military service and was told that he had for the previous three years. With this additional information, Melanie concluded that Elwood could exclude up to $250,000 of the gain he realized when he sold his home.

Marlon Aly was asked whether Janay Tellers could deduct interest he paid on a loan incurred to pay for a variety of expenses, not including expenses to acquire, construct, or substantially improve Janay's principal residence. After Marlon determined that the interest could not be deducted as interest on acquisition indebtedness, Marlon wondered whether Janay's mortgage loan could qualify as home equity indebtedness and obtained additional information from Janay. With that additional information, Marlon determined that Janay's mortgage loan qualified as home equity indebtedness but that the amount of interest that Janay could deduct was limited because the amount of the loan exceeded $100,000.

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Drawing Conclusions and Developing Recommendations Once you have analyzed and evaluated the relevant primary sources in light of all facts obtained from a client, it is time for you to draw conclusions and develop recommendations. Often there is a clear conclusion. Other times it may be unclear how the tax law applies. Under such circumstances, you must use your best professional judgment to determine how the tax law will be applied.

Planning Pointer: If it is unclear how the tax law applies to a tax question and the answer to the tax question can save or cost a client a substantial amount of taxes, consider asking the IRS for a letter ruling answering the tax question.

Before making a recommendation, you must consider the preferences of your client and what it would cost your client to defend against a challenge by the IRS. The strategy that saves the most in taxes may not necessarily be acceptable to your client or save your client the most money over the long term.

The IRS assessed a $500 deficiency against Renton Industrial Trade Show Exhibits, Inc. The company's tax adviser, Boyd Pelikan, believed that the IRS' interpretation of the Code provision was incorrect, and some commentators agreed with Boyd, but there were no judicial decisions either supporting or opposing the IRS' interpretation.

Boyd estimated that it would cost the company $10,000 to challenge the IRS before the U.S. Tax Court and tens of thousands of dollars more if the case were appealed to a Court of Appeals. Although Boyd was confident that Renton Industrial Trade Show Exhibits would prevail, he could not recommend a strategy guaranteed to cost the company at least $10,000 but saving the company no more than $500.

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Communicating Research Results to Other Professionals and Clients Once you have drawn conclusions and developed recommendations regarding a tax question, you should write a memorandum of those conclusions and recommendations as a record of the research and for a colleague (typically the partner or supervisor who assigned the research project) to review your analysis, conclusions, and recommendations.

Following that review, the conclusions and recommendations should be communicated to your client.

Properly communicating an answer to a tax question is as important as finding the correct answer to the question. If an answer is not properly communicated and it is misunderstood by the client or partner/supervisor, an item of income or expense or transaction may be improperly reported, or a transaction may be improperly structured to achieve the best tax results.

A typical memorandum for a tax adviser's records and review by a partner or supervisor is divided into five parts:

Facts. States the pertinent facts and identifies the source of those facts. Issues. States the original tax question and any ancillary tax questions that have arisen. Law. Mentions the tax laws that affect the issue. Analysis. Applies the tax laws to the pertinent facts. Conclusion. If the tax question is a matter of compliance, this portion of a memorandum concludes how an item of income or expense or transaction should be reported. If the tax question involves tax planning, this portion of a memorandum recommends how best to plan for income not yet received, expenses not yet incurred, or transactions that have not yet occurred to achieve the most favorable tax consequences. When the answer to a tax question is not clear cut, the conclusions and recommendations will be a mixture of objective and subjective findings. Recommendations should include advice as to benefits, as well as risks.

Sample Memorandum

Date: December 11, 2009 To: Client File By: Meggan Bong

Facts: According to Darnell Gacek, he purchased a residence at 800 Ceasars' Boulevard in Reno, Nevada on May 1, 2008 and sold the residence on November 1, 2009. During that period, he and his two children used it as their principal residence. His adjusted basis in the residence was $350,000, and he sold the property for $450,000. On April 1, 2008, Darnell sold other property in Reno that he had owned and used as a principal residence and took advantage of Code Sec. 121 to exclude from his gross income his $200,000 of gain from that sale. Darnell made the November 1, 2009 sale because he took a new job in Las Vegas, Nevada on September 2, 2009. Darnell is not married and is not a member of the U.S. uniformed services or U.S. Foreign Service. His place of employment in Reno was five miles from his home in Reno. His new place of employment is 340 miles from his former residence in Reno.

Issue: Can Darnell exclude any portion of his gain from the sale of his principal residence? If so, what amount?

Law: Code Sec. 121(a) permits taxpayers to exclude from their gross income gain from the sale or exchange of property if they owned and used the property as their principal residence for periods aggregating two years or more during the five-year period ending on the date of the sale or exchange. The maximum amount of gain that can be excluded by an unmarried individual is $250,000 [Code Sec. 121(b)(1)]. As a general rule, the exclusion is available only once every two

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years [Code Sec. 121(b)(3)]. A special rule [Code Sec. 121(c)] provides a reduced maximum exclusion for certain taxpayers who did not own and use the property as their principal residence for periods aggregating two years or more during the five-year period ending on the date of the sale or exchange or who took advantage of the exclusion for another sale or exchange during the two-year period ending on the date of the current sale or exchange.

The reduced maximum exclusion is available if the current sale or exchange was by reason of a change in place of employment, health, or unforeseen circumstances. The amount of the reduced maximum exclusion is calculated by multiplying the maximum exclusion for the taxpayer by a fraction. The numerator of the fraction is the shortest of the period of time (measured in days or months) that the taxpayer owned the property as the taxpayer's principal residence during the five-year period ending on the date of the sale or exchange, the period of time that the taxpayer used the property as the taxpayer's principal residence during the five-year period ending on the date of the sale or exchange, or the period of time between the date of a prior sale or exchange of property for which the taxpayer excluded gain under Code Sec. 121 and the date of the current sale or exchange. The denominator of the fraction is 730 days or two years (depending on whether the period of time in the numerator was measured in days or months).

A sale or exchange is deemed to be by reason of a change in place of employment if a change in place of employment occurred during the period that the taxpayer owned and used the property as the taxpayer's principal residence and the taxpayer's new place of employment is at least 50 miles farther from the residence sold or exchanged than was the former place of employment (Reg. §1.121-3(c)).

Analysis: Darnell does not qualify for the maximum exclusion because he did not own and use the property at 800 Ceasars' Boulevard In Reno as his principal residence for at least two years during the five-year period ending on to the date that he sold the property. However, he qualifies for a reduced maximum exclusion because he took a new job in Las Vegas while he owned and used the property at 800 Ceasars' Boulevard as his principal residence and his new place of employment in Las Vegas is at least 50 miles farther from the residence sold than was his former place of employment in Reno. The reduced maximum exclusion is $250,000 multiplied by a fraction whose numerator is 18 months and whose denominator is 24 months. The reduced maximum exclusion is $250,000 X (18/24) = $187,500. Therefore, Darnell may exclude the entire amount of his $100,000 gain ($450,000 - $350,000 = $100,000).

Conclusion: Darnell may exclude all of his $100,000 gain from the sale of his home in Reno.

Although a memorandum typically is structured as previously described, that is not the only form that a memorandum can take. If an issue is straightforward, you may wish to start the memorandum by stating the conclusion and then explain how you reached that conclusion. When communicating with a client, a more informal approach usually is taken. In addition to the types of information included in a memorandum, a letter to a client should include a statement regarding your understanding of what the client asked you to do. By including such a statement, misunderstandings between you and your client as to what your client wanted you to do can be avoided. A sample client letter follows.

Tax Research: Process (Third Edition) 35

Sample Client Letter

Dear Mr. Gacek:

This letter answers your question whether you can exclude from your gross income any portion of your gain from the sale of your residence at 800 Ceasars' Boulevard in Reno and, if so, how much.

It is my understanding, based on our meeting on December 11, 2009, that you purchased your residence at 800 Ceasars' Boulevard in Reno, Nevada on May 1, 2008 and sold the residence on November 1, 2009. You sold the residence because you took a new job in Las Vegas, Nevada on September 2, 2009. During the period that you owned the property, you used it as your principal residence. Your adjusted basis in the residence was $350,000, and you sold the property for $450,000. On April 1, 2008, you sold another home that you owned in Reno and were able to exclude from your gross income gain from that sale. You are not married and are not a member of the U.S. uniformed services or U.S. Foreign Service. Your place of employment in Reno was five miles from your home in Reno. Your new place of employment is 340 miles from your former residence in Reno.

Although the Internal Revenue Code (Section 121) permits unmarried taxpayers to exclude from their gross income up to $250,000 of their gain from the sale or exchange of their principal residence, you are not eligible for the maximum exclusion because you did not own and use your residence as your principal residence for at least two years during the five years before you sold it and because you used the exclusion within two years of your current sale (when you sold your other home in Reno). However, you are entitled to a reduced maximum exclusion because the reason for your sale was your new job in Las Vegas and your new place of employment is at least 50 miles farther from your Reno residence than your former place of employment was to your Reno residence.

The amount of your reduced maximum exclusion is calculated by multiplying $250,000 by a fraction whose numerator is the number of months that you owned and used your Reno residence as your principal residence,18, and whose denominator is 24. Therefore, your reduced maximum exclusion is $187,500, which means that you can exclude all of your $100,000 gain from your sale of your Reno home.

If you have any questions about anything discussed in this letter or have questions about other matters, do not hesitate to call me.

Sincerely,

Meggan Bong

It is crucial that you provide your client all information that your client needs to make an informed decision. Such information should be provided not only because it is the client who ultimately is responsible for deciding what to do, but also because providing such information makes the letter a record that the client was informed of all potential risks and benefits and heads off claims to the contrary in a malpractice suit.

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To avoid having written advice characterized as a covered opinion (discussed later in this course) and being penalized for not satisfying the rules governing such opinions, tax practitioners have been including a disclaimer like the following in their written communications (including e-mails) to clients:

Circular 230 Disclaimer. I am required by Treasury Regulations to tell you that, unless I’ve expressly indicated otherwise, any federal tax advice I provide in this letter is not intended to be used, and may not be used, to avoid tax-related penalties under the Internal Revenue Code or to promote, market, or recommend to another person any tax matters addressed by this letter.

Study Question 1. Which one of the following items is NOT discussed in a memorandum prepared to answer a tax

question?

The facts relevant to the tax question.

The tax adviser's fee agreement with the client.

The original tax question and any ancillary tax questions that have arisen.

The tax adviser's conclusion regarding the answer to the tax question.

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Standards for Tax Research As part of its standards of practice for tax professionals, (Treasury Department Circular No. 230 (31 C.F.R. Part 10)) the IRS has provided standards applicable to those conducting tax research.

Best practices require the following (31 C.F.R. §10.33(a)):

• Establishing the facts, determining which facts are relevant, evaluating the reasonableness of any assumptions or representations, relating the applicable law (including potentially applicable judicial doctrines) to the relevant facts, and arriving at a conclusion supported by the law and the facts.

• Advising the client regarding the significance of the conclusions reached (including, for example, whether a taxpayer may avoid accuracy-related penalties under the Code if the taxpayer acts in reliance on the advice).

Tax advisers with responsibility for overseeing a firm’s practice of providing tax advice or of preparing or assisting in the preparation of submissions to the IRS must take reasonable steps to ensure that the firm’s procedures for all members, associates, and employees are consistent with best practices (31 C.F.R. §10.33(b)).

Positions Taken on a Tax Return

If you’re a tax return preparer, you prepare a return or claim for refund with an understatement of tax liability due at least in part to an unreasonable position, and you knew or reasonably should have known that the position was unreasonable, you can be penalized the greater of $1,000 or 50 percent of the income you derived (or are to derive) with respect to the return or claim. Code Sec. 6694(a)(1).

Tax return preparer. An individual is a "tax return preparer" if the individual is primarily responsible for a position on a return or claim for refund giving rise to an understatement of tax liability. Reg. 1.6694-1(b)(1).

Exception. No penalty will be imposed if there is reasonable cause for the understatement and the tax return preparer acted in good faith. Code Sec. 6694(a)(3).

Increased penalty for willful or reckless conduct. If a tax return preparer willfully attempts in any manner to understate tax liability on a return or claim or recklessly or intentionally disregards rules or regulations, the penalty is the greater of $5,000 or 50 percent of the income derived (or to be derived) with respect to the return or claim. Code Sec. 6694(b)(1).

Unreasonable position. A position is unreasonable if (Code Sec. 6694(a)(2)):

• The position (other than a position with respect to a tax shelter or a reportable transaction) was adequately disclosed but there is no reasonable basis for it.

Reasonable basis standard. Reasonable basis is a relatively high standard of tax reporting, significantly higher than not frivolous or not patently improper. The reasonable basis standard is not satisfied by a return position that is merely arguable or merely a colorable claim. If a return position is reasonably based on one or more of the authorities set forth in Reg. §1.6662-4(d)(3)(iii) (taking into account the relevance and persuasiveness of the authorities and subsequent developments), the return position will generally satisfy the reasonable basis standard. For purposes of determining whether a tax return preparer has a reasonable basis for a position, the tax return preparer may rely in good faith without verification on information furnished by the taxpayer and information and advice furnished by another tax return preparer or other preparer. Reg. §1.6694-2(d)(2).

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Adequate disclosure by a signing tax return preparer. Disclosure is adequate if (1) it is made on a properly completed and filed IRS Form 8275, Disclosure Statement, or IRS Form 8275-R, Regulation Disclosure Statement, as appropriate, or on the tax return in accordance with instructions provided by a revenue procedure, (2) the tax return preparer provides the taxpayer with a prepared tax return that includes the disclosure, or (3) for returns or claims for refund subject the Code Sec. 6662 accuracy-related penalty on underpayments (other than an underpayment due to a substantial understatement of income tax), the tax return preparer advises the taxpayer of the penalty standards applicable to the taxpayer under Code Sec. 6662 and contemporaneously documents the advice in the tax return preparer’s files. Reg. §1.6694-2(d)(3).

Adequate disclosure by a nonsigning tax return preparer. Disclosure is adequate if it is made on a properly completed and filed IRS Form 8275, Disclosure Statement, or IRS Form 8275-R, Regulation Disclosure Statement, as appropriate, or on the tax return in accordance with instructions provided by a revenue procedure, If a nonsigning tax return preparer provides advice to a taxpayer, disclosure is adequate if the tax return preparer advises the taxpayer of any opportunity to avoid any accuracy-related penalties under Code Sec. 662 that could apply to the position and of the standards for disclosure and contemporaneously documents the advice in the tax return preparer’s files. If a nonsigning tax return preparer provides advice to another tax return preparer, disclosure is adequate if the nonsigning tax return preparer advises the other tax return preparer that disclosure under Code Sec. 6694(a) may be required and contemporaneously documents the advice in the nonsigning tax return preparer’s files.

• The position (other than a position with respect to a tax shelter or a reportable transaction) was not adequately disclosed and there is or was no substantial authority for it.

Substantial authority standard. The substantial authority standard is an objective standard involving an analysis of the law and application of the law to relevant facts. It is less stringent than the more likely than not standard but more stringent than the reasonable basis standard.

• The position is with respect to a tax shelter or a reportable transaction and it is not reasonable to believe that the position would more likely than not be sustained on its merits.

Reportable transaction. A "reportable transaction" is any transaction with respect to which information is required to be included with a return because the IRS has determined that the transaction has potential for tax avoidance or evasion. Code Sec. 6694(a)(2)(C).

More likely than not standard. It is reasonable to believe that a position would more likely than not be sustained on its merits if the tax return preparer reasonably concludes in good faith that the position has a greater than 50 percent likelihood of being sustained on its merits.

The possibility that a position will not be challenged by the IRS (e.g., because the taxpayer’s return may not be audited or the issue may not be raised on audit) is not taken into account in determining whether the substantial authority, reasonable basis, or more likely than not standard has been satisfied. Reg. 1.6694-2(b)(1).

Advising Clients About Potential Penalties

If you advise a client to take a position on a tax return or prepare or sign a tax return, you must inform your client of any penalties reasonably likely to apply to the client with respect to the position. You also must inform your client of any opportunity to avoid any such penalties by disclosure, if relevant, and of the requirements for adequate disclosure (31 C.F.R. §10.34(c)).

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Requirements Regarding Written Advice

If you give written advice (including electronic communications) concerning one or more federal tax issues you must satisfy the following requirements (31 C.F.R. §10.37(a)):

• You must not base your written advice on unreasonable factual or legal assumptions (including assumptions as to future events).

• You must not unreasonably rely on representations, statements, findings, or agreements of the taxpayer or any other person.

• You must consider all relevant facts that you know or should know.

• In evaluating a federal tax issue, you may not take into account the possibility that a tax return will not be audited, an issue will not be raised on audit, or an issue will be resolved through settlement if raised on audit.

Covered Opinions

Stricter standards of practice have been prescribed for tax advisers who provide a covered opinion (31 C.F.R. §10.35).

'Covered Opinion' Defined

A "covered opinion" is written advice (including electronic communications) by a tax adviser concerning one or more federal tax issues arising from: (1) a transaction that is the same as or substantially similar to a transaction that, at the time the advice is rendered, the IRS has determined to be a tax avoidance transaction and identified by published guidance as a listed transaction; (2) any partnership or other entity, any investment plan or arrangement, or any other plan or arrangement whose principal purpose is the avoidance or evasion of any tax imposed by the Code; or (3) any partnership or other entity, any investment plan or arrangement, or any other plan or arrangement that has as a significant purpose the avoidance or evasion of any tax imposed by the Code if the written advice is a reliance opinion, is a marketed opinion, is subject to conditions of confidentiality, or is subject to contractual protection (31 C.F.R. §10.35(b)(2)(i)).

Reliance opinion. Written advice is a "reliance opinion" if it concludes at a confidence level of more than likely than not (a greater than 50 percent likelihood) that one or more significant federal tax issues would be resolved in the taxpayer’s favor (31 C.F.R. §10.35(b)(4)(i)).

Marketed opinion. Written advice is a "marketed opinion" if the tax adviser knows or has reason to know that it will be used or referred to by a person other than the tax adviser (or a person who is a member of, associated with, or employed by the tax adviser’s firm) in promoting, marketing, or recommending a partnership or other entity, investment plan, or arrangement to one or more taxpayers (31 C.F.R. §10.35(b)(5)(i)).

Conditions of confidentiality. Written advice is subject to "conditions of confidentiality" if the tax adviser imposes on one or more recipients of the written advice a limitation on disclosure of the tax treatment or tax structure of the transaction and the limitation on disclosure protects the confidentiality of that tax adviser’s tax strategies, regardless of whether the limitation on disclosure I legally binding (31 C.F.R. §10.35(b)(6)).

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Contractual protection. Written advice is subject to "contractual protection" if the taxpayer has the right to a full or partial refund of fees paid to the tax adviser (or a person who is a member of, associated with, or employed by the tax adviser’s firm) if all or a part of the intended tax consequences from the matters addressed in the written advice are not sustained or if the fees paid to the tax adviser (or a person who is a member of, associated with, or employed by the tax adviser’s firm) are contingent on the taxpayer realizing tax benefits from the transaction (31 C.F.R. §10.35(b)(7)).

Competence to Provide a Covered Opinion A tax adviser must be knowledgeable in all aspects of federal tax law relevant to the opinion being rendered. However, a tax adviser may rely on the opinion of another practitioner with respect to one or more significant federal tax issues unless the tax adviser knows or should know that the other practitioner’s opinion should not be relied on (31 C.F.R. §10.35(d)(1)).

Planning Pointer: If a tax adviser relies on another practitioner’s opinion, the tax adviser’s opinion must identify the other opinion and set forth the conclusions reached in the other opinion (31 C.F.R. §10.35(d)(1)).

Requirements for Covered Opinions

If you provide a covered opinion, you must comply with strict requirements regarding what facts you can rely on, how you relate the applicable law to the relevant facts, how you evaluate significant federal tax issues, how you come to an overall conclusion, and what disclosures you must make.

Factual Matters (31 C.F.R. §10.35(c)(1)):

• Tax advisers must use reasonable efforts to identify and ascertain the facts (which may relate to future events if a transaction is prospective or proposed) and determine which facts are relevant.

• Tax advisers must identify and consider all facts that they determine are relevant • Tax advisers must not base a covered opinion on any unreasonable factual assumption (i.e., any

factual assumption that they know or should know is incorrect or incomplete). • Tax advisers must not base a covered opinion on any unreasonable factual representation,

statement or finding of the taxpayer or any other person.(i.e., a factual representation that the tax adviser knows or should know is incorrect or incomplete).

Relating Law to Facts (31 C.F.R. §10.35(c)(2)):

• Tax advisers must relate the applicable law (including potentially applicable judicial doctrines) to the relevant facts.

• Tax advisers must not assume the favorable resolution of any significant federal tax issue or otherwise base an opinion on any unreasonable legal assumptions, representations, or conclusions.

• A tax adviser’s legal analyses and conclusions must be internally consistent.

Evaluation of Significant Federal Tax Issues (31 C.F.R. §10.35(c)(3)):

• Tax advisers must consider all significant federal tax issues unless the opinion is a limited scope opinion and certain other requirements are satisfied.

• Tax advisers must provide their conclusion as to the likelihood that the taxpayer will prevail on the merits with respect to each significant federal tax issue considered in the opinion. If a tax adviser is unable to reach a conclusion with respect to one or more of those issues, the tax adviser must say so. Tax advisers must describe their reasons for their conclusions, including the facts and analysis supporting the conclusions, or describe the reasons that the practitioner is unable to reach a conclusion as to one or more issues.

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• In the case of a marketed opinion, if a tax adviser cannot conclude that the taxpayer is more likely than not to prevail with respect to each significant federal tax issue the tax adviser must not provide the opinion.

Overall Conclusion (31 C.F.R. §10.35(c)(4)):

• Tax advisers must provide their overall conclusion as to the likelihood that the federal tax treatment of the transaction or matter that is the subject of the opinion is the proper treatment and the reasons for that conclusion. If they cannot reach an overall conclusion, they must say so and explain why.

• In the case of a marketed opinion, tax advisers must provide their overall conclusion that the federal tax treatment of the transaction or matter that is the subject of the opinion is the proper treatment at a confidence level of at least more likely than not.

Required Disclosures (31 C.F.R. §10.35(e)):

• A covered opinion must prominently disclose the existence of any referral agreement or compensation arrangement between the tax adviser (or the tax adviser’s firm or any person who is a member of, associated with, or employed by the tax adviser’s firm) and any person (other than the client for whom the opinion is prepared) engaged in, or with respect to, promoting, marketing or recommending the entity, plan, or arrangement (or a substantially similar arrangement) that is the subject of the opinion.

• A marketed opinion must prominently disclose that (1) it was written to support the promotion or marketing of the transaction(s) or matter(s) addressed in the opinion and (2) the taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor.

• A limited scope opinion must prominently disclose that (1) it is limited to the one or more federal tax issues addressed in the opinion, (2) additional issues may exist that could affect the federal tax treatment of the transaction or matter that is the subject of the opinion, and (3) the opinion was not written, and cannot be used by the taxpayer, with respect to any significant federal tax issues outside the limited scope of the opinion to avoid penalties that may be imposed on the taxpayer.

• An opinion that does not reach a conclusion at a confidence level of at least more likely than not with respect to a significant federal tax issue must prominently disclose that fact and that it cannot be used by the taxpayer to avoid penalties with respect to that tax issue.

Clients Not in Compliance With Tax LawsIf you know that a client has not complied with the tax laws or has made an error in or omission from any return, document, affidavit, or other paper that the client has submitted or executed, you must advise the client promptly of the noncompliance, error, or omission and the consequences of that noncompliance, error, or omission (31 C.F.R. §10.21).

Study Question 1. Which one of the following statements about a tax adviser's duties under the IRS' standards of

practice for tax professionals (Circular 230) is NOT correct?

If a tax adviser advises a client to take a position on a tax return, the adviser must inform the client of any penalties reasonably likely to apply to the client with respect to the position.

A tax return preparer may be penalized for a position that is adequately disclosed to the IRS if there is no reasonable basis for the position.

The substantial authority standard is less stringent than the more likely than not standard but more stringent than the reasonable basis standard.

When deciding how likely it is that a tax position will be sustained by the IRS, consider how likely it is that the IRS will audit the tax return.

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Special Ethical Duties for Accountants in Conducting Tax Research The American Institute of Certified Public Accountants (AICPA) has adopted Statements on Standards for Tax Services that are enforceable against members of the AICPA. The AICPA's Statement on Standards for Tax Services No. 1, Tax Return Positions, sets forth standards to be followed when recommending tax return positions. Among those standards are:

• As a general rule, a CPA should not recommend that a tax return position be taken unless the CPA has a good-faith belief that the position has a realistic possibility of being sustained administratively or judicially on its merits if challenged (Statement on Standards for Tax Services No. 1, Tax Return Positions, paragraph 2a).

Realistic possibility standard. To satisfy the realistic possibility standard, a CPA should in good faith believe that a tax return position is warranted by existing law or can be supported by a good-faith argument for an extension, modification, or reversal of existing law through the administrative or judicial process (Statement on Standards for Tax Services No. 1, Tax Return Positions, paragraph 7; Interpretation No. 1-1, "Realistic Possibility Standard" of Statement on Standards for Tax Services No. 1, Tax Return Positions, paragraph 2). The likelihood of an audit or detection is not taken into consideration when determining whether the realistic possibility standard has been satisfied (Interpretation No. 1-1, "Realistic Possibility Standard" of Statement on Standards for Tax Services No. 1, Tax Return Positions, paragraph 4).

The realistic possibility standard is less stringent than the substantial authority standard and the more likely than not standard (a greater than 50-percent likelihood of the position being upheld) but is stricter than the reasonable basis standard (Interpretation No. 1-1, "Realistic Possibility Standard" of Statement on Standards for Tax Services No. 1, Tax Return Positions, paragraph 5).

• A CPA may recommend a tax return position that does not satisfy the realistic possibility standard if the CPA concludes that the position is not frivolous and recommends appropriate disclosure of the position (Statement on Standards for Tax Services No. 1, Tax Return Positions, paragraph 2c). A position is frivolous if it is knowingly advanced in bad faith and is patently improper (Statement on Standards for Tax Services No. 1, Tax Return Positions, paragraph 9).

Mininger Kitchen Cabinets, Inc. engaged in a transaction adversely affected by a new Code provision. Prior law was favorable to the company. The company and its CPA, Kelle Pullam, both believe that the new Code provision is unfair to taxpayers in the company's situation. However, the Code provision is unambiguous and constitutional. Because the Code provision is unambiguous and constitutional, a position contrary to the Code provision ordinarily would be considered frivolous (Interpretation No. 1-1, "Realistic Possibility Standard" of Statement on Standards for Tax Services No. 1, Tax Return Positions, paragraphs 12, 13).

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The facts are the same as in the previous example except that the legislative history for the new Code provision addresses the company's situation and supports a position favorable to the company. Because the legislative history addresses the company's situation, taking a position based on that legislative history would satisfy the realistic possibility standard (Interpretation No. 1-1, "Realistic Possibility Standard" of Statement on Standards for Tax Services No. 1, Tax Return Positions, paragraphs 14, 15).

The facts are the same in the previous example except that the legislative history does not specifically address the company's situation but can be interpreted as providing some authority for the company's position. Because the legislative history does not specifically address the company's situation, taking a position based on that legislative history would not meet the realistic possibility standard. However, taking a position based on that legislative history would not be frivolous (Interpretation No. 1-1, "Realistic Possibility Standard" of Statement on Standards for Tax Services No. 1, Tax Return Positions, paragraphs 16, 17).

Janay Masino insisted on taking a particular tax return position even though her CPA, Angelena Lanouette, concluded that Janay's position was frivolous. Janay decided to take the position even though it was frivolous because she did not believe that the position would be detected by the IRS on an audit. The likelihood of an audit or detection cannot be considered when determining whether the realistic possibility standard has been satisfied. Therefore, Angelena cannot prepare or sign a return that contains a frivolous position even if that position is disclosed (Interpretation No. 1-1, "Realistic Possibility Standard" of Statement on Standards for Tax Services No. 1, Tax Return Positions, paragraphs 28, 29).

Kilingworth Light Fixtures, Inc. asked its CPA, Cary Radunz, whether it could currently deduct an expenditure or whether it would have to capitalize the expenditure and amortize it over a number of years. Cary found a revenue ruling requiring taxpayers to capitalize that type of expenditure. He also found a U.S. Tax Court decision permitting taxpayers to currently deduct that type of expenditure. The realistic possibility standard would be met by either tax return position (Interpretation No. 1-1, "Realistic Possibility Standard" of Statement on Standards for Tax Services No. 1, Tax Return Positions, paragraphs 34, 35).

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Subsequent Developments Affecting Advice Previously Provided

The AICPA does not impose any obligation on a CPA to inform a client about developments that affect prior advice unless the CPA is assisting the client in implementing plans or procedures associated with the advice given or the CPA has agreed to inform a client about developments that affect advice given by the CPA (Statement on Standards for Tax Services No. 8, Form and Content of Advice to Taxpayers, paragraph 4).

Study Question 1. Which one of the following statements about the Statements on Standards for Tax Services

adopted by the American Institute of Certified Public Accountants (AICPA) is NOT correct?

As a general rule, a CPA should not recommend that a tax return position be taken unless the CPA has a good-faith belief that the position has a realistic possibility of being sustained administratively or judicially on its merits if challenged.

To satisfy the realistic possibility standard, a CPA should in good faith believe that a tax return position is warranted by existing law or can be supported by a good-faith argument for an extension, modification, or reversal of existing law through the administrative or judicial process.

The realistic possibility standard is less stringent than the substantial authority standard and the more likely than not standard but stricter than the Code's reasonable basis standard.

A CPA is required to inform a client about developments that affect advice that the CPA previously has given the client.

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Conclusion Whether research is for tax compliance or for tax planning, the process is the same:

• Gather relevant facts

• Take the factual situation presented by a client and identify the tax questions posed

• Locate primary sources relevant to the tax question

• Analyze and evaluate the primary sources

• Obtain any additional facts required, and apply the relevant primary sources to those additional facts

• Draw conclusions and develop recommendations

• Communicate research results to other professionals and clients

By following these steps, you can improve the quality of your work and minimize the risk of dissatisfied clients.

Tax Research: Process (Third Edition) 46

Final Exam

Exam Instructions: Choose the best answer for each question below based upon the information provided in the course content. Then submit your answers.

You can change your answers any time prior to clicking the submit test button.

You have three (3) chances to submit the exam for a passing grade. Each time you click the Submit button is considered an attempt.

You must pass the Final Exam with a score of 70% or higher in order to receive Continuing Professional Education (CPE) credit for completing the course.

Your Certificate of Completion will be available after you successfully complete the course.

Users of JAWS accessibility software may use the "P" key to navigate the screens containing Study Questions or the Final Exam.

Expiration: This course must be completed within one year of enrollment.

1. Which one of the following statements is NOT correct?

When a tax adviser does research to determine whether a deduction is allowed for an expenditure that a taxpayer has made, the tax adviser is doing tax compliance research.

When a tax adviser does research to determine how a transaction can be structured to save a client taxes, the tax adviser is doing tax planning research.

Taking advantage of a tax loophole is tax avoidance.

Illegally reducing one's tax liability is tax avoidance.

2. Which of the following is NOT one of the steps in the tax research process?

Gathering relevant facts.

Locating all of the secondary sources that pertain to the client's tax question.

Identifying tax questions.

Analyzing and evaluating the primary sources that have been located.

3. Which one of the following is NOT an example of a fact? Assume that information provided is

correct.

Emilio Farrey turned 36 during the year.

Valerie Rizvi had a car accident.

Salam Frames opened a new office.

Marlin Baese was paid a reasonable salary for his work.

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4. Under which one of the following circumstances would Madelene Wesby be required to verify

information supplied by a client?

Madelene's client told her that he was a U.S. citizen.

Madelene's client told her that she was single.

Madelene's client told her that the $15,000 she paid her 14-year-old son to do work for her business during the summer was what she would have paid anyone hired for the same work.

Madelene's client told her that he had lived in his home for the past eight years.

5. Marlen Osoria said that he disposed of some property and wants to know whether he has to

include any of the proceeds in his gross income for the year. Which one of the following questions does NOT have to be asked when gathering information to answer Marlen's question?

When did the disposition occur?

Was the disposition a sale or exchange?

What amount of compensation did Marlen receive for the year?

What is the relationship between Marlen and the transferee?

6. Which one of the following is NOT an example of a tax question?

Is a client entitled to an education credit for tuition payments?

How much compensation did a client receive from the client's employer?

Can a client claim a child as a dependent?

Can a client deduct travel expenses from home to work?

7. Which one of the following is NOT a primary source?

A memorandum written on a similar tax question by another tax adviser.

A Treasury regulation.

A decision by the U.S. Tax Court.

The Internal Revenue Code.

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8. Which one of the following is NOT a secondary source?

The official publication of the proceedings of a tax institute.

A tax service.

An IRS revenue procedure.

A citator.

9. Which one of the following steps would be LEAST helpful in answering a tax question?

Using a computer to search for judicial decisions relating to the tax question.

Calling the IRS.

Consulting a treatise that discusses the tax question.

Using a citator.

10. Devora Abdul has been asked to determine whether a client can deduct the cost of a stop-

smoking program as a medical expense. Which one of the following authorities is most important in answering this tax question?

A U.S. Tax Court decision that permitted a taxpayer to deduct the cost of a weight-loss program.

A U.S. Supreme Court decision that the cost of medical care to prevent an illness can be deducted as a medical expense.

A U.S. Court of Appeals decision that the cost of a drug rehabilitation program can be deducted as a medical expense.

An IRS revenue ruling deciding that the cost of a stop-smoking program can be deducted as a medical expense.

11. If each of the following authorities provides a different answer to a tax question, on which one should a tax adviser rely?

A Treasury regulation.

A treatise.

The U.S. Court of Appeals with jurisdiction over the taxpayer.

IRS instructions for a tax form.

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12. Which one of the following statements is NOT correct?

A U.S. Tax Court decision can apply to a taxpayer even though it was rendered for a taxpayer in another state.

An IRS technical advice memorandum cannot be relied on as authority by a taxpayer other than the taxpayer to whom it was issued.

The IRS need not follow a decision by a U.S. Court of Appeals with respect to a taxpayer if that court has no jurisdiction over the taxpayer.

The U.S. Tax Court must follow the decision of a U.S. Court of Appeals even though the Tax Court's decision cannot be appealed to that particular court.

13. Which one of the following typically is included in a tax adviser's letter to a client but not in a tax memorandum?

A statement regarding the tax adviser's understanding of what the client asked the adviser to do.

A statement of the pertinent facts.

A statement of the applicable law.

An analysis of the applicable law.

14. Which one of the following is NOT a duty imposed on a tax adviser by the IRS' standards of

practice for tax professionals (Circular 230)?

Tax advisers must inform their client of any penalties that they are reasonably likely to have to pay if they take the recommended position.

When doing tax research, tax advisers must establish the facts, determine which facts are relevant, relate the applicable law to the relevant facts, and arrive at a conclusion supported by the law and the facts.

When determining how likely it is that a recommended position will be sustained by the IRS, a tax return preparer must consider the possibility that the client's tax return will not be audited or that any dispute regarding a position taken on a tax return will be settled.

A position that a tax return preparer recommends a client take on a tax return must satisfy a higher standard if it is not adequately disclosed.

15. Which one of the following is NOT permitted by the Statements on Standards for Tax Services adopted by the American Institute of Certified Public Accountants (AICPA)?

A CPA may recommend that a client take a tax return position that is frivolous, but only if the CPA recommends appropriate disclosure of the position.

A CPA can recommend that a client take a tax return position if the CPA believes in good faith that there is a realistic possibility that the position will be sustained administratively or judicially on its merits if challenged.

A CPA can recommend that a client take a tax return position that is not warranted by current law if the CPA can make a good-faith argument that current law has been wrongly decided.

A CPA need not inform a client about developments that affect advice that the CPA previously gave the client if the CPA no longer is performing services for the client and never agreed to inform the client about subsequent developments that affect advice previously given.

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